Research Handbook on Corporate Taxation (Research Handbooks in Private and Commercial Law series) 1803923105, 9781803923109

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RESEARCH HANDBOOK ON CORPORATE TAXATION

RESEARCH HANDBOOKS IN PRIVATE AND COMMERCIAL LAW The Research Handbooks in Private and Commercial Law series is a forum for Research Handbooks covering both the traditional private law topics, such as torts, contracts, equity and unjust enrichment, as well as more commercial topics such as the sale of goods, corporate restructuring, commercial contracts and taxation, among others. Reflecting the approach of the wider Elgar Research Handbooks programme they are unrivalled in their blend of critical, substantive analysis and synthesis of contemporary research. Each Research Handbook stands alone as an invaluable source of reference for all scholars interested in private and commercial law. Whether used as an information resource on key topics or as a platform for advanced study, volumes in this series will become definitive scholarly reference works in the field. For a full list of Edward Elgar published titles, including the titles in this series, visit our website at www​.e​-elgar​.com​.

Research Handbook on Corporate Taxation Edited by

Reuven S. Avi-Yonah Irwin I. Cohn Professor of Law, University of Michigan Law School, USA

RESEARCH HANDBOOKS IN PRIVATE AND COMMERCIAL LAW

Cheltenham, UK • Northampton, MA, USA

© The Editor and Contributors Severally 2023

Cover image: drmakete lab on Unsplash All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023939689 This book is available electronically in the Law subject collection http://dx.doi.org/10.4337/9781803923116

ISBN 978 1 80392 310 9 (cased) ISBN 978 1 80392 311 6 (eBook)

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Contents

List of contributorsvii PART I

FOUNDATIONS

1

Introduction to the Research Handbook on Corporate Taxation2 Reuven S. Avi-Yonah

2

Why tax corporations? Yariv Brauner

3

The history of the corporate tax Steven Bank

22

4

The incidence of the corporate tax Eric Toder

38

PART II

4

CORPORATE OPERATIONS

5

Corporate/shareholder tax integration George K. Yin

57

6

Tax aspects of incorporations Gregg Polsky

72

7

Tax aspects of corporate mergers and acquisitions Heather M. Field

83

8

International aspects of US corporate taxation J. Clifton Fleming, Jr.

112

PART III COMPARATIVE CORPORATE TAXATION 9

Corporate taxation in the EU Christiana HJI Panayi

130

10

Corporate taxation in the UK Michael McGowan

150

11

Corporate taxation in Germany Joachim Englisch

168

12

Corporate taxation in France Marilyne Sadowsky

194

v

vi  Research handbook on corporate taxation 13

Corporate taxation in Italy Carlo Garbarino

208

14

Corporate taxation in Canada Scott Wilkie

225

15

Corporate taxation in Turkey Funda Başaran Yavaşlar

250

16

Corporate taxation in New Zealand Craig Elliffe

271

17

Corporate taxation in Japan Yoshihiro Masui

288

18

Corporate taxation in China Wei Cui

302

19

Corporate taxation in India Arvind P. Datar

319

20

Corporate taxation in Brazil Luís Eduardo Schoueri and Guilherme Galdino

329

PART IV CORPORATE TAX PLANNING 21

Corporate tax shelters Joshua Blank and Ari Glogower

348

22

Economic substance Amandeep S. Grewal

366

23

Corporate tax and corporate social responsibility Peter Barnes

376

24

Executive compensation and corporate governance Michael Doran

391

PART V

CONCLUSION

25

The future of the corporate tax Daniel Shaviro

409

26

A new corporate tax? Reuven S. Avi-Yonah

434

Bibliography444 Index451

Contributors

Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, University of Michigan Steven Bank, Paul Hastings Endowed Chair in Business Law, University of California Los Angeles School of Law Peter Barnes, Senior Lecturing Fellow, Duke Law School Funda Başaran Yavaşlar, Professor, Alexander von Humboldt Foundation Joshua Blank, Professor of Law, Faculty Director of Strategic Initiatives, University of California Irvine Law School Yariv Brauner, Hugh Culverhouse Eminent Scholar Chair in Taxation and Professor of Law, Levin College of Law, University of Florida Wei Cui, Professor, Peter A. Allard School of Law, University of British Columbia Arvind P. Datar, Lecturer, Sai University; Senior Advocate, Supreme Court of India Michael Doran, Professor of Law, University of Virginia Craig Elliffe, Professor of Taxation and Law, University of Auckland Faculty of Law Joachim Englisch, Professor of Public Law and Tax Law, Münster University Heather M. Field, Stephen A. Lind Professor of Law and Co-Director of Center on Tax Law, University of California College of the Law, San Francisco J. Clifton Fleming, Jr., Ernest L. Wilkinson Chair and Professor of Law, J. Reuben Clark Law School, Brigham Young University Guilherme Galdino, M.Sc. and LL.B., University of São Paulo Carlo Garbarino, Professor of Law, Bocconi University Ari Glogower, Professor of Law, Northwestern Pritzker School of Law Amandeep S. Grewal, Orville L. and Ermina D. Dykstra Professor in Income Tax Law, University of Iowa Christiana HJI Panayi, Professor in Tax Law, Queen Mary University of London Yoshihiro Masui, Professor of Law, University of Tokyo Michael McGowan, Visiting Professor, King’s College London Gregg Polsky, Francis Shackelford Distinguished Professor in Taxation Law, University of Georgia Marilyne Sadowsky, Associate Professor of Tax Law, University Panthéon-Sorbonne vii

viii  Research handbook on corporate taxation Luís Eduardo Schoueri, Professor of Tax Law, University of São Paulo Daniel Shaviro, Wayne Perry Professor of Taxation, New York University Eric Toder, Institute Fellow and Co-Director of the Urban-Brookings Tax Policy Center, Urban Institute Scott Wilkie, Former Distinguished Professor of Practice, Osgoode Hall Law School, York University George K. Yin, Edwin S. Cohen Distinguished Professor of Law and Taxation Emeritus, University of Virginia

PART I FOUNDATIONS

1. Introduction to the Research Handbook on Corporate Taxation Reuven S. Avi-Yonah

Corporations are everywhere and nowhere in our society. They are everywhere, first and foremost, on the economic scene: over 80 percent of economic activity in the US is effectuated through the corporate form. But the reach of corporations is far broader than that. Many of our other institutions, including universities, churches, hospitals, and other non-profit organizations are in corporate form. Other salient features of our society, such as representative democracy, originated from the use of the corporate form in medieval England. Even the idea of the state itself originated in Roman and medieval legal notions about corporate bodies.1 And yet, corporations are nowhere. The leading academic theory about corporations, the nexus of contracts (or contractarian) theory, posits that corporations do not really exist: they are merely a convenient connection point for a bundle of relationships between shareholders, bondholders, employees, and customers, to name the most important stakeholder groups. And any useful academic analysis of the corporation must begin by denying its existence and looking through it directly at the various groups of people that interact through it. This is the ‘aggregate’ view of the corporation that sees it primarily as the amalgam of its owners. It was not always so. Around 1909, when the US corporate income tax was first adopted, there were a variety of theories of the corporation, such as the ‘artificial entity’ view that the corporation was a creature of the state. Another theory posited that corporations had a ‘real’ existence separate from both shareholders and the state. Of course, the corporation itself was but a legal fiction, but corporate management was real, and the power that corporate management was able to exercise through use of the corporate form over employees, shareholders, and society at large was real as well. Why and whether the state should tax corporations depends on which view of the corporation is adopted. Under the dominant ‘aggregate’ view, the reason to tax corporations is to indirectly tax their shareholders, which implies that if the state could tax them directly there would be no need for a corporate tax. Under the ‘artificial entity’ view, the state can tax corporations in exchange for the benefits it confers on corporations like limited liability for the shareholders, which in the US implies that only the states should have a corporate tax because there are no federal corporations. The ‘real’ view of corporations, on the other hand, supports taxing corporations as a way of limiting corporate power and regulating corporate economic activities.

This introduction is based in part on Reuven Avi-Yonah, Corporations, Society and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193 (2004). See also more recently Giancarlo Anello, Mohamed A. Arafa, and Sergio Alberto Gramitto Ricci, Sacred Corporate Law, 45 Seattle University Law Review (2021), accessed February 24, 2023 at SSRN: https://​ssrn​.com/​abstract​=​4197184 or http://​ dx​.doi​.org/​10​.2139/​ssrn​.4197184. 1

2

Introduction  3 Regardless of these academic debates, it is a fact that most countries in the world tax corporations, and therefore that the corporate tax is of great practical as well as theoretical interest. About 10 percent of total tax revenues in Organisation for Economic Co-operation and Development (OECD) countries derive from the corporate tax, and that percentage is higher in developing countries that find corporations easier to tax than individuals. The goal of this Research Handbook is to examine the corporate income tax both in the US and around the world. This examination is designed to be useful to tax practitioners, policy makers, and academics. For practitioners, it offers an overview of this important tax as it is practiced around the world. For policy makers, it addresses some of the cutting-edge normative issues in designing a corporate tax. For academics, it addresses the relationship among corporations, society, and the state through the lens of the corporate income tax. The Handbook is divided into five parts: Foundations (Chapters 1–4), Taxation of US Corporate Operations (Chapters 5–8), Comparative Corporate Taxation (Chapters 9–20), US Corporate Tax Planning (Chapters 21–24), and Conclusion (Chapters 25–26). After this introduction, Part I addresses basic questions like why the corporate tax exists (Yariv Brauner), the history of the corporate tax (Steven Bank), and the incidence of the corporate tax (Eric Toder). Part II explains the taxation of US corporations. George Yin lays out the US treatment of corporate/shareholder tax integration. Gregg Polsky addresses incorporations, Heather Field explains corporate taxable and tax-free mergers, divisions, and liquidations, and Cliff Fleming covers the international aspects of US corporate taxation. Part III explains the taxation of corporations in 12 jurisdictions: the EU (Christiana Panayi), the United Kingdom (Michael McGowan), Germany (Joachim Englisch), France (Marilyne Sadowsky), Italy (Carlo Garbarino), Canada (Scott Wilkie), Turkey (Funda Başaran Yavaşlar), New Zealand (Craig Elliffe), Japan (Yoshihiro Masui), China (Wei Cui), India (Arvind Datar), and Brazil (Lúis Eduardo Schoueri and Guilherme Galdino). Part IV addresses US corporate tax planning with chapters on corporate tax shelters (Joshua Blank and Ari Glogower), the economic substance doctrine (Amandeep Grewal), taxation and corporate social responsibility (Peter Barnes), and executive compensation and corporate governance (Michael Doran). Part V concludes with two visions of the future of the corporate tax by Daniel Shaviro and Reuven Avi-Yonah. It closes the circle by returning to the question of how the reason for taxing corporations (Chapter 2) should inform the form of the corporate tax (Chapter 26).

2. Why tax corporations? Yariv Brauner

1. INTRODUCTION The corporate income tax attracts more attention and controversy than any other tax. Recent developments made it the center of one of the most ambitious international tax policy coordination projects in history, namely the Base Erosion and Profit Shifting (BEPS) project.1 BEPS benefitted from an unprecedented political will (and pressure). This attention was somewhat strange for a tax that is not that important in terms of revenue, and its rates universally decreasing for many years.2 It is also curious since there is little consensus over the rationale of the corporate income tax, which is the topic of this chapter. Rationale aside, corporate income taxes are today virtually universal. Automatically adhering to the legal construct of separate corporate personality, countries generally view corporations as taxpayers, independent of their shareholders and other stakeholders. Corporate income taxes personify corporate taxpayers using rules that are quite similar to the tax rules applicable to flesh and blood taxpayers. The differences between the individual and corporate income tax rules are essentially adjustments to the unique personhood of corporations,3 and almost always have administrative and enforcement (or anti-abuse) purposes. The reliance on the separate corporate personality is blind and not coordinated with its source, namely the business organizations law that had already adopted norms and mechanisms for piercing the corporate veil. Corporate income taxes elected rather to develop their own sets of anti-abuse rules, presumably based on their different functions, often resulting in voluminous and complex legal regimes.4 If that is not enough, corporate income taxes are often used to implement various governments’ policies, which complicates them even further. Understanding corporate income taxes and using them as platforms for policy delivery requires, first and foremost, an understanding of their impact. In simple terms, one must understand who bears the burden of the corporate income tax if one wishes to use it for such purpose. Economists have struggled for many years with this question that they term the corporate tax incidence, as elaborated on in Chapter 4, infra. Alas, the answers to this question are quite complex and often difficult to translate to simple policy measures. One key message of this chapter is therefore that corporate income taxes are crude policy instruments that are difficult (or even impossible) to fine-tune for the purposes of implementing specific policies. Despite

See https://​www​.oecd​.org/​tax/​beps/​ (last accessed 22 July 2022). See, e.g., OECD, Corporate Tax Statistics (3rd ed., 2021), available at https://​www​.oecd​.org/​tax/​ tax​-policy/​corporate​-tax​-statistics​-third​-edition​.pdf (last accessed 22 July 2022). 3 Take, for example, the corporate residence rules that naturally cannot rely on the physical presence of corporations, these being mere legal fictions, and hence require proxies, such as the place of management and control or place of effective management. 4 The complexity is therefore inherent in the corporate income tax. See David A. Weisbach, The Irreducible Complexity of Firm-Level Income Taxes: Theory and Doctrine in the Corporate Tax, 60 Tax L. Rev. 215 (2007). 1 2

4

Why tax corporations?  5 the legal personification of corporations as taxpayers, their taxation is not, and cannot be, born by their fictional personalities; it is born by natural persons with varying and different economic relations with corporations. The difficulty to predict such burdens must raise the question: why tax corporations when it is not clear what will be the impact of such taxation? This chapter reviews various answers provided by scholars and other tax experts to this question, with this author concluding that none of these answers are satisfactory, leaving political and administrative convenience as the only possible answer to the core question of this chapter.5 The chapter proceeds as follows. Section 2 next discusses the origins of the corporate income tax debate. Section 3 reviews the arguments in support of different rationales of the corporate income tax and a critical assessment of these arguments. Section 4 explores what we know about the corporate income tax incidence and how we can use that knowledge in its design. Section 5 concludes with an attempted explanation of the resilience of corporate income taxes despite their lack of a robust policy rationale.

2.

THE ORIGINS OF THE CORPORATE INCOME TAX DEBATE

2.1

The Ascent of the Modern Corporation6

Corporations could be tracked to as early as the Roman Empire. Roman law permitted certain entities’ existence in perpetuity, which was the primary reason for originally having them. They had various rights and obligations independent from their human representatives. These early corporations were typically related to church (indeed, the Catholic Church itself was one), municipalities, and so on. Their legal status was created by charter, usually from an emperor. The origins of the modern corporation are in the various colonial corporations that facilitated international trade for the European powers of the time, beginning with the Dutch East India Company and the British East India Company, who clearly had commercial profits as their primary goal.7 Towards the 19th century corporations further assumed private profits and commercial goals rather than public purposes. In the United States, corporations were explicitly given independent rights and freedom from the tight public purpose regulation of years past.8 States began enacting laws to attract incorporated businesses, beginning with New Jersey and Delaware. An 1886 Supreme Court 5 This chapter is a continuance of prior work of the author on this topic, included in Yariv Brauner, The Non-Sense Tax: A Reply to New Corporate Income Tax Advocacy, 2008 Mich. St. L. Rev. 591; and Yariv Brauner, Should Corporations Be Taxpayers?, in Anthony C. Infanti, Controversies in Tax Law: A Matter of Perspective (Routledge, 2017), 177. 6 A comprehensive study of the history of corporations and income taxes is, of course, beyond the scope of this chapter. For a more thorough introduction to the topic see, e.g., Ron Harris, The Institutional Dynamics of Early Modern Eurasian Trade: The Commenda and the Corporation, 71 J. Econ. Behavior & Org. 606 (2009). 7 See, e.g., Nick Robins, The Corporation that Changed the World: How the East India Company Shaped the Modern Multinational (Pluto Press, 2006). 8 Which was the reason that many large businesses had originally chosen not to incorporate. The legal sea change became clear with the Supreme Court decision in Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819). This decision shattered the last franchise or charter elements of corporate law. In the U.K. it took a few more years, until the Joint Stock Companies Act of 1844 and Limited

6  Research handbook on corporate taxation decision, in Santa Clara County vs. Southern Pacific Railroad Company, that a private corporation was a ‘natural person’ under the Constitution and therefore entitled to protection under the Bill of Rights solidified this progression.9 Suddenly, corporations enjoyed all the rights and sovereignty previously enjoyed only by people. Corporations could now be large enterprises with complex structures and spread ownership that has increasingly been disassociated from their actual control. The trend towards legal personification of corporations has continued, and corporations may now be criminally liable and even claim civil rights such as the freedom of speech in some jurisdictions. Corporate law has also evolved to deal with the challenges that the new, modern corporation poses to society, such as facilitation of market operation, protection of investors in general, and regulating the various agency problems arising from the separation of ownership and control. 2.2

The Parallel Growth of Income Taxation

Income taxes have gained popularity during the same times. Prior to the 20th century there were just a few examples for taxes measured by income, with the first traditionally attributed to William Pitt the Younger in the very last year of the 18th century. Yet, until the 20th century income taxes were limited in scope and instituted exclusively for war financing purposes. This included the United States’ civil war tax. In 1894 Congress enacted the first civil income tax, yet it was ruled unconstitutional,10 eventually leading to the 16th Amendment and the enactment of the individual income tax in 1913. Since then, almost all the world’s countries adopted income taxes of various forms, and these became their primary source of revenue during the 20th century. The United States’ corporate income tax was enacted prior to the current individual income tax, yet that happened solely due to political and historic circumstances rather than for any policy or otherwise intellectual reasons. The tax was enacted in 1909 as a political compromise among the supporters of an income tax, who failed to institute one at the beginning of the 20th century due to constitutional constraints (and would not succeed until the passage of the 16th Amendment and the Income Tax Act of 1913) and large corporate interests who were particularly opposed to the taxation of undistributed earnings. Thus, the corporate income tax was enacted as a surtax measured on corporate earnings. On the side of the administration, the hope to control corporate power accumulation was central to the original political decision to enact the tax in 1909.11 The stated justifications for the corporate income tax enactment included:12 (1) a benefits theory argument, viewing the tax as one that is imposed on the distinct privilege of doing business in the corporate form; (2) administrative convenience – the ease of collection at the ‘source’ of income and from a ‘person’ that is able (at that time) to pay the tax; and (3) the Liability Act of 1955. Corporations can now simply register as such rather than apply to the authorities for a discretionary charter. 9 118 U.S. 394 (1886). 10 Pollock v. Farmers’ Loan & Trust Company, 157 U.S. 429 (1895), aff’d on reh’g, 158 U.S. 601 (1895). 11 See Reuven S. Avi-Yonah, Why Was the U.S. Corporate Tax Enacted in 1909?, in John Tiley, ed., Studies in the History of Tax Law, vol. 2 (Hart Pub., 2007), 377. 12 See Reuven S. Avi-Yonah, Corporations, Society, and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193 (2004), 1217–20.

Why tax corporations?  7 federal government’s desire to regulate corporations.13 An important aspect of this desire was the understanding that corporate tax returns will be public.14 Nonetheless, this last crucial element in the compromise was violated and corporate tax returns, with a limited exception for a short time period, have not been made public in the United States. The compromise was further violated when this temporary proxy tax was not abolished upon the enactment of the individual income tax in 1913. Again, corporate interests worried about the regulatory power that might be given to the government if undistributed earnings were subject to the federal income tax and the administration focused on keeping regulatory power, albeit illusory. This formula, established by an ill-studied, very time and situation specific political compromise still serves as the backbone of the United States corporate income tax despite the tremendous change in circumstances. Needless to say, such historical analysis cannot assist in present day normative research of the corporate income tax despite its great explanatory use in its positive analysis.15 2.3

The Origins of the Corporate Income Tax Debate

The core corporate tax discourse revolves around three analytically separate yet not independent questions: Why tax corporations? How should we tax corporations? Is it politically feasible to reform corporate income taxes? This chapter focuses on the first question, yet necessarily engages with the other two tangential questions. The discussion of the rationale of the corporate income tax must begin with the automatic adherence of tax laws to the separate corporate personality fiction. This fiction had been central to the success of the modern corporation, allowing investors to engage in riskier investment and improve the efficiency of markets and general economic growth. Following it for tax law purposes is puzzling, however, and seems not to have been based on similar grounds, as clearly demonstrated by the historic origins of the corporate income tax summarized above. Over the years, scholars have provided technical, policy, or political reasons for wanting to tax corporations. The technical argument is straightforward: corporations enjoy legal personhood and consequent benefits and therefore should also bear the (nominal) burdens of such separate personhood, including taxation.16 This argument is weak and at the present it is not a serious factor in the sophisticated corporate income tax discourse.17 The policy argument 13 See also Marjorie Kornhauser, Corporate Regulation and the Origins of the Corporate Income Tax, 66 Ind. L. J. 53 (1990), 53. 14 Id. This understanding has not materialized to full disclosure, and today corporate tax returns are essentially all confidential. The latter reason was in line with President Roosevelt’s focus on increasing the power of the Federal government vis-à-vis the large corporations. See Avi-Yonah, supra note 12, 1215–16. 15 See Brauner, The Non-Sense Tax, supra note 5. Interestingly, this picture is not much different in other jurisdictions; not even in the United Kingdom which corporate tax nominally preceded the United States’, yet careful study demonstrates that its modern, real corporate tax followed closely that of the United States. See John Avery Jones, Defining and Taxing Companies 1799 to 1965, in John Tiley, ed., Studies in the History of Tax Law, vol. 5 (Bloomsbury Publishing, 2012), 35–6. 16 See, e.g., Richard M. Bird, Why Tax Corporations? Working Paper 96-2 (prepared for the Technical Committee on Business Taxation) (1996), 4–5. 17 A recent attempt to revive this argument by circumventing the incidence problem is invalid since it proposes a tax different than the corporate income tax (aligning the burdens and benefits of incorporation and corporate taxation) we have at the present, and it does not explain how one would go about

8  Research handbook on corporate taxation includes various elements and versions, yet its core premise relates to the view of corporations as real entities that are different and, in that manner, separate from their stakeholders. According to this view, one cannot simply view corporations as aggregations of their shareholders (or stakeholders) since such view would skew the economic position of corporations in the market. Related arguments include the support of the opportunities that a corporate income tax gives governments to implement other policies (through corporate income tax incentives programs) and the control that a corporate income tax provides governments over corporations. These arguments may be criticized as either false, that is, that corporations should not be viewed as real entities, or as useless in better regulating, from a tax policy perspective, corporations in the market. Finally, the political argument, simplified, is that corporations create opportunities to the better-off in our societies and taxing them would contribute to fairer redistribution of wealth, which is desirable and a goal of our income tax systems. Curiously, this empirical argument is highly influential yet hardly supported by empirical evidence. Against these arguments, the opposition to the corporate income tax focused on its distortive nature and its significant compliance and enforcement costs.18 The straightforward inefficiency created by the corporate tax is that it distorts the allocation of investment between the corporate and the non-corporate sectors. One can make an investment directly or indirectly through a corporation or an unincorporated entity. At the end of the day, it is the same economic investment, yet, if one made the investment through an incorporated entity, one would suffer an additional layer of taxation – the corporate income tax – and thus such a tax creates a disincentive to invest through corporations. This position is simple and easy to understand, yet the law has added to it a multitude of complexity layers that created additional incentives and disincentives to invest (or not invest) through corporations. For example, tax law created significant disincentives to use branches, such as the branch profits tax,19 and other incentives to invest through corporations, such as special allowances, reorganization opportunities, and the opportunity to indefinitely defer the taxation of the shareholders without a loss of financial accounting value.20 This tangle of incentives and disincentives obviously results in significant planning, compliance, and enforcement costs; we all understand that the best, brightest and highest charging tax planners all focus on exactly this tangle of norms. Yet, beyond such costs, the tax clearly shifts investment from and to the corporate sector that would not end up where it does absent the independent corporate income tax, resulting in efficiency losses. A second classical inefficiency created by the tax is in that it distorts the financing of investment. The basic argument is that corporations rely too much on debt rather than equity. Some added that this is also undesirable from a national policy standpoint since it may hurt capital accumulation and consequently economic growth.

implementing that idea. See Simon Naitram and Matthew Weinzierl, The Incidence of the Corporate Income Tax Is Irrelevant for its (Benefit-Based) Justification (December 2021), NBER Working Paper No. w29547, available at SSRN: https://​ssrn​.com/​abstract​=3​ 978405 (last accessed 22 July 2022). 18 See, e.g., Charles E. Mclure, Jr., Must Corporate Income Be Taxed Twice? (The Brookings Institution, 1979); Jane G. Gravelle, The Economic Effects of Taxing Capital Income (The MIT Press, 1994). 19 26 U.S.C. §884. 20 See, e.g., Michael P. Donohoe, Gary A. McGill, and Edmund Outslay, Through a Glass Darkly: What Can We Learn about a US Multinational Corporation’s International Operations from its Financial Statement Disclosures? 65 Nat’l Tax J. 961 (2012).

Why tax corporations?  9 The complexity of the impact of the corporate income tax on the economy often masks the more straightforward or direct costs of the tax. The corporate income tax is not a critical revenue source for almost all the countries. At the same time, there is no question that the most sophisticated and expensive tax planning focuses solely on corporate tax planning exactly for these largest of taxpayers. Consequently, tax authorities must expend their best resources to respond with equally sophisticated and expensive enforcement. Once the inherent complexity of corporations, their ability to reorganize and divide, change seat, and so on are added, it is not difficult to understand that the corporate income tax is considerably more expensive than the individual income tax, for example. These significant costs are typically not considered in the debate over the tax. Despite the above, the corporate income tax has been very resilient, politically, and even the universal critique of the tax that eventually led to the BEPS project has never seriously included a consideration to replace it, but rather consistently aimed at emboldening it. Note that asking for a rationale for taxing corporations in a vacuum is fruitless. Therefore, this chapter assumes that the subject of the discussion is the corporate income tax that we have today, almost universally. The many proposals to completely overhaul the domestic and international tax regime have consistently faced strong opposition that ensured the survival of the classical corporate income tax system. The sentiment that ‘the rich’ bear the burden of the tax and hence they are behind the lobby for its repeal is universally strong, the small revenue contribution of the tax and its costs nonetheless. Finally, there is a strong belief that taxing corporations on a look-through basis is impossible, due mainly to valuation challenges, a belief that further impedes any discussion of alternatives to the corporate income tax. Next, the chapter discusses the strength of all these arguments.

3.

TRADITIONAL ARGUMENTS IN SUPPORT OF TAXING CORPORATIONS

3.1

The Technical Arguments

The basic version of the technical argument is that corporations are separate legal persons and therefore they should not only enjoy the benefits of such status but also bear its burdens, or even pay the price for such benefits in the form of taxation. The problem with this assertion is that corporations do not actually bear the burden of the tax. It is people rather than corporations that both enjoy the benefits of incorporation and potentially suffer the tax on corporations. The benefactors and the sufferers, however, may not be the same people, as is elaborated on in section 4, infra. Moreover, corporate taxes worldwide are not designed based on the logic of this naïve argument. Corporations are taxed on their ‘income’ rather than the benefits they or people affected by them enjoy from their legal status. Also, the corporate tax base and rates are very different from those applying to individuals, which annuls any argument about parity between corporate and real persons. 3.2

The Policy Arguments

A different version of the technical arguments in support of the corporate tax relies on the universal ability-to-pay principle, and hence purports to be policy, or fairness, driven. This

10  Research handbook on corporate taxation version assumes that the better-off in our society disproportionately benefit from the special legal status of corporations. An implicit assumption that is not often articulated is that such people also enjoy further benefits, due to timing realization and other rules that allow them to not immediately include the entire enjoyment in income. This imbalance is righted through the taxation of corporations, leading to adherence to the ability-to-pay principle and a more just or more truly progressive tax system.21 Yet again, this argument is based on a false perception of the incidence of the corporate tax. It ignores the fact that some of the incidence may fall on labor, for instance, or on consumers or on foreigners. Further, it ignores the fact that a very large proportion of corporate ownership is held by workers directly and via institutional investors such as mutual funds. A somewhat administrative argument in support of the corporate tax has been that everybody else (other countries) taxes corporations and hence we should too.22 A derivative argument of this prima facie inadequate argument is that the corporate income tax presents opportunities for politicians to implement policies (via holidays and other breaks), both domestic and international, assuring a country’s standing in the global tax competition. Note, however, that this is a political rather than a policy argument, especially due to the complexity of determining the incidence of the corporate income tax. More transparent policy incentives are necessarily superior in terms of effectiveness to corporate income tax incentives if one were to ignore the political implications of such a choice. Another semi-administrative argument is that the corporate tax is necessary to ensure compliance with the (imperfect) individual income tax.23 There are several versions of this argument, from a claim that absent a corporate income tax individuals could incorporate and avoid full taxation to the use of corporations to obscure ownership and other relationship patterns.24 These arguments cannot support retention of the existing corporate tax since it has the opposite effect than that assumed by the argument: it further obscures the relationship between the income and the individuals who eventually bear the burden of the tax or who may enjoy the benefits of incorporation, whoever they are. Eliminating the corporate income tax would necessarily result in increased transparency. Moreover, experienced tax professionals and, independently the recent BEPS initiative, have proven that there is much tax avoidance at the corporate level,25 so the corporate tax would be a poor device to fight avoidance of the individual income tax. Finally, the basic concern about incorporation of individuals would necessarily be more simply and directly better relieved under a tax scheme where corporations would be See, e.g., Bird, supra note 16, 2. See, e.g., id., 7–8. 23 See, e.g., id., 9. Note that Bird accurately asserts that this justification of the corporate income tax is independent of the integration debate, an insight on which this chapter elaborates further in section 5.1, infra. Id. 24 A version of this argument claims that the majority of corporate equity in the United States is held by tax-exempt organizations which represent a specific form of individual income tax avoidance. This version is invalid since the entire income tax system is peppered with various exemptions and incentives that result in lower tax paying by some. See, e.g., Kimberly A. Clausing, Strengthening the Indispensable U.S. Corporate Tax (2016), 19–20, available at https://​equitablegrowth​.org/​research​-paper/​strengthening​ -the​-indispensable​-u​-s​-corporate​-tax/​?longform​=​true (last accessed 22 July 2022). 25 See the OECD dedicated website at: https://​www​.oecd​.org/​tax/​beps/​beps​-actions/​action11/​ (last accessed 22 July 2022). See also, e.g., Alex Cobham and Petr Janský, International Corporate Tax Avoidance, in Estimating Illicit Financial Flows: A Critical Guide to the Data, Methodologies, and Findings (Oxford, 2020). 21 22

Why tax corporations?  11 subject to a transparency enhancing withholding tax regime as advocated by this author rather than the current independent corporate tax.26 A more sophisticated, international version of this argument is that the corporate income tax is a proxy for source taxation, which countries have found to be increasingly difficult to collect in recent decades.27 The power of this argument is in the hint or color of fairness it adds to the support of the corporate income tax. The core of the argument is similar to the general sentiment in policy circles against ‘base erosion,’ which culminated in the BEPS project official designation of base erosion as a key ailment of the international tax regime. The problem with this sentiment is that it is very vague; for a tax base to be eroded it must first be established as such, and we all know that each country’s tax base is a product of a controversial and somewhat arbitrary political process, as is the division of tax bases among jurisdictions. The connection between a country and its corporate income tax base and similarly its domestic source corporate earnings and distributions (dividends) is particularly tenuous since it heavily relies on legal (corporate residence) or other formalities (having an office or similar permanent establishment) rather than a participation in the local economy or exploitation of local resources.28 Justifying the corporate income tax for this reason, as a crude proxy for another crude proxy, is therefore questionable. 3.3

The Political Arguments

The freshest and most appealing argument in support of the corporate income tax is that restraining corporate management power is desirable, and since the corporate income tax does so, it is desirable.29 The argument is appealing since it corresponds to the basic, popular intuition that it is not fair that large corporations do not pay enough tax and that corporate management is getting unjustly rich at the expense of the public. It is smart because it avoids the critique of the corporate tax as a poor revenue collection and redistribution mechanism, including, at the first glance, the debate over the incidence of the corporate tax. Finally, it is built on steady historical grounds since this was a primary motivation for the administration to enact the tax in the first place.30 Interestingly, Avi-Yonah further portrays his articulation of this argument with technical and policy colors. He relies on the real entity theory and its alleged historical support. According to him, if indeed the corporation cannot be viewed as representing the interests of its stakeholders, having a ‘life of its own’ and accumulating independent riches, then it would be technically wrong, perhaps inefficient and obviously unfair not to tax it as such,

26 See Brauner, supra note 5. See also, e.g., Eric Toder and Alan D. Viard, Replacing Corporate Tax Revenues with a Mark-to-Market Tax on Shareholder Income, 69 Nat’l Tax J. 701 (2016); Michael S. Knoll, An Accretion Corporate Income Tax, 49 Stan. L. Rev. 1 (1996); and Joseph M. Dodge, A Combined Mark-to-Market and Pass-Through Corporate-Shareholder Integration Proposal, 50 Tax L. Rev. 265 (1995). 27 See, e.g., Alfons J. Weichenrieder, (Why) Do We Need Corporate Taxation? CESifo Working Paper Series 1495 (2005). 28 It is true that the international tax regime universally relies on these indicators but such reliance is controversial and beyond the scope of this chapter. 29 The most explicit, and most comprehensive, version of this argument is in Avi-Yonah, supra note 12. 30 See, e.g., id., and Kornhauser, supra note 13.

12  Research handbook on corporate taxation independently. Nonetheless, the true target of Avi-Yonah is corporate management and its accumulation of power. Such accumulation is undesirable according to Avi-Yonah for several reasons:31 it concentrates political power in the hands of management without democratic protection; it allows management economic power over employees, and market power over consumers. Moreover, power in any of these spheres may convert to power in other spheres. Avi-Yonah argues that taxation may be one of the only ways to curb such powers. This author responded to that by noting, inter alia, the notorious influence of politics on tax policies more generally, which put into question its utility in this context. Further, it is unclear whether taxation can curb the economic and market powers abovementioned, since such powers do not directly arise from the income or wealth of corporations. It may be the case that the corporate tax itself adds to the market power of management over consumers because of the opacity it imposes on corporate actions. Finally, there are other, potentially more powerful devices to curb management powers, including corporate governance, consumer regulation, and antitrust. The corporate income tax does not tax or purports to tax the accumulation of power by corporate management. It is further a very bad and rough proxy for this purpose, since even if one makes the heroic assumption that the corporate income tax reduces such power by reducing the income of corporations, one will find it difficult to demonstrate that such reduction of power is meaningful or significant. It is hard to imagine that the significant costs of the corporate tax are justified by its desirable consequences. Consequently, even if valid, this argument cannot explain the corporate tax we have. Avi-Yonah’s response to this critique was a proposal for a new corporate income tax specifically designed to regulate large corporations.32 His proposal would tax (only) corporate rents with relatively high graduated rates. This idea is more plausible than the former support of the existing corporate income tax based on the desire to regulate corporate management power, yet, first, it advocates a significant departure from the existing tax and hence cannot serve as a valid justification for its preservation; second, it is essentially a tax on rents and there are other proposals targeting rents against which it should be measured (all beyond the scope of this chapter); and third, the proposal still insists on a separate tax on corporations, which preserves the opacity of the tax and which is also problematic in the view of this author since even if one could initially design it in a perfectly neutral manner, such a tax would be vulnerable to political tinkering (rate reductions, special exemptions, and so on) because of its standalone design. Another argument that may be viewed as political is that it is desirable, and perhaps efficient, to tax foreigners who do not vote and therefore the fact that the incidence of the corporate tax falls on all capital, not just domestic shareholders, is advantageous.33 A different version of this argument is that the corporate tax is perhaps the only way for us to tax foreigners investing in corporations that do business in the United States, and therefore it is desirable on both benefit and administrative (‘just because we can …’) grounds. The difficulty with this argument is that it applies to all countries. Indeed, some of the burden of our corporate tax falls on non-voters, but then some of the burden of foreign corporate taxes falls on United States taxpayers. It is

Avi-Yonah, supra note 12, 1237–8. Reuven S. Avi-Yonah, A New Corporate Tax, Tax Notes Fed. 653 (27 July 2020). 33 See, e.g., Bird, supra note 16, 6. 31 32

Why tax corporations?  13 unclear whether the United States is a ‘winner’ on balance, and it would be difficult to predict the balance changes as countries respond to that effect.34 3.4

Strong Support Based on Multiple Weak Arguments

The weakness of the different arguments in support of the corporate income tax hardly cuts into the general (popular and/or intuitive) support of the tax.35 Some contend that this weakness does not mean that the tax is undesirable and could still be supported based on an accumulation of the weak arguments in its favor.36 There are at least three problems with this contention: first, the accumulation of invalid arguments cannot overcome their initial invalidity; second, to prevail, the accumulation of weak arguments in support of the corporate income tax must compensate for the costs of the tax, costs ignored by the main proponents of this argument; and, finally (and most importantly), the entire support of the corporate income tax based on an accumulation of weak arguments takes place in a reform context and therefore cannot be viewed as justifying the corporate income tax we have at the present.

4.

THE INCIDENCE OF THE CORPORATE INCOME TAX

Who bears the burden of the corporate income tax? This is obviously the most fundamental question in the whole debate. If we could simply (or even not so simply) answer this question, then most of the debate would have been about implementation. Alas, we cannot. The answer is inherently complex and rich in variations to the extent that it may not be useful to seek an answer that directly supports or opposes the corporate income tax.37 We must, however, understand the complexity of the question to comprehend the composite of consequences that the tax imposes on our society.38 The debate among economists over the incidence of the corporate tax is more than half a century old. The duality of real and fictional existence necessitated much of the complexity since, first, the nominal incidence (who actually pays the tax to the government?) provides no useful guidance to the analysis of the real incidence, and, second, attribution in proportion to ownership stakes is difficult and raises the same complexity issues that the real incidence 34 It is further unclear that this motivation drives policymakers in the design of the corporate income tax. See, e.g., Weichenrieder, supra note 27. 35 See, Bird, supra note 16, 1–3. 36 Id. See also, Clausing, supra note 24. 37 See, e.g., Alan J. Auerbach, Who Bears the Corporate Tax? A Review of What We Know, 20 Tax Pol’y & Econ. 1 (2006), 13 (‘it is misleading to allocate the burden of a corporate tax increase to all capital … and … it is difficult to convey the incidence story in a one-dimensional breakdown of households, say, by wealth, income, or asset ownership …’). See also John Whalley, The Incidence of the Corporate Tax Revisited, Technical Comm. on Bus. Taxation, Working Paper No. 97-7 (1997), available at https://​citeseerx​.ist​.psu​.edu/​viewdoc/​download​?doi​=​10​.1​.1​.201​.372​&​rep​=​rep1​&​type​=​pdf (last accessed 22 July 2022), 10, 13 (concluding that the complex web of various effects makes a general analysis ‘not well-posed’ or ‘misfocused’). 38 This section is based primarily on the review by Auerbach, id. For a more current, concise and complete review of the matter see Alan J. Auerbach, Measuring the Effects of Corporate Tax Cuts, 32 J. Economic Perspectives 97 (2018), 99–101. For a more comprehensive analysis, see the dedicated chapter by Toder in this book, Ch. 4, infra.

14  Research handbook on corporate taxation raises.39 Then, we get to the incidence analysis, where there are many candidates for bearing this burden: shareholders, capital owners in general, other stakeholders, employees, consumers, and really everybody who comes in contact with the corporation. Timing matters and the incoherence of the corporate tax itself further complicate the analysis.40 The original, and most famous, work on the corporate tax incidence was Arnold Harberger’s, who originally concluded that the tax was borne fully by owners of capital, economy-wide.41 This means, in simple terms, that the corporate tax distorts the allocation of capital between the corporate and non-corporate sectors, and that it is not as helpful in progressivity terms since owners of capital in society in general are less affluent than corporate shareholders.42 It did not reject the possibility that labor suffered some of the burden in certain circumstances. Later, dynamic analyses criticized Harberger’s model that captured solely the long run, while in the transitional periods the effects of the tax may be very different in terms of redistribution.43 Hedging the tax risks may further distort the picture and likely in favor of the better-off in our society. Such analyses overcame some of the more problematic limitations of Harberger’s model, including the international effects. The key issues here included: the degree of mobility of capital between countries; the elasticity of substitution between countries (substitutability of products manufactured, for instance, in one country for products manufactured in another); and the relative sizes of the relevant countries. Results ranged from the burden falling completely on global (rather than domestic) capital to a shifting of the burden to countries’ non-mobile factors, such as the better-off in our society. Such analyses overcame some of the more problematic limitations of Harberger’s model, including the international effects. The key issues here included: the degree of mobility of capital between countries; the elasticity of substitution between countries (substitutability of products manufactured, for instance, in one country for products manufactured in another); and the relative sizes of the relevant countries.44 Results ranged from the burden falling completely on global (rather than domestic) capital45 to a shifting of the burden to countries’ non-mobile factors, such as labor.46 See Auerbach, supra note 37, 5–8. See, e.g., Whalley, supra note 37, 3, 10–11, and Auerbach, supra note 37, 33–4. 41 Arnold C. Harberger, The Incidence of the Corporation Income Tax, 70 J. Pol. Econ. 215 (1962). 42 Auerbach, supra note 37, 9. Nonetheless, he adds that since capital owners are generally more affluent than workers or consumers in general, it may contribute something to the popular view of the overall progressivity of the corporate income tax system. 43 Id., 10–13. 44 Id., 33–7. 45 See, e.g., Jane G. Gravelle, Corporate Tax Incidence in an Open Economy, in National Tax Association Proceedings of the 86th Annual Conference on Taxation (National Tax Association, 1994). A more recent paper by the same author revisited the issue and particularly tests the issue of exportation of the burden, concluding that most of the burden is borne by domestic capital (similar to Harberger’s conclusions), and that when it is not, it is mostly exported, i.e., little, if any, of the burden is borne by domestic labor. Jane G. Gravelle and Kent Smetters, Who Bears the Burden of the Corporate Tax in the Open Economy? NBER Working Paper No. 8280 (2001), available at SSRN: http://​ssrn​.com/​abstract​=​ 268889 (last accessed 22 July 2022). 46 See, e.g., John H. Mutti and Harry Grubert, The Taxation of Capital Income in an Open Economy: The Importance of Resident-Nonresident Tax Treatment, 27 J. Pub. Econ. 291 (1985); Wiji Arulampalam, Michael P. Devereux, and Giorgia Maffini, The Direct Incidence of Corporate Income Tax on Wages, 56 Eur. Econ. Rev. 1038 (2012) (based on a large European data set covering 1996–2003); and Jonas Knaisch and Carla Poeschel, Wage Response to Corporate Income Taxes: A Meta-Regression Analysis (2022), available at SSRN: https://​ssrn​.com/​abstract​=​4032555 (last accessed 3 March 2023). 39 40

Why tax corporations?  15 The magnitude of this shifting is highly debated among economists, with mixed empirical results.47 The country size aspects were particularly interesting, although they significantly complicated the analysis, because it is possible that a large country would ‘export’ the burden to other countries and maybe even benefit overall from the tax.48 Auerbach summarizes the literature as cautioning against assignment of the economic burden of the corporate income tax to all capital at once, even if it is true in the long term.49 He also cautions against an attempt to describe the effects of the tax in terms of a simple breakdown of households by wealth or income, for instance.50 He asserts that simply assigning the burden to certain groups in our society at certain times may not be very informative.51 Adding to that the fact that certain components of the tax have different incidences, Auerbach concludes that it is more meaningful to analyze corporate tax changes rather than the corporate income tax in its entirety.52 Typical economic studies of the corporate tax incidence have some limitations. The classic framework, exploring to what extent the burden of the tax fell on the firm, usually from the perspective of division of the burden between the firm (shareholders) and labor (its employees), left out, inter alia, the impact of corporate income tax changes on consumers. It is obvious that such impact, or the extent to which firms shift the burden (or, somewhat differently, the benefit) of the corporate income tax to consumers depends on the market in which they operate, most straightforwardly on what economists call the elasticity of demand. The few studies of this issue demonstrate that such burden shifting is not negligible, although economists still debate its magnitude.53 Auten and Kalambokidis also note in this context the hybrid properties of the corporate income tax as being partly a tax on cash flow, a feature normally

47 Id. Note that this disagreement has practical implications, namely government and congressional budgetary and revenue estimates that have an important role in the legislative and regulatory process use models based on certain positions that may vary dramatically. See, e.g., Renu Zaretsky, Corporate Taxes: Are They Fair? Who Really Pays Them, and When? (4 March 2020), available at https://​ www​.taxpolicycenter​.org/​taxvox/​corporate​-taxes​-are​-they​-fair​-who​-really​-pays​-them​-and​-when (last accessed 22 July 2022) (explaining these implications, the position of the Tax Policy Center, and the dramatically different versions adopted by officials). See also CRS, Who Pays the Corporate Tax? (29 September 2021), available at https://​crsreports​.congress​.gov/​product/​pdf/​IF/​IF10742 (last accessed 22 July 2022). This is a good real-life example how crude and problematic is the corporate income tax as a policy device. 48 See several studies referred to in Diane Rogers, The Incidence of the Corporate Income Tax, Congressional Budget Office Paper (1996), 19–20, available at https://​www​.cbo​.gov/​sites/​default/​files/​ cbofiles/​ftpdocs/​3xx/​doc304/​corptax​.pdf (last accessed 22 July 2022). 49 See Auerbach, supra note 37, 13. 50 Id. 51 This is because different points in time present arbitrary snapshots that are difficult to interpret in terms of what is desirable and what is not; they may result in very different distributions, and only the changes over time can really tell us what is happening in terms of fairness (based on redistribution as it occurs over time). 52 Auerbach, supra note 37, 33–4. See also Whalley, supra note 37, 10. 53 See, e.g., Scott R. Baker, Stephen Teng Sun, and Constantine Yannelis, Corporate Taxes and Retail Prices (2020), NBER Working Paper No. w27058, available at SSRN: https://​ssrn​.com/​abstract​=​ 3586190 (last accessed 22 July 2022); and Martin Jacob, Maximilian A. Mueller, and Thorben Wulff, Do Consumers Pay the Corporate Tax? TRR 266 Accounting for Transparency Working Paper Series No. 15 (20 January 2022), available at SSRN: https://​ssrn​.com/​abstract​=​3468142 or http://​dx​.doi​.org/​10​.2139/​ ssrn​.3468142 (last accessed 3 March 2023).

16  Research handbook on corporate taxation ignored, which led them to conclude that the tax is less progressive than had been assumed.54 In addition, little work was done on the lifetime incidence of the corporate income tax in contrast to annual or other shorter perspectives, but existing scholarship indicates that the tax is less distributionally desirable from a lifetime perspective than some of the consequences of shorter term analyses.55 In conclusion, the existing empirical evidence suggests that (at least some) of the burden of the corporate income tax is shouldered by labor, and, to a different extent, by consumers. This part of the controversy is the most heated and most politicized, but this is for a reason. If workers and consumers bear a good portion of the burden, then the tax may be redistributing from the less well-off to the better-off.56 International analysis further inflames this debate because it may suggest that more of the burden is shifted to immobile factors, yet also perhaps to non-voting factors. The international model is complex, and its variables constantly change – economies open, and substitutability of products changes as globalization accelerates.57 Moreover, the corporate income tax is not a tax on pure profits of corporations and there is no basis, therefore, to conclude that those who benefit from corporate profits suffer from the imposition of this tax. Finally, not all aspects of the question have been empirically studied to date; the relative lack of data, the complexity of corporate behavior,58 and globalization effects make it essentially impossible to control the fairness of the corporate income tax, even if we had agreement over its goals. This deficiency makes the corporate income tax a very poor policy device.

5.

CONCLUSION: EXPLAINING THE CORPORATE INCOME TAX’S RESILIENCE

This chapter is not tasked with predicting the future of the corporate income tax or the historical reasons for its rise, yet the reasons for taxing corporations necessarily play a role in all these questions. The reasons for the tax’s enactment still echo in the debate and impact its resilience despite the change in circumstances. This section argues that the resilience of the corporate income tax could only be explained by its political convenience rather than its value to society and the economy. First, however, it disposes of two issues that often distract from the real question of why we tax corporations: the almost automatic leap to alternative versions of the corporate income tax and the feasibility of its abolition. 54 See analysis and explanation in Rogers, supra note 48, 25–6, referring to Gerald E. Auten and Laura T.J. Kalambokidis, The Effect on the Distribution of the Tax Burden of Replacing the Corporate Income Tax with a Consumption Tax (U.S. Treasury, Office of Tax Analysis, 1995). 55 See Don Fullerton and Diane Lim Rogers, Who Bears the Lifetime Tax Burden? (Brookings Institution, 1993). See analysis in Rogers, supra note 48, 20–21. 56 Even this is a simplified conclusion since workers (and consumers) are not all the same, which further complicates conclusions on the distributional consequences of the corporate income tax. See, e.g., Auerbach, supra note 38, 117–18. 57 Auerbach, supra note 37, 33–7. 58 One aspect that has been increasingly studied lately is the interaction of corporate tax avoidance and the incidence of the corporate income tax, with interesting results. See, e.g., Scott D. Dyreng, Martin Jacob, Xu Jiang, and Maximilian A. Müller, Tax Incidence and Tax Avoidance, Contemporary Accounting Research, 39 Contemp. Account. Res. 2622 (2022), available at https://​doi​.org/​10​.1111/​ 1911​-3846​.12797 (last accessed 22 July 2022).

Why tax corporations?  17 5.1 Distractions Much of the corporate income tax discourse has over the years been devoted to implementation problems, taking for granted the desirability of the tax or the claim that it would be politically impossible to repeal it. The two most significant reform proposals made in this context have been the calls for rate reductions and for integration of the tax on corporate earnings (the corporate income tax) with the tax on corporate distributions (the dividend tax or the individual income tax as imposed on dividends). Rate reduction advocacy has much of the characteristics of the politics of the corporate tax discourse. Rate reductions are intuitively appealing when presented as reducing also the distortions created by the corporate income tax. Rate reductions also enjoy important political qualities: they appeal to politicians, who buy the argument that it is possible to raise more revenue with rate reductions, and to those who believe that rate reductions would result in growth and hence in jobs’ creation. Nonetheless, if indeed the corporate income tax is primarily a smoke screen that serves corporate managers and other corporate functionaries to maintain separation of their actions, rent seeking behavior, and power accumulation from other stakeholders in corporations, as this author argued elsewhere,59 then rate reduction can get them the best of all worlds. It simply reduces the ‘price’ that they pay – and we know that the price is quite low and declining – as the reduced rate tax reduces less their profits and cash. A reduced rate corporate income tax requires less attention to costly tax planning, but, at the same time, it is almost as effective as a higher rate tax as an opacity buffer. It is not identical since lower taxes may increase the political pressure of those who oppose corporations paying ‘too little’ taxes, yet such pressure may be kept in balance and may fluctuate according to general political climates and circumstances. The BEPS project serves a good example for this balance: public outrage erupted against the low taxpaying multinational enterprises (MNEs), yet its outcome has not been more corporate income taxpaying by MNEs; even the currently promoted, post-BEPS global minimum tax is only a minimum tax, accepting the narrative of rate reduction, yet, most importantly, keeping intact the corporate income tax itself.60 The BEPS project is also a good example for the problem with rate reduction advocacy, which serves as a diversion from the core question of why tax corporations in the first place. Of course, this advocacy is not necessarily undesirable; it may also, as already mentioned, increase awareness to the undesirable tax status of corporations, albeit often inaccurately.61 Yet, its potential relative advantages are certain to be dwarfed by the damage it does by diverting the discourse from the fundamental debate. The result of this diversion is always some sort of an alleged compromise, where the corporate sector gets the best of both worlds: the retention of opacity and often also some effective rate reduction. Ironically, we are still far from getting back to even the original compromise that required publicity of corporate tax returns.62 See, Brauner, supra note 5. See, OECD, Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy (8 October 2021), available at https://​www​.oecd​.org/​tax/​beps/​ statement​-on​-a​-two​-pillar​-solution​- to-address-the-tax-challenges-arising-from-the-digitalisation-of-theeconomy-october-2021.htm (last accessed 22 July 2022). 61 Since the public more often than not focuses on how little tax is paid by corporations, not on the undesirable effects of the corporate tax regime as a whole. 62 Although the BEPS project fostered one positive development by accelerating the universal acceptance of Country-by-Country Reporting (CbCR), which improves the ability of some countries to fairly tax corporations. 59 60

18  Research handbook on corporate taxation Corporate tax integration advocacy is even a greater distraction than rate reductions. Its bottom line is desirable, and practically not much different from proposals to eliminate the corporate tax. Integration can eliminate the so-called double taxation of corporate earnings and aspires to eliminate the distortions created by the taxation of corporations. Full imputation, which used to be the most obvious and perhaps even most common method of integration63 indeed met that end by requiring that the corporate income tax serve as a credit in the hands of shareholders against their individual income tax. Nonetheless, once the discourse was diverted from the question of whether we should tax corporations independently to corporate tax integration, it was universally and immediately colored by implementation concerns. The question then became not what the most desirable tax regime was but what was the most desirable integration regime. That instantaneously led to some sort of partial rather than full imputation to become the front runner, usually for one pragmatic political reason or another.64 The logical leap made is completely ignored in tax scholarship and the policy debate has been overwhelmed by administrative concerns. Many countries that swore by the policy merits of integration had fallen into this fallacy and for a variety of reasons switched to partial integration that is akin to any other corporate tax regime in terms of the undesirable effects described in this chapter.65 Note, however, that countries that insisted on keeping the benefits of imputation had essentially maintained full imputation regimes, with success.66 5.2

Feasibility of Abolition

The most powerful argument made for the retention of the corporate tax, regardless of all of the above theory and policy arguments, is that it is politically not feasible to abolish it and therefore one should focus on desirable reform rather than the fundamental question that this chapter poses.67 This argument is intimately related to the political argument in support of the corporate tax, since it feeds on its appeal, and succumbs to the diversions mentioned in the former section, since they all divert scholarship and policymaking from the fundamental question into a debate over reform of the existing corporate income tax. This argument is also powerful because it is self-fulfilling. One must intuitively feel that there is some truth to it considering the resilience of the tax, yet perhaps the strongest intuition in this context is that it would be impossible to tax corporations on a look-through basis. The multitude of shareholders, their transient nature, and the opacity of some shareholdings seem to automatically overwhelm any attempt to do so. Taken at face value, this argument, and the intuitions behind 63 For an extensive review of integration methods and history, see, e.g., Hugh J. Ault, Corporate Integration, Tax Treaties and the Division of the International Tax Base: Principles and Practices, 47 Tax L. Rev. 565 (1992); and Michael J. Graetz and Alvin C. Warren, Jr., Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (1998). 64 See, e.g., the analysis of Professor Richard Vann, in Richard Vann, Trends in Company/ Shareholder Taxation: Single or Double Taxation, 88a Cahiers de Droit Fiscal International 21 (2003). For a recent example of this progression see George K. Yin, A Brief History of U.S. Approaches to Corporate Tax Integration and Some Lessons (12 July 2022), Virginia Public Law and Legal Theory Research Paper No. 2022-47, Virginia Law and Economics Research Paper No. 2022-13, available at SSRN: https://​ssrn​.com/​abstract​=​4162912 (last accessed 22 July 2022). 65 Most notably, most of the European countries. See, e.g., Vann, id. 66 E.g., Australia. See, e.g., https://​www​.ato​.gov​.au/​Business/​Imputation/​ (last accessed 22 July 2022). 67 See, e.g., Daniel N. Shaviro, Decoding the U.S. Corporate Tax (The Urban Institute, 2009), 178–9.

Why tax corporations?  19 it, cannot stand scrutiny. First, as already described above, corporate tax integration, such as Australia’s imputation system, elegantly and successfully avoids a separate corporate level tax. Second, multiple past corporate tax reform proposals suggested alternative methods (such as mark-to-market) to avoid the difficulty of taxing corporate shareholders directly.68 Third, many business enterprises, some of which as complex as corporations, are already taxed on a look-through basis in most countries. Four, recent developments have dramatically increased transparency of corporate (and other) accounts, with the effective abolition of bank secrecy, the almost universal automatic exchange of information regime, CbCR, and the general adoption of advanced computing in all corporate systems, making this argument essentially anachronistic. Therefore, the resilience of the corporate income tax cannot be explained by a simple impossibility of taxing corporate shareholders directly, but rather requires other reasons, namely, as argued next, political convenience. 5.3

Only Political Convenience Can Explain the Resilience of the Corporate Income Tax

Once one accepts that the corporate income tax cannot be justified by economic, social, or redistribution reasons, its resilience could only be explained by politics. Path dependence and a conservative reluctance not to rock the boat may contribute to persistence of legislation relics, yet these could hardly be the only explanation for such a long-standing tax and one that constantly occupies the top of the political agenda in many countries. This chapter argues that at least three factors contribute to the resilience of the corporate income tax. First, big business69 and supportive politicians prefer the corporate tax to a look-through regime. Historically, the compromise that led to the enactment of the corporate income tax resulted from the opposition of business circles to the taxation of undistributed profits.70 This may seem illogical at the present since the corporate income tax nominally imposes an additional layer of tax on corporations, yet, as already explained, the value of the opacity that the corporate income tax provides, as well as the opportunities to minimize its impact compensate for the additional potential burden.71 Rate reductions, corporate tax benefits, and opportunities to shift the burden to others are therefore preferred to the abolition of the corporate tax and transparent taxation. Second, the popular view that the corporate income tax must fall on the more well-off in our society and the personified image of corporations as part of that group is apparently so powerful that pro-distribution politicians are even more protective of the corporate income tax than their oft-rivals pro big business politicians. This sentiment is so strong that even scholars that understand its fallacy view the popular support as sufficient to support keeping the corporate income tax.72 Finally, the corporate income tax provides politicians fertile ground

See, supra note 26. Note that the corporate tax debate involves mainly (effectively only) big business since large and public corporations pay almost all the corporate tax, smaller business having multiple organization forms not subject to the corporate income tax available. 70 See, supra section 2.2. 71 See also Jennifer Arlen and Deborah M. Weiss, A Political Theory of Corporate Taxation, 105 Yale L. J. 325 (1994) (demonstrating that corporate managers therefore do not have sufficient incentive to lobby a repeal of the corporate income tax). 72 See, e.g., Bird, supra note 16, 11–12. 68 69

20  Research handbook on corporate taxation for maneuvers in the form of tax incentives. The opacity of the corporate income tax and the complexity of its incidence effectively shields them from accountability. The key role that opacity plays in the debate over the rationale of the corporate income tax leads to the secondary, yet in the opinion of this author, the important conclusion or insight that clarity over the purpose of the tax is essential for a coherent debate with a stable outcome. The chapter demonstrates that, despite the intensity of the debate, mostly it has been challenged to the unprincipled path of incremental or partial reform. This path is problematic since even when it leads to desirable outcomes (such as in a case of full imputation), it is vulnerable to political tweaking that would gnaw at its achievements. Only a clear principle that the income tax is imposed only on people, not legal persons, could stir the debate back to safety. Once that is established, multiple collection and compliance mechanisms become available for a more productive (and, yes, transparent) discourse.

SELECTED REFERENCES Jennifer Arlen and Deborah M. Weiss, A Political Theory of Corporate Taxation, 105 Yale L. J. 325 (1994). Alan J. Auerbach, Who Bears the Corporate Tax? A Review of What We Know, 20 Tax Pol’y & Econ. 1 (2006). Alan J. Auerbach, Measuring the Effects of Corporate Tax Cuts, 32 J. Economic Perspectives 97 (2018). Hugh J. Ault, Corporate Integration, Tax Treaties and the Division of the International Tax Base: Principles and Practices, 47 Tax L. Rev. 565 (1992). Reuven S. Avi-Yonah, Corporations, Society, and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193 (2004). Reuven S. Avi-Yonah, Why Was the U.S. Corporate Tax Enacted in 1909?, in John Tiley, ed., Studies in the History of Tax Law, vol. 2 (Hart Pub., 2007). Reuven S. Avi-Yonah, A New Corporate Tax, Tax Notes Fed. 653 (27 July 2020). Richard M. Bird, Why Tax Corporations? Working Paper 96-2 (prepared for the Technical Committee on Business Taxation) (1996). Yariv Brauner, The Non-Sense Tax: A Reply to New Corporate Income Tax Advocacy, 2008 Mich. St. L. Rev. 591 (2008). Kimberly A. Clausing, Strengthening the Indispensable U.S. Corporate Tax (2016) available at https://​ equitablegrowth​.org/​research​-paper/​strengthening​-the​-indispensable​-u​-s​-corporate​-tax/​?longform​=​ true ((last accessed 22 July 2022). Joseph M. Dodge, A Combined Mark-to-Market and Pass-Through Corporate-Shareholder Integration Proposal, 50 Tax L. Rev. 265 (1995). Don Fullerton and Diane Lim Rogers, Who Bears the Lifetime Tax Burden? (Brookings Institution, 1993). Michael J. Graetz and Alvin C. Warren, Jr., Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (1998). Jane G. Gravelle, The Economic Effects of Taxing Capital Income (The MIT Press, 1994). Jane G. Gravelle and Kent Smetters, Who Bears the Burden of the Corporate Tax in the Open Economy? NBER Working Paper No. 8280 (2001). Arnold C. Harberger, The Incidence of the Corporation Income Tax, 70 J. Pol. Econ. 215 (1962). Martin Jacob, Maximilian A. Mueller, and Thorben Wulff, Do Consumers Pay the Corporate Tax? TRR 266 Accounting for Transparency Working Paper Series No. 15 (20 January 2022), available at SSRN: https://​ssrn​.com/​abstract​=​3468142 or http://​dx​.doi​.org/​10​.2139/​ssrn​.3468142 (last accessed 3 March 2023). Michael S. Knoll, An Accretion Corporate Income Tax, 49 Stan. L. Rev. 1 (1996). Marjorie Kornhauser, Corporate Regulation and the Origins of the Corporate Income Tax, 66 Ind. L. J. 53 (1990).

Why tax corporations?  21 Charles E. Mclure, Jr., Must Corporate Income be Taxed Twice? (Brookings Institution, 1979). John H. Mutti and Harry Grubert, The Taxation of Capital Income in an Open Economy: The Importance of Resident-Nonresident Tax Treatment, 27 J. Pub. Econ. 291 (1985). Diane Rogers, The Incidence of the Corporate Income Tax, Congressional Budget Office paper (1996) available at https://​www​.cbo​.gov/​sites/​default/​files/​cbofiles/​ftpdocs/​3xx/​doc304/​corptax​.pdf (last accessed 22 July 2022). Daniel N. Shaviro, Decoding the U.S. Corporate Tax (The Urban Institute, 2009). Eric Toder and Alan D. Viard, Replacing Corporate Tax Revenues with a Mark-to-Market Tax on Shareholder Income, 69 Nat’l Tax J. 701 (2016). Richard Vann, Trends in Company/Shareholder Taxation: Single or Double Taxation, 88a Cahiers de Droit Fiscal International 21 (2003). Alfons J. Weichenrieder, (Why) Do We Need Corporate Taxation? CESifo Working Paper Series No. 1495 (2005). David A. Weisbach, The Irreducible Complexity of Firm-Level Income Taxes: Theory and Doctrine in the Corporate Tax, 60 Tax L. Rev. 215 (2007). John Whalley, The Incidence of the Corporate Tax Revisited, Technical Comm. on Bus. Taxation, Working Paper No. 97-7 (1997), available at https://​citeseerx​.ist​.psu​.edu/​viewdoc/​download​?doi​=​10​ .1​.1​.201​.372​&​rep​=​rep1​&​type​=​pdf (last accessed 22 July 2022).

3. The history of the corporate tax Steven Bank

Separately taxing corporations on their income, which has been going on for well over a century in the United States and as long or longer in other countries, was not inevitable when the corporation first appeared as a legal device for owning property and conducting activities. Indeed, taxing corporations on their income might have been surprising when they (or similar arrangements that preceded them) were primarily used for public or religious functions or for single voyage trading ventures to far-flung lands that were quickly followed by their dissolution and a distribution of all the profits from the voyage.1 How did what is called the ‘classical corporate income tax’ – in which corporations are taxed separately from their owners – emerge? There are two main explanations offered for its adoption in the United States. The first explanation is that a corporate income tax was necessary as an aid to the individual income tax in collecting taxes on shareholder income.2 As corporations increasingly began to be used for more permanent business operations,3 it became difficult for tax authorities to ignore their accumulation of wealth and generation of profits.4 The second explanation is that the corporate income tax was justified as a means of addressing the growing power of corporations and their managers both by restricting the funds available to managers and providing a tool that could be used to incentivize and punish where appropriate.5 Although these are sometimes portrayed as competing explanations,6 it is probably more accurate to say that the classical corporate income tax emerged in four stages or ‘acts’ and each of these two explanations predominated at different stages in the early development of the corporate income tax. In the United States, these acts could each be described in one or two words: (1) Revenue, (2) Shielding, (3) Avoidance, and (4) Regulation/Mitigation. Calling them stages or acts does not mean they necessarily occurred sequentially and have now been completed. Indeed, the acts were often overlapping and some of them have reappeared as politics and the economy have provided the impetus for the retrenchment (or advancement) of the 1 See Harry G. Henn, Handbook of the Law of Corporations and Other Business Associations, 10–11 (West Publishing Company, 1961) (describing municipal and religious corporations); Robert W. Hillman, Limited Liability in Historical Perspective, 54 Wash. & Lee L. Rev. 615, 621–5 (1997) (describing the commenda arrangement for limited liability on single voyage investments). 2 Steven A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present (Oxford University Press, 2010). 3 George Heberton Evans, Jr., Business Incorporations in the United States 1800–1943, 31 (National Bureau of Economic Research, 1948) (describing the ‘phenomenal expansion in the use of the corporate form’ by businesses during the post-Reconstruction period until just before the turn of the century). 4 Peter A. Harris, Corporate/Shareholder Income Taxation and Allocating Taxing Rights between Countries, 40–41 (International Bureau of Fiscal Documentation, 1996). 5 See Reuven S. Avi-Yonah, Corporations, Society and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193 (2004); Marjorie E. Kornhauser, Corporate Regulation and the Origins of the Corporate Income Tax, 66 Ind. L. J. 53 (1990). 6 See, e.g., Omri Marian, Jurisdiction to Tax Corporations, 54 B. C. L. Rev. 1613, 1624, n. 42 (2013).

22

The history of the corporate tax  23 tax. Moreover, other countries never went through all four stages, which may help explain how alternatives to the classical corporate income tax emerged. Nevertheless, a four-stage description of the development of the classical corporate income tax helps to explain the U.S. system and contextualize why some corporate income tax systems developed differently than others.

I.

ACT ONE: REVENUE

The political will to adopt new taxes is often greatest when the need for new sources of revenue is the most urgent and the move toward corporate income taxation is no exception to this maxim. This can come from an increase in expenses beyond what traditional sources of revenue alone can support, decline of traditional sources of revenue, or, as often happens, some combination of the two. During the Civil War, wartime expenses were primarily the motivation for exploring an alternative source of revenue – an income tax – although a decline in revenues from tariffs or customs duties because of lower demand for and availability of imports was a contributing factor.7 Initially, the income tax enacted in 1862 did not mention corporations at all and revenue was low.8 By the time Congress got serious about income taxation in 1864, corporations were specifically mentioned. Under Section 117 of the Act, ‘the gains and profits of all companies, whether incorporated or partnership … shall be included in estimating the annual gains, profits, or income of any person entitled to the same, whether divided or otherwise.’9 Although this pass-through taxation of shareholders on their allocable share of corporate income was challenged in court, it was later upheld by the U.S. Supreme Court, noting that the phrase ‘whether divided or otherwise’ effectively permitted shareholders to be taxed as if they had received the funds in dividend or liquidating distribution.10 Congress could have taxed the corporation directly as Pennsylvania had prior to the Civil War,11 but chose not to do so because it was only using the corporation as a means of getting at shareholder income. Later in the nineteenth century, the move to tax corporate income was at least partially a result of the declining political viability of tariffs or customs duties, which was one of the most important sources of revenue in the United States at the time. Tariffs raised revenues by effectively charging a tax on imported goods, but they also served to protect domestic industries. The problem was that this protection was controversial, both because it favored certain industries and regions (such as northern manufacturers over southern agricultural producers) and because it allowed domestic producers to raise their prices just below the tariff-induced rise in the price of imported goods, with the burden falling disproportionately on the poor.12 Politicians then, rightly or wrongly, blamed tariffs for the rise in prices.

Bank, From Sword to Shield, supra note 2, at 12; John F. Witte, The Politics and Development of the Federal Income Tax, 67 (University of Wisconsin Press, 1985). 8 Joseph A. Hill, The Civil War Income Tax, 8 Q. J. Econ. 416, 423 (1894). 9 Act of June 30, 1864, § 117, 13 Stat. at 282. 10 Collector v. Hubbard, 79 U.S. (12 Wall.) 1, 16–18 (1870). The arrangement was upheld in dicta as the case was barred on jurisdictional grounds. Id. at 14–15. 11 Edwin R.A. Seligman, Essays in Taxation, 149–50 (Macmillan Company, 1895); Delos O. Kinsman, The Income Tax in the Commonwealths of the United States, 31 (Macmillan Company, 1903). 12 Thomas G. Shearman, The Owners of Wealth, Forum 262–73 (Nov. 1889). 7

24  Research handbook on corporate taxation In his first State of the Union Address in 1893, President Grover Cleveland called for Congress to enact ‘a small tax upon incomes derived from certain corporate investments’ as part of a program for reducing the high tariff rates enacted by Republicans in 1890.13 Although the income tax enacted in 1894 was ultimately struck down by the U.S. Supreme Court,14 President William Howard Taft revived a version of it when he directed Congress to adopt ‘new kinds of taxation’ in 1909 as part of his proposed reform measure designed to reduce tariff rates.15 In both instances, the corporate tax ultimately adopted either served or was in lieu of the individual income tax, rather than being specifically designed to target corporations. Under the House bill for the 1894 income tax, corporations would have had to deduct and withhold from dividends the 2 percent income tax imposed on individuals.16 This mirrored a pass-through tax imposed on corporations as part of the Civil War-era income tax.17 Only if the corporation chose to forgo paying dividends would a tax apply to ‘undistributed sums or sums made or added during the year to their surplus or contingent funds.’18 The Senate changed the proposal to a direct tax on corporate net income with an exemption from the individual income tax for dividends, but the theory was that it was still really just a tax on the shareholders at the corporate level. Senator George Graham Vest of Missouri, who drafted the provision as a member of the Senate Finance Committee, explained that it was a simplification measure ‘allowing the corporation to adjust its relations with its own stockholders as it sees proper’ on the question of whether to pay dividends.19 Since most corporations paid all of their net income as dividends each year, the expectation was that the tax would effectively operate as a proxy for a dividend withholding tax on shareholder income.20 The 1909 corporate tax was not accompanied by an income tax like the short-lived 1894 tax. Instead, it was enacted in lieu of an income tax as part of an effort to reach shareholder income in a way that would pass constitutional muster in the wake of the Supreme Court’s decision to strike down the 1894 version. To do this, Congress imposed an excise tax on the privilege of operating as a corporation, with the amount of the tax based upon the size of a corporation’s income,21 a strategy it had employed on a more limited scale against the petroleum and sugar industries during the Spanish-American War in 1898.22 The tax was sold at least in part on its regulatory potential – likely to bolster President Taft’s commitment to continue the progressive policies of his predecessor Theodore Roosevelt – but the only regulatory component of

President Grover Cleveland, First Annual Message, in A Compilation of the Messages and Papers of the Presidents, 1789–1897, 434, 460 (James D. Richardson, ed., Bureau of National Literature, 1899). 14 Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1894). 15 Maurice H. Robinson, The Federal Corporation Tax, 1 Am. Econ. Rev. 691, 691 (1911). Taft originally proposed an inheritance tax to go along with an income tax, but proposed a corporation tax because of concerns that the income tax would not meet constitutional muster. Id. 16 26 Cong. Rec. 6831 (1894). 17 Senator George Vest said the House ‘adopted the system as to its details which was in the old law of 1864.’ Id. at 6866. 18 Id. at 6831. 19 Id. at 6866 (statement of Sen. Vest). Under the Civil War income tax, some corporations had done just that, choosing not to withhold the tax due from dividends paid and instead paying the tax out of surplus. Edwin R.A. Seligman, The Income Tax, 9 Pol. Sci. Q. 610, 672, n. 1 (1894). 20 Bank, From Sword to Shield, supra note 2, at 49–52. 21 Act of August 5, 1909, ch. 6, § 38, 36 Stat. 112. 22 Steven A. Bank, Anglo-American Corporate Taxation: Tracing the Common Roots of Divergent Approaches, 42–5 (Cambridge University Press, 2011). 13

The history of the corporate tax  25 the tax was a requirement that corporate tax returns be made public.23 That provision had been watered down from the version pressed by corporate reformers and, within two years, public access to corporate tax returns was eliminated entirely.24 Taft himself reportedly viewed the corporation tax as ‘the best form of income tax that could be levied, and indeed embodies many of the “best features of the English income tax law.”’25

II.

ACT TWO: SHIELDING

In all three of these examples of early corporate taxation – the Civil War, 1894, and 1909 – Congress resorted to taxing corporate income because of revenue needs. It was designed to serve the income tax or to operate in lieu of an income tax, rather than to accomplish some alternative policy goals related to the corporation itself. Critical to this was that there was never an attempt to subject corporate income to tax at a different rate, or to different rules, than other forms of income. After the Sixteenth Amendment was ratified in 1913,26 however, and the constitutional barrier to enacting the 1894 income tax no longer applied, the two types of taxes were allowed to grow in different directions. In the first income tax enacted in 1913, Congress continued to try to align the individual and corporate income taxes. Unlike the 1894 version, though, which was a flat rate tax, the 1913 income tax introduced the concept of progressivity to the income tax.27 This complicated the notion that the corporate income tax could be a de facto withholding tax for individual investors. Having the corporation deduct and withhold the tax owed by each shareholder, as under the 1894 Act, would either require that the corporation pay at a different rate for each shareholder – which would require them to either know and pay various shareholder rates – or to do so at a flat rate that would leave some shareholders bearing an indirect tax burden that was too great and others bearing one that was too light. Under the 1913 Act, Congress resolved this problem by separating the income tax into a base, or ‘normal,’ rate of 1 percent, and a surtax with graduated rates that reached as high as 6 percent. It then subjected corporate income to the normal rate only and exempted dividends from a shareholder’s normal tax, but not their surtax.28 This meant that for individuals with an income level subject to tax, but below the surtax exemption, their tax on dividend income was entirely collected at the corporate level, while for shareholders with income subject to the surtax, the normal tax on dividends was collected at the corporate level and the surtax on the dividend income was imposed at the shareholder level. Although this two-part normal/surtax structure allowed the corporate income tax to remain as a collection device for the individual income tax, it also created the conditions for the emer23 Taft Planned Tax on Roosevelt Lines, N.Y. Times, 24 June 1909, at 1. See Act of August 5, 1909, ch. 6, § 38(6), 36 Stat. 11, 116 (directing that all corporate tax returns ‘shall be filed in the office of the Commissioner of Internal Revenue and shall constitute public records and be open to inspection as such’). 24 Bank, From Sword to Shield, supra note 2, at 69–70. 25 Taft Favors Income Tax, La Follette’s Weekly Mag., 2 Oct. 1909, at 13. 26 U.S. Const. amend. XVI. 27 It was progressive, but only in the sense of compensating for the regressive burdens of tariff taxation. See Steven A. Bank, Origins of a Flat Tax, 73 Denv. U. L. Rev. 329, 333 (1996). 28 Tariff Act of 1913, ch. 16, § II(B), (G), 38 Stat. 166–8, 172.

26  Research handbook on corporate taxation gence of a truly separate tax on corporate income. With the breakout of World War I, total U.S. government expenses skyrocketed from 3 percent of gross domestic product in 1913 to 17 percent in 1918 as it moved from an ally to a full participant.29 To pay for this, Congress resorted to significant increases in the top surtax rate, rising from 6 percent in 1913 to 13 percent in 1916, 50 percent in 1917, before topping out at 65 percent in 1918.30 Corporations, however, were subject to much lower rates – initially the normal rate explicitly and then to their own rate that matched the normal rate – and not the surtax rates.31 The normal rate was increasing at the same time as the surtax, but at much lower levels. It went from 1 percent in 1913 to 2 percent in 1916, and 6 percent in 1917, before jumping to 12 percent in 1918.32 Effectively, the normal/surtax structure allowed Congress to shield corporations from the steep surtax rate hikes Congress needed to finance World War I. This was by design. Although there were popular concerns about war profiteering, leading Congress to enact a profits tax on munitions manufacturers in 1916, which was extended to all businesses in 1917 and then only corporations in 1918,33 there was at least as much concern about the need to protect corporations from the punishingly high wartime surtax rates. Business leaders, not surprisingly, complained bitterly about the high tax burden placed on corporations. Jacob Schiff, a prominent investment banker with the firm of Kuhn, Loeb & Co., wrote a letter to Treasury Secretary William McAdoo cautioning that the high tax burden ‘would curb the push and ambition which is at the bottom of all material progress and development.’34 More colorfully, automobile manufacturer Cleveland Dodge warned McAdoo not to pursue ‘schemes of taxation [such as the excess profits tax under consideration] which would kill the goose that lays the golden egg.’35 Government leaders tended to agree with these views. As T.S. Adams, a Yale economist and special advisor to the Treasury Department, wrote, ‘the best corporations of the country are probably our largest and most effective savers … To apply to this fund the heavy super-taxes authorized in the general income tax would be a very serious matter.’36 Senate Finance Committee Chair Furnifold Simmons reported that if corporations were not allowed to retain their surplus ‘they would be utterly unable to meet the requirements of the present war U.S. Department of Commerce, Bureau of the Census, Historical Statistics of the United States, 1789–1945, at 296, 299 (1949); Louis Johnston and Samuel H. Williamson, What Was the U.S. GDP Then?, MeasuringWorth (2023), accessed 1 March 2023 at http://​www​.measuringworth​.org/​usgdp. 30 Revenue Act of 1916, ch. 463, § 1(b), 39 Stat. 756, 757; War Revenue Act of 1917, ch. 63, § 2, 40 Stat. 300, 301; Revenue Act of 1918, ch. 18, § 211, 40 Stat. 1057. 31 Bank, From Sword to Shield, supra note 2, at 97, n. 52. 32 Tax Foundation, Federal Corporate Income Tax Rates, Income Years 1909–2012, accessed 23 Feb. 2023 at https://​taxfoundation​.org/​federal​-corporate​-income​-tax​-rates​-income​-years​-1909​-2012/​. 33 Steven A. Bank, Kirk J. Stark and Joseph J. Thorndike, War and Taxes, 56–7, 63–8, 74–9 (Urban Institute Press, 2008); Randolph E. Paul, Taxation in the United States, 118 (Little, Brown, and Co., 1954). The move to narrow the excess profits tax to corporations was designed to at least partially address the inequity caused by subjecting individuals and partnerships, but not corporations, to the high surtax rates. S. Rep. No. 617, at 8, reprinted in 1939-1 C.B. 117, 124 (Senate Finance Committee Report on the Revenue Act of 1918). 34 W. Elliot Brownlee, Social Investigation and Political Learning in the Financing of World War I, in The State and Social Investigation in Britain and the United States, 330 (Michael J. Lacey and Mary O. Furner, eds., Cambridge University Press, 1993) (quoting letter from Schiff to McAdoo, dated 12 April 1917). 35 Id. (quoting letters from Dodge to McAdoo, dated 10 and 16 April 1917). 36 T.S. Adams, Federal Taxes upon Income and Excess Profits, 8 Am. Econ. Rev. Supp. 18, 25 (1918) (papers and proceedings of the Thirtieth Annual Meeting of the American Economics Association). 29

The history of the corporate tax  27 and emergency situation,’ which business leaders were quick to remind was in part because government war bonds and securities ‘had to a large extent preempted the investment markets of the country.’37

III.

ACT THREE: AVOIDANCE

The downside to separating the corporate income tax rate from the individual income rate was that it appeared to open the door for corporate tax avoidance. Individuals could contribute their income-producing assets to a newly formed corporation to shelter the income from the surtax. Senator John Sharp Williams, a Mississippi Democrat, explained that they were concerned that ‘men may escape not the normal tax but escape the additional tax by merely forming themselves, or using a brother, wife, or somebody, or an office boy.’38 By not distributing profits as dividends and instead extracting those profits through some other means, whether as an employee, lender, or supplier, the profits would avoid the surtax rates altogether.39 As progressive Senator William Borah of Idaho observed, they ‘might incorporate, pay the 1 per cent upon their net earnings, and entirely escape the graduated tax or surtax.’40 It also appeared to create an incentive for corporations to retain rather than distribute its profits. Williams noted ‘it was thought for the purpose of obtaining revenue a corporation might now and then pass up a portion of its profits to surplus or otherwise refrain from distributing them.’41 This would have been unusual in the late nineteenth century when many corporations distributed around 80 percent of their profits as dividends each year.42 Dividends provided liquidity at a time when few corporations were publicly-traded and volume was relatively low on the stock markets anyway.43 Moreover, dividends signaled a corporation’s profitability, which was important when there were not audited financial statements available for investors and they had little other means of measuring the success of their investment.44 This concern about the potential use of the corporation to avoid taxes led some to propose taxing the corporation on a pass-through basis like a partnership. According to Senate Finance Chair Simmons, ‘[t]he first suggestion was to apply to the corporation the rule that now applies to the partnership and to treat the surplus as distributed for the purpose of the income tax whether in fact distributed or not.’45 While this was rejected because of constitutional concerns related to questions about whether undistributed profits constituted income that had been ‘realized,’46 Senator Andrieus Jones of New Mexico later proposed to subject certain undis-

55 Cong. Rec. 5966 (1918) (statement of Sen. Simmons). 50 Cong. Rec. 5318 (1913) (statement of Sen. Williams). 39 Id. 40 Id. at 3775 (statement of Sen. Borah). 41 50 Cong. Rec. 3774 (1913) (statement of Sen. Williams). 42 Bank, From Sword to Shield, supra note 2, at 50–51, Fig. 2. 43 Jonathan Barron Baskin and Paul J. Miranti, Jr., A History of Corporate Finance, 18–19 (Cambridge University Press, 1997). 44 Id. 45 55 Cong. Rec. 5966 (1918) (statement of Sen. Simmons). 46 Id. A few years later, in Eisner v. Macomber, the Supreme Court struck down a tax on stock dividends on constitutional grounds because it concluded that income must be realized, or severed from the capital, before it can be subject to taxation. 252 U.S. 189 (1920). 37 38

28  Research handbook on corporate taxation tributed profits to a 15 percent surtax.47 In effect, the proposal was to mitigate tax avoidance by adopting a rough form of integration of the corporate and individual income taxes. A portion of corporate income beyond what was deemed necessary to operate the business would be subject to the individual surtax as if it had been distributed as a dividend to shareholders. Ultimately, concerns about shielding outweighed concerns about addressing tax avoidance through some form of undistributed profits tax. By the time the Sixteenth Amendment was ratified, the dividend payout ratio had dropped to around 60 percent, reflecting a fundamental shift in corporate finance toward the value of retained earnings rather than a response to the income tax.48 Taxing undistributed profits or incentivizing corporations to distribute their profits so they would be subject to the surtax seemed unwise. As the New York Times wrote: [i]t is too plain for argument that the division of earnings too closely weakens the corporation. It would be better that the law should require all corporations to maintain reserves, like banks, than that the law should require distribution of dividends which would better be used to enlarge facilities for the use of customers.49

Instead of trying to integrate the corporate and individual income taxes through some form of undistributed profits tax, Congress chose to more explicitly separate them by raising the corporate rate two percentage points above the individual normal rate.50 Senator Simmons explained that they increased the corporate rate from 2 to 6 percent, while raising the normal rate from 2 to only 4 percent ‘chiefly for the purpose of equalizing any possible difference which might exist between the individual and the corporation with respect to surtaxes.’51 Although the corporate and individual income taxes had never really been identical because individuals were entitled to an exemption, while corporations were not,52 and the 2 percentage point difference likely did not capture the surtax that otherwise would have applied to corporate income if distributed as dividends,53 it did for the first time formally establish what Harvard economist and U.S. Tariff Commission Chair F.W. Taussig called ‘a special levy on corporations.’54 According to Taussig, because of the higher rate, ‘the tax comes even more to be regarded not as one that reaches the shareholders’ income, but one that is to be assimilated to other taxes, to be shifted to the general public, and to leave the shareholders’ income undiminished.’55 This was the camel’s nose under the tent. By 1935, the 2 percentage

55 Cong. Rec. 5966, 6173 (1917). Under the proposal, undistributed profits beyond 20 percent of earnings would have been subject to the 15 percent tax, which would be in addition to the normal corporate income tax rate. 48 Bank, From Sword to Shield, supra note 2, at 91–2; William H. Lough, Business Finance: A Practical Study of Financial Management in Private Business Concerns, 477 (Ronald Press Co., 1917). 49 Editorial, Taxing Undistributed Profits, N.Y. Times, 18 July 1917, at 7. 50 War Revenue Act of 1917, ch. 63, 40 Stat. 300. 51 55 Cong. Rec. 6172 (1917) (statement of Sen. Simmons). 52 Bank, Anglo-American Corporate Taxation, supra note 22, at 71, n. 9 (taxpayers were exempt on up to $3,000 of their income if single and $4,000 if married). 53 See 55 Cong. Rec. 6331 (1917) (statement of Sen. McCumber) (complaining that the additional two percentage points would hardly capture the surtax owed by a shareholder subject to a 30 percent surtax). 54 F.W. Taussig, The War Tax Act of 1917, 32 Q. J. Econ. 1, 20 (1917). 55 Id. 47

The history of the corporate tax  29 point difference adopted in 1917 had become a 9.75 percentage point difference, effectively severing the tie between the corporate and individual taxes.56

IV.

ACT FOUR: REGULATION AND MITIGATION

After the separate corporate income tax was fully established, it became a lever Congress could use for other purposes. Sometimes, it used this lever to protect the corporation from high tax rates, in a revival of the shielding stage, or to incentivize the corporation to invest in a targeted way to aid the economy. This generally involved reducing the corporate rate vis-à-vis the individual rate, providing corporations with special deductions or credits that encouraged its investment in preferred activities, or preferencing shareholders’ investment in certain corporations.57 Other times, it used the corporate tax as a lever to regulate problematic corporate governance behavior or to mitigate the negative issues associated with shielding, such as excessive accumulation of earnings. Although using the corporate tax as a regulatory device had some success, it usually worked best when it was done to reinforce existing norms rather than trying to establish new ones from the top down.58 The former use of the corporate tax was particularly evident during the 1920s. The country was trying to transition from a war economy to a peace economy and it was evident that corporations needed the resources to help power this transformation. To do this, Congress needed to remove some of the obstacles identified by corporations so it could take the necessary steps to aid the economy. One of those steps – and the associated tax obstacle to it – was engaging in the mergers and acquisitions that would allow capital to flow to its highest and best use. The problem was that corporations and their stockholders were chilled by the potential tax consequences for these transactions. Although Congress had enacted the first tax-free reorganization provision in 1918,59 practitioners complained that it was written in an unclear and unhelpful way,60 causing many to second guess whether it would cover their transaction. As T.S. Adams testified before the Senate Finance Committee in 1921, ‘where any heavy tax is involved the reorganization is held up. They do not do it. All kinds of business readjustments have been stopped … the principal defect of the present law is in blocking desirable readjustments.’61 Under the Revenue Act of 1921 and again in the Revenue Act of 1924,62 Congress expanded and clarified the tax, specifically defining the transactions that would qualify. The congressional tax writing committees explained that these reforms ‘will, by removing a source Bank, From Sword to Shield, supra note 2, at 109, Fig. 4. One example of the latter is the so-called small business stock, which allows investors in qualified corporations with assets not in excess of $50 million to exclude from gross income gains from the sale of that stock. I.R.C. § 1202. For further discussion of the myriad tax benefits provided to encourage investment in small business corporations, see Mirit Eyal-Cohen, Down-Sizing the Little Guy Myth in Legal Definitions, 98 Iowa L. Rev. 1041, 1081–6 (2012). 58 Steven A. Bank, Tax, Corporate Governance, and Norms, 61 Wash. & Lee L. Rev. 1159, 1165–6 (2004). 59 Revenue Act of 1918, ch. 18, § 202(b), 40 Stat. 1058 (1919). 60 Bank, From Sword to Shield, supra note 2, at 136–7. 61 Hearings on H.R. 8245 before the Senate Comm. on Fin., 67th Cong. 29 (1921) (statement of Dr. T.S. Adams, advisor to the Treasury Department). 62 Revenue Act of 1921, ch. 136, § 202, 42 Stat. 227; Revenue Act of 1924, ch. 234, § 203(h)(1), 43 Stat. 253, 257. 56 57

30  Research handbook on corporate taxation of grave uncertainty … permit business to go forward with the readjustments required by existing conditions.’63 These pro-business tax reforms continued with rate reductions under Treasury Secretary Andrew Mellon and corporate cash surpluses ballooning by $5.6 billion between 1926 and 1929.64 This pro-business sentiment soon gave way to concerns about the dangers of corporate power and abuse caused by this favoritism. Proponents of corporate income taxation in the U.S. had long cited its advantage as a means of regulating corporations and their managers, including during the infancy of the corporate tax.65 President Cleveland’s 1893 proposal to tax corporate income was one such example. Representative William L. Wilson, Chair of the House Ways and Means Committee, wrote ‘[t]he very limited public supervision incident to the assessment and collection of such a tax … might be salutary in its influence.’66 These statements appeared to have been designed to appeal to the growing anti-corporate sentiment in the country, though, rather than to truly regulating corporations.67 Similarly, President Taft observed that one of the benefits of the corporate excise tax he proposed in 1909 was ‘the federal supervision which must be exercised in order to make the law effective over the annual accounts and business transactions of all corporations.’68 As Congress investigated the causes of the stock market crash and the ensuing Great Depression in the early 1930s, arguments for using the corporate tax as a regulatory device reappeared. Franklin Delano Roosevelt (FDR), as a candidate for President, and his so-called ‘Brain Trust’ of advisors were concerned about the corporation and what one member of the Brain Trust – Columbia law professor Adolf Berle – characterized as ‘a greater accumulation of surpluses than were ever before realized in economic history.’69 This was less a concern about tax avoidance – although tax rules were considered part of the cause and part of the solution – and more a concern about how this concentration of wealth in corporate hands was affecting the economy and politics. The primary concern was that such ‘corporate hoarding’ had ‘upset the balance of production and consumption’ and thereby helped to create the conditions that led to the financial crisis.70 Nevertheless, the underlying worry was much greater. It was that in not returning these H.R. Rep. No. 67-350, at 1 (1921); S. Rep. No. 67-275, at 12 (1921). John Martin, Jr., Taxation of Undistributed Corporate Profits, 35 Mich. L. Rev. 44, 55 (1936). 65 See Steven A. Bank and Ajay K. Mehrotra, Corporate Taxation and the Regulation of Early Twentieth-Century American Business, in Corporations and American Democracy, 177, 178 (Naomi R. Lamoreaux and William J. Novak, eds., Harvard University Press, 2017); Reuven Avi-Yonah, The Story of the Separate Corporate Income Tax: A Vehicle for Regulating Corporate Managers, in Business Tax Stories, 11, 17–22 (Steven A. Bank and Kirk J. Stark, eds., Foundation Press, 2005); Kornhauser, supra note 5, at 53. 66 William L. Wilson, The Income Tax on Corporations, 158 N. Am. L. Rev. 1, 7 (1894). 67 Bank, From Sword to Shield, supra note 2, at 44. 68 44 Cong. Rec. 3344 (1909) (message of Pres. Taft). See Kornhauser, supra note 5, at 99 (suggesting that Taft viewed the tax as furthering his goal of regulating the corporation). 69 Memorandum of 19 May 1932 of Raymond Moley and others for Franklin Delano Roosevelt outlining national program for recovery in Box 282, Folder 3, Raymond Moley Papers, Hoover Institution Library and Archives, Stanford University, at 1 (‘Memorandum of 19 May 1932’). For more on the ‘Brain Trust,’ see Daniel R. Fusfield, The Economic Thought of Franklin Delano Roosevelt and the Origins of the New Deal 207 (Columbia University Press, 1956); Raymond Moley, After Seven Years, 21–2 (Harper & Brothers, 1939). 70 Memorandum of 19 May 1932, supra note 69, at 2–3; Bank, From Sword to Shield, supra note 2, at 157, n. 62. 63 64

The history of the corporate tax  31 surpluses to stockholders as dividends, ‘corporate administrators have assumed that they were private funds, capable of being withdrawn from personal uses and used to satisfy unrestrained ambitions for expansion.’71 In response to these concerns about corporations, Congress enacted a variety of reforms to the taxation of corporations that were largely designed to either prevent or mitigate the concentration of wealth that had built up in corporations during the 1920s. These included a variety of provisions during FDR’s first term, such as (1) new rules for qualifying a merger or acquisition as a tax-free reorganization,72 (2) limits on the ability of most corporations to file consolidated income tax returns,73 (3) an increase in the tax burden on intercorporate dividends – or dividends paid from a subsidiary to its parent corporation,74 and (4) graduated corporate income tax rates to allow Congress to specifically target large corporations with higher taxes than small businesses that operated in the corporate form.75 Effectively, the separate corporate income tax had fully transformed from a means of reaching shareholder wealth to a means of reaching the corporations and its managers. In his second term, Congress adopted perhaps the most hotly contested of FDR’s corporate governance-related tax reforms – the undistributed profits tax. Enacted in 1936, the tax was originally proposed as a means of ‘forcing undistributed surplus into the general market for capital.’76 As introduced in the House, the undistributed profits tax would have subjected corporations with annual income over $10,000 to rates ranging from 4 percent on the first 10 percent of undistributed profits to 42.5 percent on undistributed profits of 57.5 percent or more.77 Corporate managers called the proposal ‘radical’ and by penalizing retained earnings and promoting dividends would deprive ‘business management [of] one of the most essential matters of management involved in business.’78 Lacking the votes to defeat the undistributed profits tax proposal outright, opponents resorted to a different tactic in the Senate. By questioning the revenue raising possibilities of the undistributed profits tax, corporate managers and their political allies managed to insert a counter to the distributive pressure imposed by the tax. As enacted, the undistributed profits rates under the Revenue Act of 1936 ranged from 7 percent to 27 percent, but Congress also removed the exemption for dividends from the normal tax, thereby subjecting corporate income to double taxation if distributed.79 With the top undistributed profits rate equal to the lowest surtax rate for incomes over $44,000, the additional normal tax on dividends helped to Memorandum of 19 May 1932, supra note 69, at 4. Revenue Act of 1934, Pub. L. No. 73-216, § 112(g), 48 Stat. 680, 705 (1934). 73 Id. at § 141, 48 Stat. at 720–21. In 1932, Congress had imposed a 0.75 percent tax on corporations for filing a consolidated return. It was increased to 1 percent in 1933 and, in 1934, abolished for all corporations except railroad corporations, which were subjected to a 2 percent tax for the privilege of continuing to file consolidated returns. Bank, Tax, Corporate Governance, and Norms, supra note 58, at 1164, n. 13. 74 Revenue Act of 1935, Pub. L. No. 74-407, § 102(h), 49 Stat. 1014, 1016 (1935). 75 Id. at § 102(a), 49 Stat. at 1015. 76 Revenue Act of 1936, Pub. L. No. 74-740, § 14(b), 49 Stat. 1648, 1656 (1936); Memorandum of 19 May 1932, supra note 69, at 3. 77 Revenue Act of 1936: Hearings on H.R. 12395 before the House Comm. on Ways and Means, 74th Cong., 2d Sess. 6 (1936) (‘1936 House Hearings’). 78 Id. at 857 (statement of John W. O’Leary, president, Machinery and Allied Products Institute); id. at 352 (statement of G.L. Waters, Illinois Manufacturing Association). 79 Bank, From Sword to Shield, supra note 2, at 182. 71 72

32  Research handbook on corporate taxation tip the balance back in favor of retained earnings.80 More notably, although the undistributed profits tax did not last long,81 double taxation survived and became an enduring part of the classical corporate income tax system in the U.S.82 This pattern of shielding and then regulating corporations through the income tax has been a recurring phenomenon in the U.S. in the post-World War II period. Between the late 1940s and the early 1960s, Congress once again heeded the pleas of corporations for relief after bearing the high tax burden imposed during the war.83 It repealed the excess profits tax (although briefly revived during the Korean War),84 provided for accelerated depreciation allowances, and enacted an investment tax credit.85 It also provided some measures that were a nod toward an earlier era when the corporate and personal income taxes were more integrated, such as enacting a dividend tax exclusion and credit to help revive interest in stock investment,86 as well as providing pass-through tax treatment options for small business corporations.87 These moves, however, were limited, designed to appeal to certain constituencies or a certain political narrative. Using a credit to provide dividend tax relief, for example, rather than a percentage, in combination with the modest dividend exclusion, was a targeted benefit for lower bracket shareholders.88 It was considered a ‘limited’ benefit that had been ‘watered down’ from the initial proposal.89 Similarly, the pass-through tax options were focused on small businesses. Effectively, these moves to mitigate double taxation for lower bracket shareholders and small business corporations reinforced double taxation for the largest corporations – and its ability to shield corporate managers – by removing it as a populist issue.

V.

EPILOGUE: OTHER COUNTRIES

The four-act description of the development of the classical corporate income tax is not unique to the U.S. Other countries experienced a similar progression as they navigated through the challenges of taxing corporate income. What distinguished these countries from the U.S., Id. Id. at 183–5. 82 Id. at 186–9. 83 Steven A. Bank, The Rise and Fall of Post-World War II Corporate Tax Reform, 73 L. & Contemp. Problems 207, 208 (2010). 84 Id. at 215. 85 E. Cary Brown, Tax Incentives for Investment, 52 Am. Econ. Rev. 335 (1962). 86 Carl Shoup, The Dividend Exclusion and Credit in the Revenue Act of 1954, 8 Nat’l Tax J. 136 (1955). The exclusion was on the first $50 of dividend income and the credit was set at 4 percent on dividend income beyond the exclusion. 87 Richard Rutter, Small Business Hits the Jackpot, N.Y. Times, 17 Aug. 1958, at F1; Mirit Eyal-Cohen, When American Small Business Hit the Jackpot: Taxes, Politics, and the History of Organizational Choice in the 1950s, 6 Pitt. Tax Rev. 1 (2008). 88 Bank, From Sword to Shield, supra note 2, at 224. The fact that the credit was not refundable, however, made it less useful for shareholders who owed no federal income taxes. Scott A. Taylor, Corporate Integration in the Federal Income Tax: Lessons from the Past and a Proposal for the Future, 10 Va. Tax Rev. 237, 286 (1990). 89 Eugene Neil Feingold, The Internal Revenue Act of 1954: Policy and Politics (Ph.D. dissertation, Princeton University) 179 (1960); John D. Morris, Eisenhower Sets 1956 for Tax Cut, N.Y. Times, 21 Jan. 1955, at 10. 80 81

The history of the corporate tax  33 however, is that some reversal occurred at one or more of the steps, generally leading to a move to at least a partial imputation system that credited shareholders for some, or all, of the tax paid at the corporate level ostensibly on their behalf. New Zealand and the United Kingdom, both of which at one point had a classical corporate income tax, offer examples of how and why such reversals occurred. A.

New Zealand

New Zealand’s classical corporate income tax developed in much the same way as in the U.S. Starting in 1891, corporations were taxed on their income, while shareholders were exempt on dividends.90 The rationale for this exemption was that ‘the income had already been taxed in the hands of the company.’91 That system broke down, however, when, much like in the U.S., individual and corporate rates, which had been identical in 1891, diverged when the flat rate company tax was replaced by a graduated scale.92 Individuals started to incorporate activities that had been previously conducted individually to take advantage of the lower corporate rates.93 In 1958, the country resorted to a classical system of corporate income taxation, like in the U.S., as a way to alleviate the tax avoidance problem without subjecting corporations to the high post-World War II rates that had been imposed upon individuals.94 It did not subject dividends to full double taxation at both the corporate and shareholder levels because it erected a ceiling on the level of dividends subject to the shareholder tax.95 Nevertheless, it did erect a form of disincentive to distributing rather than retaining earnings. By 1988, New Zealand had become concerned that shielding ‘locked capital into less productive activities within existing companies’ by preferencing retained earnings over dividends.96 Companies in New Zealand had found ways to get around the double tax, but that only exacerbated the system’s complexity and forced Parliament to enact anti-avoidance provisions.97 As a result, the country decided to diverge from the U.S. It dramatically reduced top marginal individual income tax rates from 66 percent to 33 percent, which matched the company rate adopted a year later, and New Zealand moved from a classical corporate tax system to a full imputation system.98 This alignment of the corporate and individual income tax rates has been called ‘the cornerstone of the New Zealand system.’99 Since the classical system Annie Cho, The Five Phases of Company Taxation in New Zealand, 1840–2008, 14 Auckland Univ. L. Rev. 150–51 (2008). 91 Id. at 155 (quoting Herbert Adam Cunningham, Land and Income Tax in New Zealand, par. 299 (1st ed., Butterworth and Co. Ltd., 1933)). 92 Id. at 155. 93 Id. at 165. 94 Harris, supra note 4, at 701; Cho, supra note 90, at 150–51. 95 Harris, supra note 4, at 701. 96 Andrew Prevost, John D. Wagster, and Ramesh P. Rao, Dividend Imputation and Shareholder Wealth: The Case of New Zealand, 29 J. Bus. Fin. & Acct’g 1079 (2002). 97 John Prebble, Tax Reform in New Zealand, 6 Economic Papers (of the Economic Society of Australia) 61, 74 (1987). 98 Cho, supra note 90, at 170–71 and n. 154; Robert Stephens, Radical Tax Reform in New Zealand, 14 Fisc. Stud. 45, 48 (1993). 99 Matt Benge and David Holland, Company Taxation in New Zealand, in Tax Reform in Open Economies: International and Country Perspectives, 289, 291 (Iris Claus, Norman Gemmell, Michelle Harding, and David White, eds., Edward Elgar, 2010). 90

34  Research handbook on corporate taxation was a reaction to the shielding and avoidance problem, eliminating the differential between the individual and corporate rate made the classical system no longer necessary and allowed the transition to an imputation system. B.

United Kingdom

The United Kingdom had a similar route toward (and away from) a classical corporate tax as New Zealand, although for different reasons. The U.K. had integrated its company and individual income tax systems through a shareholder imputation system starting as early as the Income Tax Act of 1803 and continued it throughout the nineteenth and early twentieth centuries.100 Like New Zealand, the U.K. did increase individual income tax rates. In the Finance Act of 1910, the U.K. imposed a 2.5 percent super-tax on top of the regular 6 percent income tax for incomes in excess of £3,000, but it did not apply to corporations and the shareholder credit under the imputation system only applied to the standard rate and not the super-tax.101 Theoretically, this super-tax, which was eventually replaced by a progressive surtax,102 should have created the retained earnings tax avoidance problem like it did in the U.S. and in New Zealand, but apparently the custom of high dividends was too firmly entrenched in British corporate culture. During World War II, there was ‘grave doubt’ in the U.K. ‘about the adequacy of individual and corporate savings to maintain and expand the industrial economy.’103 Reformers blamed the over-distribution of corporate earnings as dividends, which stood in stark contrast to the pre-war concern in the U.S. about the under-distribution of earnings.104 In 1945, Hugh Dalton, the Chancellor of the Exchequer, stated in a speech to Parliament that ‘[i]n the national interest, capital development must stand in front of high dividends, particularly in the critical next years when we have to convert and modernise at high speed so large a part of our industrial outfit.’105 To address the high dividends problem, Parliament adopted a Profits Tax in 1947, which imposed a differential burden on distributed profits that was ‘specifically designed to encourage retention of earnings.’106 Under the Profits Tax, undistributed profits were taxed at 5 percent, while distributed profits were taxed at 12.5 percent. Because of what Dalton described as ‘a continuing and persistent inclination on the part of many concerns to declare increased dividends,’107 the rates were doubled to 10 percent on undistributed profits and 25 percent on

100 Income Tax Act of 1803, 1803 Geo. 3, 122, § 127; Income Tax Act of 1842, 1842 5 & 6 Vict., 35, § 54; Income Tax Act of 1918, 8 & 9 Geo. Ch. 40 (General Rule 20). 101 Finance Act of 1910, § 66; Report of the Royal Commission on the Income Tax, 1920, Cmd. 615, at 123. 102 Roswell Magill, L.H. Parker, and Eldon P. King, A Summary of the British Tax System, 24–5 (1934) (a report prepared for the U.S. Joint Committee on Taxation). 103 George May, Corporate Structures and Federal Income Taxation, 22 Harv. Bus. Rev. 16 (1943). 104 Bank, Anglo-American Corporate Taxation, supra note 22, at 134–5. 105 421 Parl. Deb., H.C. (5th ser.) (1945) 896–7 (statement of Mr. Dalton). 106 Morris Beck, British Anti-Inflationary Tax on Distributed Corporate Profits, 1948 Nat’l Tax J. 275 (1948). 107 444 Parl. Deb., H.C. (5th ser.) (1947) 401; Parliament, The Times (London), 13 Nov. 1947, at 6.

The history of the corporate tax  35 distributed profits the next year, and distributed profits were raised again to 30 percent in 1950 and 50 percent in 1951.108 Although the focus on restraining dividends waned when Conservatives took over control of government from Labour in the 1950s,109 culminating in the removal of the differential rate feature to the Profits Tax in 1958,110 it returned when Labour regained power in the early 1960s. In 1965, Niall MacDermot, the Financial Secretary to the Treasury, reported that ‘[w]hen the differentiated Profits Tax was abolished in 1958, and tax incentives for retentions were removed, there was an immediate upsurge in distributions, and that has continued to the present day.’111 The blame was laid at the feet of the company tax system. James Callaghan, Labour’s Chancellor of the Exchequer, observed in his first Budget statement to Parliament that the tax system ‘does not provide sufficient incentive to companies to plough back profits for growth rather than to distribute them as dividends.’112 In response to these concerns, the U.K. adopted a classical corporate income tax as part of the Finance Act of 1965.113 Nicholas Kaldor, an economist at Cambridge, had advocated such a move in a dissent to a report prepared by the Royal Commission on the Taxation of Profits and Income in 1955.114 This dissent to the Commission’s recommendation to end the differential feature of the Profits Tax had argued that even if the differential rates had not dramatically reduced dividends, ‘nobody would dispute that a differential rate of say, 50 per cent. would not only prevent increased distributions but force companies to reduce the existing level of dividends.’115 The new Corporation Tax, by virtue of its double taxation of dividends, appeared to be structured to test Kaldor’s prediction. It imposed a burden of 35–40 percent, as compared with the 15 percent burden imposed under the differential Profits Tax.116 John Diamond, Chief Secretary of the Treasury, argued that by preferencing retained earnings it would create ‘a tax structure under which a business man will, out of his realised profits, have 50 per cent. more cash available for investment and plough-back than he has under the present system.’117 The experiment with a classical corporation tax was short-lived, replaced with an imputation system a few years after the Conservatives regained power.118 Studies had shown that the tax did little to change dividend payouts, as dividends remained stable, while retained earnings appeared to be largely a function of earnings, not taxation.119 Part of the reason may have been

108 Martin Daunton, Just Taxes: The Politics of Taxation in Britain, 1914–1979, 211 (Cambridge University Press, 2002). 109 Id. 110 Bank, Anglo-American Corporate Taxation, supra note 22, at 65. 111 712 Parl. Deb., H.C. (5th ser.) (1965) 52 (statement of Mr. Niall MacDermot). 112 701 Parl. Deb., H.C. (5th ser.) (1964) 1041, 1964 (statement of Mr. Callaghan). 113 Finance Act of 1965, c. 25, ss. 46–89. 114 Royal Commission on the Taxation of Profits and Income, Memorandum of Dissent to Final Report, Cmd 9474 (1955) at 383–4 9 (dissent authored by Kaldor, who was joined by G. Woodcock and H.L. Bullock). 115 Id. at 386, par. 99. 116 713 Parl. Deb., H.C. (5th ser.) (1965) 1724 (statement of Mr. Barber). 117 713 Parl. Deb., H.C. (5th ser.) (1965) 1833 (statement of Mr. John Diamond). 118 Finance Act of 1972, c. 41; Colin Mayer, The Structure of Corporation Tax in the U.K., 3 Fisc. Stud. 121, 124 (1982). 119 R.J. Brinston and C.R. Tomkins, The Impact of the Introduction of Corporation Tax upon the Dividend Policies of United Kingdom Companies, 80 Econ. J. 627 (1970). There was also concern about overseas income earned by British corporations, which some felt could be better addressed through

36  Research handbook on corporate taxation that a strong regular dividend was deeply ingrained in the U.K. corporate culture, whereas in the U.S. and New Zealand, it was more easily susceptible to changes in tax rates. That did not mean that the tax system was incapable of influencing corporate behavior, but it meant that the U.K. was facing a regulatory problem more than a shielding problem of its own making. Much like in the U.S. during the New Deal with the Undistributed Profits Tax, attempting to use tax to overturn corporate norms regarding dividend payouts proved to be too difficult.

VI. CONCLUSION Since 2003, the classical corporate income tax, at least in its purest form with a full layer of tax at both the corporate and shareholder level, has not existed in the U.S. At that time, Congress elected to treat dividends as net capital gains rather than ordinary income. This mitigated the double tax burden by subjecting dividends to the lower capital gains rates, while reducing the differences to the tax treatment of shareholders from stock sales and dividend distributions.120 In some respects, this step back from the most robust version of the classical corporate income tax reflects the same reversal from shielding that occurred in other countries. The previously large differential between individual and corporate income tax rates in the 1950s, when the top individual marginal rate was 91 percent and the corporate rate was 25 percent, had been whittled down to nothing by 2003, with the top individual and corporate income tax rates both set at 35 percent.121 Although the retreat from full double taxation was facilitated by the elimination in the differential between individual and corporate rates, it was part of a larger move to regulate the corporation through the corporate tax. In the wake of corporate scandals such as in Enron and WorldCom, attention was focused on the decline of dividends.122 Commentators argued that the absence of dividends helped to obscure the lack of real profits that was at the heart of these scandals.123 By reducing the double tax burden on dividends, the hope was that shareholders

treaties with an imputation system than a classical corporate tax. Report from the Select Committee on Corporation Tax, Session 1970–71 (20 Oct. 1971) at xiii, par. 24. 120 It did not eliminate the differences since dividends are taxed on the entire amount distributed, while sales are subject to taxation on only the amount realized in excess of basis. Moreover, under Section 1(h)(11), dividends are considered ‘net’ capital gains and therefore cannot be offset with capital losses like in sales. 121 Tax Foundation, Historical U.S. Federal Corporate Income Tax Rates & Brackets, 1909–2020, 24 Aug. 2021, accessed 23 Feb. 2023 at https://​taxfoundation​.org/​historical​-corporate​-tax​-rates​-brackets/​; Tax Policy Center, Historical Highest Marginal Income Tax Rates, 1913–2022, accessed 9 Feb. 2022 at https://​www​.taxpolicycenter​.org/​statistics/​historical​-highest​-marginal​- income-tax-rates. 122 Dividends’ End, The Economist, 10 Jan. 2002, accessed 25 Feb. 2023 at https://​www​.economist​ .com/​finance​-and​-economics/​2002/​01/​10/​dividends​-end. Academics suggested that the decline was not heterogenous among firms, with many large companies actually increasing dividends during this period. Harry DeAngelo, Linda DeAngelo, and Douglas J. Skinner, Are Dividends Disappearing? Dividend Concentration and the Consolidation of Earnings, 72 J. Fin. Econ. 425 (2004). 123 James K. Glassman, Numbers You Can Trust: Dividends, Wash. Post, 10 Feb. 2002, accessed 25 Feb. 2023 at https://​www​.washingtonpost​.com/​archive/​business/​2002/​02/​10/​numbers​-you​-can​-trust​ -dividends/​36103c4b​-d2cf​-4a9b​-a154​-afd20160d228/​.

The history of the corporate tax  37 would begin to demand dividends rather than using stock sales as an exit strategy and this would install a measure of accountability on corporate managers.124

Charles Crumpley, Dividends May Nip Scandals, The Oklahoman, 24 Feb. 2002, accessed 25 Feb. 2023 at https://​www​.oklahoman​.com/​story/​news/​2002/​02/​24/​dividends​-may​-nip​-scandals/​ 62105310007/​. 124

4. The incidence of the corporate tax Eric Toder1

1.

INTRODUCTION: WHAT IS TAX INCIDENCE?

This chapter presents a framework for thinking about who bears the burden of the US corporate income tax and offers some conclusions. The incidence of the corporate income tax has been a long-debated question among tax policy specialists. Conventional wisdom about the topic has changed considerably over time and is still evolving. Important issues remain unexamined or have not been fully resolved. I begin with a general discussion of principles for allocating tax burdens among households. I point out how households differ in how they earn and spend their income and how the economic burden of a tax differs from the legal obligation to remit it. The next section then applies those principles to the incidence of the corporate income tax. The corporate income tax is a tax on the profits of subchapter C corporations. I note that these profits come from two sources – (1) a normal return to corporate equity assets that is required to induce individuals and institutions to purchase and retain corporate shares and (2) super-normal returns, sometimes called economic rent, which are defined as profits greater than the amount necessary to attract equity capital. The following sections of the chapter then discuss how to allocate among individuals the burdens of the portions of the tax that fall on each of these sources of corporate profits and examine evidence on the relative shares of the tax burden that fall on the two sources. I then discuss how the division of the burden between labor and capital translates into the tax’s effect on the distribution of after-tax income. A final section offers some tentative findings and discusses issues still to be resolved. The discussion in this chapter reflects my view of the current state of professional thinking on corporate tax incidence. It draws on earlier review papers on the incidence of the corporate income tax, most notably Auerbach (2006, 2018) and Gale and Thorpe (2022). None of these authors are responsible for my conclusions. This chapter does not discuss the incidence of state and local corporate income taxes, which raises a whole series of additional issues. 1.1

What Questions Does Tax Incidence Analysis Seek to Answer?

Tax incidence analysis seeks to determine how the economic burden of taxation is shared among households with different amounts of ability to pay. We must define therefore what is meant by ability to pay. 1 I thank Alan Auerbach, Thomas Brosy, Kim Clausing, Tim Dowd, Bill Gale, Harvey Galper, Mark Mazur, Jim Nunns, Ben Page, Joseph Rosenberg, Steven Rosenthal, Gene Steuerle, and Alan Viard for helpful comments on an earlier draft of this chapter and Jeffrey Rohaly of the Tax Policy Center for simulations of the distributional effects of the corporate income tax under alternative assumptions.

38

The incidence of the corporate tax  39 1.1.1 Measuring ability to pay The three most common ways to measure households’ ability to pay are wealth, income, and consumption. Wealth is typically defined as the sum of the market value of financial assets (such as stocks and bonds) and real assets (such as homes and consumer durables).2 The use of wealth as a measure of ability to pay, however, has both practical and conceptual problems. It is very difficult to measure the value of wealth in assets not traded in organized markets, especially ownership shares in privately-owned businesses, which are a major source of the wealth of some of the wealthiest Americans. Further, the principal source of wealth of most people, the value of their human capital (conceptually, the present value of their future earnings), is also unobservable. Income and consumption are the two other competing measures of ability to pay tax. Economists define income as the sum of consumption plus net saving (changes in net worth). Income is equal to accruals from all sources, including labor earnings, transfer payments, and returns to capital investment.3 Alternatively, income in any year can be measured as the sum of consumption plus changes in net worth, the amount households can consume while leaving their wealth unchanged. Income is the sum of accruals over a year, while wealth is a stock of assets at any point in time. Many households have earnings and transfers, but little or no wealth, so income is a broader measure of household well-being than wealth. It is also a broader measure than consumption because it includes net saving. Analyses of the distributional effects of tax policies typically use current income as the measure of ability to pay. Government agencies, including the Office of Tax Analysis in the US Treasury Department (OTA), the Congressional Budget Office (CBO), and the Joint Committee on Taxation (JCT), and private sector organizations, including the Urban-Brookings Tax Policy Center (TPC), the Tax Foundation, and the Penn-Wharton Budget Model, use current income both to measure ability to pay and to rank households into different groups.4 Most analyses define income more broadly than adjusted gross income (AGI) as reported on federal income tax returns, adding such items to AGI as tax-exempt interest income, tax-free fringe benefits, income accrued within qualified retirement saving plans, and government transfer payments that are excluded from AGI. For practical reasons, however, the measures usually exclude some forms of income, such as unrealized capital gains and net imputed rent on owner-occupied housing. Some economists argue that current consumption is a better measure of lifetime ability to pay than current income because it more closely aligns with the sum of wealth plus the present

2 The view that wealth is a good measure of the ability to pay tax, especially for very wealthy individuals, motivated proposals by 2020 Presidential candidates Elizabeth Warren and Bernie Sanders to impose an annual tax on high-wealth individuals and is one rationale for increasing estate and gift taxes (or imposing an inheritance tax) on large inter-generational wealth transfers. 3 Changes in net worth include accrued, but unrealized gains, which are a major component of the income of very high income individuals that escapes tax under current law due to the deferral of tax on these gains until realization and the permanent exemption of gains transferred at death or donated to charitable organizations. 4 In contrast, however, studies that examine the distributional effects of reforms to the Social Security system typically rank individuals by the present value of their lifetime earnings (assigning to them half of the combined earnings of themselves and their spouses in years they are married). See, for example, Smith et al. (2003/04).

40  Research handbook on corporate taxation value of lifetime earnings. According to this viewpoint, income is a flawed measure of lifetime ability to pay because it overstates the lifetime well-being of those with relatively high saving rates either because they consume more later in life or have higher earnings earlier in life (for example, see Bradford and U.S. Treasury Department, 1984). Others, however, have questioned whether lifetime consumption is necessarily a better measure of ability to pay than lifetime income if tax rates are graduated (Kleinbard, 2017), if tax law and/or individuals’ family circumstances change over time (Graetz, 1997), or if individuals are unable to borrow from the prospect of future earnings to smooth consumption over their lifetime. For the remainder of this chapter, I will follow the practice of estimating agencies and most commentators and use pre-tax income as the measure of household well-being that the corporate income tax affects. 1.1.2 Differences among households: sources and uses Households differ based on their sources and uses of income. Sources refer to how people earn their income: from labor compensation (wages and fringe benefits), returns to capital (interest, dividends, capital gains, rental income, profits of small proprietors), and transfer payments (Social Security benefits and other cash or near-cash transfers, such as benefits from the Supplemental Nutrition Assistance Program). Uses of income refer to how people spend (consume) their income on various goods and services. 1.1.3 Sources, uses, and the distribution of income among income groups Households’ sources of income vary substantially among income groups. For example, compared with earnings, capital income is much more concentrated among upper income groups, while transfer payments are much more concentrated among lower income groups. Consumption patterns also differ among income groups. For example, cigarette consumption represents a higher share of consumption for lower than for higher income households, while vacation travel represents a higher share of consumption for higher income households. Almost all tax instruments affect households differently depending on their sources and uses of income. In practice, most distributional estimates reported by both governmental and private groups typically look only at how taxes affect the sources side, except that effects on uses of income are often included in analyses of sales and excise taxes. 1.2

Theory of Tax Incidence

Economic burden is not necessarily borne by the people who are legally responsible for remitting taxes to the government. Most taxes are imposed on economic transactions and either raise prices that buyers pay (thereby burdening them) or reduce prices that sellers receive (thereby burdening them) or a combination of both effects. The economic burden is therefore divided between the reduction in prices sellers receive and the increase in prices buyers pay from imposition of the tax, instead of depending on whether the seller or buyer is legally responsible for paying the tax. In general, the price effects, and therefore the incidence of a tax, depend on whether it is relatively easier for the buyer or the seller to escape the tax by substituting other purchases or sales. It does not depend on whether the buyer or seller is legally responsible for payment. For example, most economists believe labor bears most of the burden of a general payroll tax because employers are more willing to hire fewer workers in response to the tax (perhaps by

The incidence of the corporate tax  41 substituting capital for labor in production) than workers are willing to forgo earnings by not working. In contrast, a payroll tax on wages in a single industry is more likely to be borne by the employer (or shifted to the consumers of the product) than by workers within that industry because employees will not accept lower net wages than they would receive for similar work in an untaxed industry. In either case, the party who bears the burden does not depend on whether the employee or the employer is legally responsible for remitting the tax. Behavioral responses by consumers or producers can also result in changes in prices received and paid by consumers and producers not directly subject to the tax. For example, if the corporate income tax causes capital to shift out of the corporate sector, it will reduce returns to investors in non-corporate firms and, if it reduces total investment in the economy, it can reduce wages paid by both corporate and non-corporate firms because lower investment would reduce the productivity of workers in both sectors. These broader (‘general equilibrium’) effects need to be considered in any analysis of tax incidence.

2.

HOW DOES ONE THINK ABOUT CORPORATE TAX INCIDENCE?

The corporate income tax is imposed on the profits of corporations organized under subchapter C of the Internal Revenue Code, generally referred to as C corporations. Flow-through entities such as subchapter S corporations, partnerships, limited liability companies (LLCs), and unincorporated sole proprietorships do not pay corporate income tax; instead, their income is allocated to their owners and is subject to personal income tax if the owners are individuals. C Corporations are a very small share of all business firms in the United States, but they account for a large share of business receipts because they include most of the largest firms. In 2015, C corporations accounted for about 60 percent of business receipts.5 2.1

Who Is Liable for the Corporate Income Tax?

As a tax on corporate profits, legal liability for payment of the corporate income tax falls on corporations and therefore indirectly on its owners: that is, the shareholders. In general, employees and bondholders are not liable to pay US corporate income tax because wages and interest payments are deductible in computing corporate profits.6 Owners of US businesses that are taxed as flow-through enterprises and foreign corporations without US-source income also do not pay US corporate income tax. In a global context, the US corporate income tax is a hybrid between a territorial tax on profits earned within the United States and a worldwide tax at reduced rates on profits earned by US-resident corporations. As a territorial tax, the US corporate income tax is imposed at the same rates (currently a flat rate of 21 percent) on the profits of US and foreign-resident

5 See Internal Revenue Service, Statistics of Income, ‘Integrated Business Data’, Table 1, accessed 2 November 2022 at https://​www​.irs​.gov/​statistics/​soi​-tax​-stats​-integrated​-business​-data. 6 There are, however, some limits on deductibility of earnings and interest payments which make some wages and interest taxable at the corporate level. For example, corporations may not deduct executive salaries in excess of $1 million per year and are subject to various limits on the amount of borrowing for which interest deductions are permitted.

42  Research handbook on corporate taxation corporations from investments in the United States and exempts normal returns (defined as 10 percent of the depreciated basis in tangible assets) that US-resident multinational corporations earn in foreign countries.7 As a worldwide tax, the US taxes some of the profits that US corporations earn outside the United States, generally at special rates and with the allowance of credits for income taxes paid to foreign governments. (The US international rules are described in Chapter 8.) To the extent that the US corporate income tax is imposed either on foreign-resident corporations (through taxation of their US-source profits) or on US-resident corporations (through taxation of their domestic-source profits and some of their foreign-source profits), it affects all the corporations’ shareholders, whether they are Americans or foreigners. 2.2

How Does One Think about the Economic Burden of the Tax?

To understand the incidence of the corporate income tax, it is useful to distinguish between two sources of corporate profits: normal returns to capital and economic rent. 2.2.1 Normal returns to equity capital To attract and retain equity capital, corporations need to pay investors a high enough return, net of the corporate income tax, to induce them to hold corporate shares instead of other assets. This expected return must compensate them for forgone interest income and provide a risk-premium to reflect the fact that corporate equity returns are more variable than returns on high-grade corporate or government bonds. This ‘risk-adjusted’ normal return is the return corporations would earn in a competitive market with no barriers to entry or other special monopoly advantages. 2.2.2 Economic rents or ‘excess returns’ These are returns on investment that exceed the amount needed to attract capital. Excess returns can go under various labels – economic profits, super-normal returns, or economic rents. I will use the term ‘economic rents’ in the remainder of this chapter. These rents may arise from a variety of sources including patents, unique know-how, superior organization and management, and brand name reputation, among others. They reflect unique advantages that certain corporations possess that cannot easily be replicated by their competitors. To understand how the incidence of the corporate income tax is shared among corporate shareholders, other capital owners, workers, and consumers of corporate and non-corporate sector products, one has to answer three questions: (1) who bears the burden of the portion of the tax that applies to economic rent, (2) who bears the burden of the portion of the tax that applies to the normal return on capital, and (3) how are corporate profits divided between economic rents and normal returns? The next three sections of this chapter address these issues.

7 In practice both US and foreign multinationals can exploit opportunities to shift reported income from the United States to low-tax foreign countries. For a discussion of the techniques multinational corporations use to shift profits from intangible investments to low-tax foreign countries, see Kleinbard (2011). This income shifting erodes the base of a territorial tax.

The incidence of the corporate tax  43

3.

WHAT IS THE INCIDENCE OF A TAX ON THE ECONOMIC RENT OF CORPORATIONS?

3.1

Sources of Economic Rent

Economic rent may come from the possession of unique physical assets, such as control of natural resources, or from government-sanctioned monopolies (such as many utility companies), but it is generally a result of the return from intangible assets that are unique to the firm. These intangible assets include patents, trademarks, and brand name reputation. They may also be a result of institutional know-how that other firms cannot easily replicate or superior internal management and organization. Because these unique assets are fixed in supply in the short and medium term, any tax on the economic rents they generate is borne by the company and its stakeholders and cannot be shifted to other agents. The portion of the US capital stock attributable to intangible assets has been rising over time, as the dominant firms in the economy have increasingly consisted of firms in research-intensive sectors, such as information technology and pharmaceuticals, instead of firms engaged in traditional heavy manufacturing, such as automobile and steel companies. But even firms in low tech activities, such as selling hamburgers (e.g., McDonalds) or coffee (e.g., Starbucks) can possess significant intangible capital in the form of brand name reputation and a large global network of retailers with access to an efficient supply chain. In part, the economic rent earned by today’s leading corporations represents a return to past entrepreneurial activities and may dissipate over time if these firms do not continue to innovate and are overtaken by new competitors. So, it is probably an overstatement to claim that the corporate income tax has no effect in the long run on the supply of assets that generate economic rent in the near and medium term.8 Nonetheless, this discussion will follow the usual assumption that, at least for a considerable time, the assets that generate economic rent are fixed and taxing their returns does not change behavior. The question then becomes one of determining who receives economic rents from corporate share ownership and therefore who would bear a burden if those rents were reduced. 3.2

Who Bears the Tax on Economic Rent?

The traditional approach to the incidence of a tax on economic rent follows legal liability and assumes that shareholders bear the burden of the corporate income tax in the form of lower after-tax profits. The estimating groups that explicitly allocate a portion of the corporate income tax to economic rent (OTA and TPC) therefore assume this component of the corporate income tax burden is fully borne by current shareholders. But that leaves us with three questions: (1) do other stakeholders also bear a portion of the tax on rent? and (2) can a tax on economic rent shift some burden to labor by causing corporate investment to move overseas? and (3) even if shareholders bear the tax, who are they?

8 Toder (2020) argues that the corporate income tax may affect the return to entrepreneurial activities by lowering the market value of the companies they create and may in that way reduce the supply of entrepreneurial activity. But there are offsetting provisions in the tax law that favor entrepreneurs, in particular preferential treatment of capital gains.

44  Research handbook on corporate taxation 3.2.1 Do other stakeholders pay some of the tax on economic rent? The traditional approach to the incidence of a tax on economic rent assumes that shareholders bear the burden of the corporate income tax in the form of lower after-tax profits. The estimating groups that explicitly allocate a portion of the corporate income tax to economic rent (OTA and TPC) therefore assume this component of the corporate income tax burden is fully borne by current shareholders. A recent paper by Gale and Thorpe (2022), however, reviews a considerable body of research findings that suggest that shareholders are not the only stakeholders who may benefit when corporations earn economic rents. Notably, workers in highly profitable firms earn higher wages (Krueger and Summers, 1988) and the connection between profitability and wages is stronger in countries like Germany with high levels of unionization (Fuest et al., 2018). There is especially strong evidence that top management officials and other highly compensated employees earn more in profitable firms (Dobridge et al., 2021; Furman and Orszag, 2018; Ohrn, 2022; Stansbury and Summers, 2020), in part reflecting incentive-based compensation and the use of stock options. Firms facing imperfect competition may also share some of their profits with workers (Liu and Altshuler, 2015). In effect, there is a form of rent-sharing that goes beyond shareholders to include other stakeholders. This evidence suggests there may be a reason to modify the assumption in distributional analyses that shareholders pay 100 percent of the portion of the tax that falls on economic rent. Gale and Thorpe consider alternative ways workers, especially those that are highly compensated, may share in the benefit of economic rent and therefore in the burden of the corporate income tax. They find that the corporate income tax remains highly progressive under the most likely alternative assumptions about rent-sharing. 3.2.2

Will some corporate investment move overseas in response to a tax on economic rent? A tax on economic rent of US corporations will induce them to hold more intangible assets in their controlled foreign affiliates in low-tax countries. This reallocation of intangible assets and taxable profits to low-tax jurisdictions does not necessarily mean that more real assets will move overseas. US companies may, for example, book a substantial amount of profits in low-tax locations such as Bermuda and the Cayman Islands where they have very little physical investment or employment. However, to the extent there is any positive correlation between the location of intellectual property and the location of real investment, a shift of rent-generating assets overseas to reduce tax liability could also lead to less domestic investment and lower US wages. In section 4, below, we discuss at greater length the more direct effect on the location of investment and wages resulting from the portion of the tax that falls on the normal return to capital.

3.2.3 Who are corporate shareholders? Rosenthal and Austin (2016) show that direct individual ownership by domestic individuals accounts for less than 25 percent of corporate share ownership.9 For these shareholders, the common practice among estimators is to allocate their burden from the corporate income tax



9

See also Burman et al. (2017).

The incidence of the corporate tax  45 in proportion to their receipt of dividends and capital gains. These forms of income are highly concentrated among upper income taxpayers. But what about the other 75 percent of share ownership? Approximately half of these other shares are held indirectly by individual investors through qualified defined-contribution retirement plans or through the value of their future entitlement to retirement income from employer sponsored defined benefit plans. The investment income earned within these plans is not reported on individual income tax returns and must be imputed based on survey data, such as those reported in the Federal Reserve Board’s Survey of Consumer Finances. Ownership of assets in retirement saving plans are also concentrated among high income individuals, but to a lesser extent than individual shares in corporate equity. The ratio of income from retirement plan assets to total income is largest in the top quintile of the income distribution, but below the top 1 percent. The two remaining groups of corporate shareholders are tax-exempt investors, such as endowments of non-profit universities, and foreign investors. The question of how to treat the burden of the corporate income tax borne by these two groups is challenging. In principle, the corporate tax burden borne by non-profits should be allocated to the beneficiaries of their activities. In practice, estimating agencies allocate this proportion of the benefits received by non-profits among individual taxpayers in the same proportion on average that they allocate other benefits of corporate share ownership among individuals. This is clearly unsatisfying, but no research exists to date that would inform how to allocate this benefit in a different manner. The treatment of foreign investors (who account for slightly over 25 percent of US corporate share holdings) is a problem of a different nature. Except for the Joint Committee on Taxation (JCT), government agencies and private estimators also allocate foreign investors’ shares of the corporate tax burden in proportion to their allocation of the burden to other investors. The JCT, in contrast, simply exempts the portion borne by foreign investors from the overall burden US individuals bear from the US corporate income tax. While the JCT assumption seems intuitively correct, it may lead to an understatement of the total tax burden American shareholders bear because neither JCT nor any other estimating group counts the burden these shareholders may bear from foreign corporate income taxes. As of now, however, the question of how to treat cross-border shareholdings in incidence analysis is one that has not been carefully examined.10 The use of portfolio share ownership of US companies by foreign investors may substantially understate the share of US corporate income tax that foreign owners bear. Recall that the US corporate income tax is imposed on US profits of both US-resident corporations and US affiliates of foreign-resident corporations. It is likely that foreign individuals own a much larger share of foreign-resident corporations than their ownership share of US-resident corporations suggests. Making this correction, Rosenthal (2017) suggests that foreign shareholders

Some reviewers of this chapter pointed out that incidence analysis typically only looks at the effects of US taxes, holding foreign taxes fixed, because the US government only controls US tax laws. While that point is correct, it is also true that there are substantial interdependencies among corporate tax laws in different countries, and other countries for competitive reasons are likely to react to any substantial changes in US tax laws. For this reason, this author believes more thought should be given to analysis of the effects of corporate taxation as a global system, in which the US rules play a significant, but not wholly determining, part. 10

46  Research handbook on corporate taxation could own up to 35 percent of the shares of corporations subject to the US corporate income tax. 3.3

Concluding Remarks on the Tax on Economic Rent of Corporations

Determining the incidence of the portion of the corporate income tax that falls on economic rent is easier than determining the incidence of the portion that falls on normal returns because corporate stakeholders bear the entire burden of the tax on economic rent. But it is still not a simple question. In addition to shareholders, top management or, in unionized firms, a broader share of employees, may capture part of the economic rent and bear part of the burden of the tax on rent. And even if shareholders receive all the benefit, determining which individuals benefit from share ownership is challenging because individuals hold directly less than 25 percent of shares issued by US corporations. And determining how to assign the burden from share ownership by non-profit institutions and foreign investors is especially challenging.

4.

WHAT IS THE INCIDENCE OF A TAX ON NORMAL RETURNS OF CORPORATIONS?

The harder question is who bears the burden of the portion of the corporate income tax that falls on the risk-adjusted normal returns to corporate equity. The starting point for this analysis is that investors will not accept a lower return on corporate equity than on other financial and real assets. Therefore, a tax that lowers corporate equity returns will induce investors to shift out of corporate equity and into other assets, thereby affecting the after-tax income of other investors and workers. I first discuss these effects in the context of a closed economy and then examine the effects of international capital movements. 4.1

What Is the Incidence of the Corporate Income Tax in a Closed Economy?

Much of the early analysis of the incidence of the corporate income tax was based on an article by Harberger (1962) on the incidence of the corporate income tax in a closed economy. It is a great tribute to Professor Harberger that after 60 years his paper is still cited in discussions of the incidence of the corporate income tax, even though his conclusions have long since been substantially modified, even by himself. Harberger’s model assumed two industries in a competitive economy – one composed of corporate firms and the other of non-corporate firms. He assumed that total supplies of labor and capital in the economy were fixed, but also assumed perfect mobility of labor and capital between the two sectors that led after-tax wages and capital returns to be the same in both. He also assumed no international movement of either labor or capital. Harberger then estimated the incidence of the corporate income tax, using alternative assumptions about the degree of substitutability to consumers between corporate and non-corporate sector products and the degree of substitutability to firms between labor and capital as productive inputs in each sector. Using reasonable assumptions about these parameters, he found that between 90 and 120 percent of the corporate income tax was paid by capital owners generally. Based on this finding, future modelers for many years assumed

The incidence of the corporate tax  47 that 100 percent of the corporate income tax was paid by capital owners generally, not just shareholders.11 Harberger’s analysis also implies that the corporate income tax raises the cost of capital in the corporate sector and reduces it in the non-corporate sector. As a result, capital shifts from the corporate to the non-corporate sector, raising per-unit production costs, and therefore prices to consumers, in the corporate sector and reducing per-unit costs and consumer prices in the non-corporate sector. This change hurts individuals who consume a relatively large share of corporate sector products and benefits individuals who consume a relatively large share of non-corporate products. These potential ‘uses side’ effects have not been addressed in estimates of corporate tax incidence in distributional analyses of tax bills, probably because analysts have little data on relative consumption shares as between corporate and non-corporate products by households in different income groups. 4.2

How Does Assuming an Open Economy Change the Analysis?

Harberger’s closed-economy assumption became increasingly counter-factual over time with the growth of globalization and multinational enterprises. Recent analyses have therefore assumed an open economy. We can represent the portion of the corporate income tax that falls on normal returns as largely a territorial tax on profits earned from capital in the United States because the US tax law currently exempts the normal return on physical assets in foreign countries (assuming the normal yield is 10 percent). In this case, the US corporate income tax would cause investors to shift funds to capital overseas, which does not bear US corporate income tax. If the United States were a small open economy whose investors’ behavior did not affect global returns to capital, the corporate income tax would raise the required pre-tax return to corporate investment in the United States, instead of reducing the after-tax yield received by US savers. This would occur because both US and foreign savers would be unwilling to accept a lower after-tax return on US than on foreign assets and therefore would shift their savings overseas until the return in the US increased enough to restore parity between US and foreign assets. The resulting increase in the cost of capital in the United States would reduce domestic investment, thereby shifting the tax burden to less mobile factors, such as labor and land. But, as the US is better represented as a large open economy, taxes that reduce returns

Harberger’s analysis had numerous limitations, aside from the assumptions of perfect competition and no economic rents. He assumed the total supplies of labor and capital in the economy were totally unresponsive to changes in after-tax wages and after-tax returns on investment, so the tax had no effect on total investment, economy-wide work effort, or economic growth. He assumed perfect mobility between sectors, even though different categories of employment and assets are not perfect substitutes and therefore after-tax wages and capital returns do differ among firms and industries and capital returns differ among types of financial assets. He assumed that industries are either all corporate or all non-corporate, although many industries have a mix of both C corporations and other firms (see J.G. Gravelle and Kotlikoff, 1989). And he had a simplistic view of the taxation of corporate sector income, ignoring preferences for capital gains (and later, dividends), the different tax rules for corporate debt and equity income, and the effects of the combination of graduated rates and selective preferences on portfolio choices by individual investors. Finally, Harberger’s 1962 paper assumed no international capital flows, the effects of which we discuss in the next section below. 11

48  Research handbook on corporate taxation on US capital will also reduce the worldwide rate of return, so US capital owners would still bear some portion of the tax.12 4.2.1

General equilibrium analyses of the incidence of the US corporate income tax in an open economy Starting with the assumption of perfect competition and no economic rents, research using general equilibrium analysis has examined the incidence of the US corporate income tax in a global economy. An early study by Randolph (2006) found that with perfect mobility of capital, no international mobility of labor, and perfect substitution in consumption between domestic and foreign-made goods, US capital bore 30 percent of the US corporate income tax and US labor 70 percent. This reflected the fact that the United States accounted for about 30 percent of the global capital stock. By inducing a shift in capital from the US to foreign countries, the corporate income tax reduced labor productivity and wages in the United States, but increased labor productivity and wages overseas. As a result, the US corporate income tax benefited foreign workers (and in a similar manner, reduced returns to foreign capital owners). In response, J.G. Gravelle and Smetters (2006) adopted more realistic assumptions about the substitutability between foreign and domestic investment and the substitutability in consumption between foreign and domestically produced goods. They concluded that capital still bore most of the burden of the corporate income tax. Reviewing these and subsequent general equilibrium analyses, J.C. Gravelle (2013) examined the effects of alternative behavioral assumptions and concluded that the evidence from simulation models suggested that capital bore about 60 percent and labor about 40 percent of the tax. Several other factors (see Clausing, 2013) may increase the share of the tax borne by US owners of capital, including debt-equity substitutability, global residence aspects of the US corporate income tax, and long-term versus transitional analysis. ● If investors regard debt instruments of different companies as closer substitutes than corporate equity issued by different firms, then the US corporate income tax, by raising the cost of corporate equity in the United States, may cause firms to substitute debt for equity finance. This would lead to an inflow of debt finance to the United States, offsetting some of the adverse effects on US corporate investment of a higher US corporate income tax. ● If the US corporate income tax is in part based on the residence or the corporation, and most equity issued by US-resident corporations is held by US investors, then the tax will cause a smaller shift of capital overseas than if the tax were totally source-based. US investors would then bear more of the burden. ● In the short run, before capital stocks can change, the portion of the tax borne by US capital owners will be larger than in the long run and could approach 100 percent. Cross-border ownership of corporate equity investments can also complicate the incidence story. If the tax causes after-tax returns on corporate equity investments in the US to decline, foreign investors who own shares in US investments will bear some of that cost. By a similar logic, US investors will bear some share of the burden of US corporate income taxes in the form of lower after-tax yields on foreign investments.

12 This line of thinking led Harberger (2008) to alter his previous view and conclude instead that the US corporate income tax was mostly paid by labor, not capital.

The incidence of the corporate tax  49 Based on these considerations and acknowledging the wide range of estimates and uncertainty about findings, both OTA and TPC assume that 50 percent of the burden of the corporate income tax on normal returns is borne by capital income and 50 percent by labor income.

5.

HOW MUCH OF THE CORPORATE TAX FALLS ON ECONOMIC RENT?

In the previous sections, we have discussed the incidence of the taxation of economic rent and the taxation of normal returns to corporations. The general results suggest that capital bears a larger share of the portion of the tax that falls on rents than of the portion that falls on normal returns. But what shares of corporate income tax fall on each source of corporate profits? If capital expenditures can be deducted immediately (expensing) and if the corporate income tax rate is unchanged over time, there is no tax at the margin on the normal return to investment. Assume, for example, a corporate investment of K dollars yields a profit, net of the annual decline in the value of the asset, of R dollars per year. The pre-tax rate of return is R/K. If the investment can be expensed, its net cost is K(1−t), where t is the corporate tax rate. The profits tax will reduce the annual return to R(1−t). The after-tax return is then equal to R(1−t)/K(1−t), or simply R/K, the same as the pre-tax return. This relationship holds even if the firms earn a very high profit rate, such that R>i, where i is the normal yield on investment. In effect, with expensing the government becomes a silent partner in the investment, putting up a share of the capital and then capturing the same share of the return. If the investment earns a normal return, the present value of government revenue is zero. If investment opportunities that yield a return equal to R are unlimited, the firm suffers no harm from a tax with expensing because it can simply scale up its investment to earn the same total profit. But if the firm can earn a large return of R on only a finite quantity of investments, then the government becomes an unwanted partner in the firm, capturing some of the scarce excess returns that the firm’s investors would otherwise receive. And because the yield on those investments exceeds the discount rate (the return on alternative investments), the present value of government revenue would be positive. Exploiting this principle, economists have tried to estimate how much of the corporate income tax base would remain if corporate investments were expensed. With expensing, only the economic rent is taxable. So, the ratio of hypothetical revenue with expensing to revenue with current law capital recovery rules can serve as a measure of the share of corporate tax receipts that represent a tax on economic rent. Earlier studies using variants of this methodology and other approaches that compare corporate yields with a hypothetical normal return estimated that economic rent accounted for between 60 and 70 percent of taxable profits (Gentry and Hubbard, 1997; Gordon et al., 2004; Toder and Rueben, 2007). Based on their interpretation of this research, OTA has assumed that 63 percent of corporate income tax receipts fall on economic rents, while TPC has used a 60 percent figure. More recent research by Power and Frerick (2016) and Fox (2020), however, suggests that the share of profits attributable to economic rent may be even higher – perhaps in the 80 to 85 percent range. Four factors account for the increase over time in the share of corporate income tax receipts attributable to economic rent. First, the share of intangible assets in the US capital stock has increased. Second, the enactment of more generous rules of capital recovery over time – the

50  Research handbook on corporate taxation modified accelerated cost recovery system (MACRS) for machinery and equipment and, in many years, full or partial immediate expensing (bonus depreciation) has reduced the share of the normal return to investment that is taxable. Third, the shift of ownership of structures (especially commercial real estate) from C corporations to partnerships and LLCs has reduced the share of corporate capital with long tax depreciation lives and therefore a high ratio of taxable normal returns to taxable profits. Finally, low real interest rates and inflation rates in recent years have also reduced the (nominal) normal return to investment. Two major developments in the economy in the past few decades – globalization and the increased importance of intangible capital – have altered views on the incidence of the corporate income tax in opposite directions. Recognition of increases in capital mobility led analysts to assign more of the burden of the corporate income tax to labor instead of capital, compared to earlier views. But recognition of the increased importance of economic rent as a share of capital returns has caused views to shift in the opposite direction, with more of the burden assigned to capital income and, within capital income, to corporate shareholders.

6.

WHAT ARE THE IMPLICATIONS FOR THE DISTRIBUTION OF THE TAX BURDEN AMONG INCOME GROUPS?

Previous sections have discussed how the burden of the corporate income tax is shared among corporate shareholders, other recipients of investment income, and workers. There is considerable uncertainty about details and views on corporate tax incidence continue to evolve. Nonetheless, most professional opinion now leans to the view that capital owners bear most of the burden from the tax.13 6.1

Practices of Estimating Agencies

Both government and private sector estimators assign large shares of the corporate income tax burden to recipients of capital income. Although their methodologies and assumptions differ to some degree, CBO, JCT, OTA, and TPC all assign between 75 and 81 percent of the burden of the corporate income tax to recipients of capital income and between 18 and 25 percent to recipients of labor income (Table 4.1).

13 A dissenting view that the corporate income tax significantly reduces wages is based on a statistical analysis of cross-country and time series data by Hassett and Mathur (2006). Their findings had the seemingly implausible implication that workers bore more than 200 percent of the corporate tax burden and was used to justify a prediction that the corporate tax reforms in the Tax Cuts and Jobs Act of 2017 would increase wages for the average household by $4,000 (Council of Economic Advisers, 2017). Clausing (2013), however, performs statistical analysis using a variety of alternative specifications and finds that most specifications fail to find any effect of corporate tax rate cuts on wages. The evidence also suggests that the Tax Cuts and Jobs Act did not increase average wages by anything close to $4,000.

The incidence of the corporate tax  51 Table 4.1

How do estimating agencies distribute the burden of the corporate income tax among factors of production

Share of Total Corporate Tax Burden Burden on Labor Income

Congressional Budget

Joint Committee on

Office of Tax Analysis,

Urban-Brookings Tax

Office (CBO)

Taxation (JCT)

US Treasury (OTA)

Policy Center (TPC)

(1)

(1)

18%

20%

(1)

(1)

18%

20%

(1)

(1)

63% (2)

60% (2)

25%

25%

18%

20%

75%

75% (3)

81%

80%

0

0

1% (4)

0

from Taxation of Normal Return Burden on Capital Income from Taxation of Normal Return Burden on Capital Income from Taxation of Economic Rent Total Burden on Labor Income Total Burden on Capital Income Other

Notes: (1) CBO and JCT do not divide burdens between those attributable to normal returns and those attributable to economic rent. (2) OTA and TPC attribute all of the burden on economic rent to current corporate shareholders. (3) JCT attributes 20.6 percent of the burden of the corporate tax on owners of US capital assets to foreign shareholders and therefore does not distribute that portion to US households. (4) OTA attributes 1 percent of corporate receipts as a return from previously expensed investments, which it does not treat as a burden to any households. Sources: Congressional Budget Office (2019), ‘Projected Changes in the Distribution of Household Income, 2016 to 2021’, Report, Congressional Budget Office, Washington, DC.; Cronin, Julie-Anne (2022), ‘U.S. Treasury Distributional Analysis Methodology’, Technical Paper 8, Office of Tax Analysis, U.S. Department of the Treasury, May; Joint Committee on Taxation (2013), ‘Modeling the Distribution of Taxes on Business Income’, JCX-14-13, 16 October; Nunns, James R. (2012), ‘How TPC Distributes the Corporate Income Tax’, Urban-Brookings Tax Policy Center, accessed 2 November 2022 at https://​www​.taxpolicycenter​.org/​publications/​how​-tpc​-distributes​ -corporate​-income​-tax.

OTA and TPC explicitly distinguish between the portions of the tax attributable to normal returns and economic rent, but CBO and JCT do not. As a result, OTA and TPC, but not CBO and JCT, estimate different distributional effects for changes that affect tax burdens on normal returns alone (such as a change in depreciation rules) than for changes that affect both normal returns and economic rents (tax rate changes). For example, OTA and TPC would allocate 50 percent of the benefit of bonus depreciation to capital owners and 50 percent to workers – a much larger share to workers than their share of the total burden of the tax (18–20 percent). Other estimating groups (not shown in the table) use similar assumptions. For example, PWBM (Penn-Wharton Budget model, 2020) also assumes that 75 percent of the burden falls on capital income and 25 percent on labor income.14 The Tax Foundation assumes the

14 See footnote to Table 2 in Penn-Wharton Budget Model, ‘The Biden Platform’, 14 September 2020 (‘When distributing the corporate income tax to households, we assume that 75 percent of the tax falls on capital owners and 25 percent falls on workers in the form of lower wages over time. These lower wages and lower investment returns are included in the “effective tax rate” measure shown above’)

52  Research handbook on corporate taxation long-run burden of the corporate income tax is divided equally between capital income and labor income (Li and Pomerleau, 2018). 6.2

Distributional Burden of the Corporate Income Tax by Income Group (Tax Policy Center)

Based on simulations using the Tax Policy Center Microsimulation Model, the incidence of the corporate income is progressive under a broad range of assumptions, but the incidence is more progressive if a larger share of the burden is assigned to shareholders (Table 4.2). Table 4.2

Distribution of corporate income tax: Tax Policy Center

Expanded Cash Income

Share of Income

Group (1)

Economic Rent (100%

Normal Returns (50%

Baseline Burden (60%

Shareholders)

Labor; 50% all Capital)

Shareholders, 20% all Capital, 20% Labor)

Bottom Quintile

4.0%

1.1%

2.2%

1.6%

Second Quintile

8.2%

3.4%

5.9%

4.4%

Third Quintile

14.2%

7.1%

11.3%

8.7%

Fourth quintile

20.3%

12.7%

17.8%

14.7%

80–90th Percentiles

13.9%

10.4%

13.3%

11.6%

90–95th Percentiles

9.8%

8.8%

9.9%

9.3%

95–99th Percentiles

13.0%

14.4%

14.4%

14.4%

Top 1 Percent

16.7%

41.4%

24.3%

34.5%

TOP QUINTILE

53.4%

75.0%

61.9%

69.8%

Notes: (1) For a description of expanded cash income, see http://​www​.taxpolicycenter​.org/​TaxModel/​income​.cfm (accessed 2 November 2022). (2) Tax units with negative AGI are excluded from their respective income classes, but are included in the totals. Tax units include both filing and non-filing units, but exclude those which are dependents of other tax units. Source: Simulations using Urban-Brookings Tax Policy Center Microsimulation Model (Version 0722-1). Jeffrey Rohaly of TPC provided the estimates used for this table.

If the entire burden is assigned to shareholders (either because 100 percent of returns are attributable to economic rent or because the burden is based on the immediate impact of changing corporate tax rules before any adjustments), then the top quintile of tax units with 53 percent of expanded cash income bears 75 percent of the burden of the corporate income tax. The top 1 percent of tax units with 17 percent of income bears 41 percent of the burden. If 50 percent of the burden is borne by labor and 50 percent by capital (the assumptions of long-run burden by TPC and OTA if 100 percent of the tax is on normal returns), then the top quintile bears about 62 percent of the burden and the top 1 percent about 24 percent. Under the TPC assumption for the baseline corporate income tax, with 60 percent of profits attributable to economic rent and 40 percent to normal returns, the top quintile bears about 70 percent and the top 1 percent about 35 percent of the corporate tax burden.

accessed 2 November 2022 at https://​budgetmodel​.wharton​.upenn​.edu/​estimates/​2020/​9/​14/​the​-biden​ -platform.

The incidence of the corporate tax  53

7. CONCLUSIONS Corporate tax incidence is a complicated subject and views on who bears the burden of corporate income taxes have evolved over the past decades. There is universal agreement among tax scholars that individual households ultimately bear the burden of the tax, but how that burden varies among households with different sources of income, different patterns of spending, and different levels of income are still not fully settled. Changes in viewpoints among tax scholars reflect both new analytical approaches and changes in the domestic and global economy over the past few decades. The increased international mobility of capital over the past few decades has increased the share of the burden analysts assign to labor income. But the growth in the share of corporate investment in the form of intangible capital has increased the share of profits analysts attribute to economic rent, thereby increasing the share of the tax burden assigned to corporate shareholders and perhaps to other influential stakeholders, such as top corporate management. Some questions that affect relative shares of incidence among groups remain unresolved. There is little understanding on how the portion of the tax paid by non-profit institutions holding corporate shares should be allocated among households at different income levels or on how changes in relative prices among industries resulting from the tax may affect household income groups with different patterns of spending. There has also been insufficient analysis of the potential international spillover effects of global corporate income taxes, with foreign owners of US investments bearing some of the burden of the US corporate income tax and US holders of foreign assets arguably bearing some of the burden of other countries’ responses to changes in US corporate income taxes. Notwithstanding all these qualifications, we can still conclude that the corporate income tax is a highly progressive source of revenue. The exact degree of progressivity matters for how one estimates the net effects of wide-ranging tax bills with many offsetting provisions. And the specific way corporate revenues are increased affects how progressive the change may be, with raising revenues through an increase in rates likely to be more progressive than raising revenues through making capital recovery provisions less generous. Even so, it is reasonably clear that corporate income tax increases will burden upper income households more as a share of their income than other households and corporate income tax reductions will disproportionately benefit upper income households.

REFERENCES Auerbach, A.J. (2006), ‘Who Bears the Corporate Tax? A Review of What We Know’ 20 Tax Policy and the Economy: 1–40. Auerbach, A.J. (2018), ‘Measuring the Effects of Corporate Tax Cuts’ 32(4) Journal of Economic Perspectives: 97–120. Bradford, D.F. and the U.S. Treasury Tax Policy Staff (1984), Blueprints for Basic Tax Reform, Arlington, VA: Tax Analysts. Burman, L.E., K.A. Clausing, and L. Austin (2017), ‘Is U.S. Corporate Income Double-Taxed’ 70(3) National Tax Journal: 675–706. Clausing, K.A. (2013), ‘Who Pays the Corporate Tax in a Global Economy?’ 66(1) National Tax Journal: 151–84. Congressional Budget Office (2019), ‘Projected Changes in the Distribution of Household Income, 2016 to 2021’, Report, Congressional Budget Office, Washington, DC.

54  Research handbook on corporate taxation Council of Economic Advisers (2017), ‘The Growth Effects of Corporate Tax Reform and Implications for Wages’, October. Cronin, J.-A. (2022), ‘U.S. Treasury Distributional Analysis Methodology’, Technical Paper 8, Office of Tax Analysis, U.S. Department of the Treasury, May. Dobridge, C., P. Landefeld, and J. Mortenson (2021), ‘Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction’, Finance and Economics Discussion Series 2021-081, Board of Governors of the Federal Reserve System. Fox, E. (2020), ‘Does Capital Bear the U.S. Corporate Tax after All? New Evidence from Corporate Tax Returns’ 17(1) Journal of Empirical Legal Studies: 71–115. Fuest, C., A. Peichl, and S. Siegloch (2018), ‘Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany’ 108(2) American Economic Review: 393–418. Furman, J. and P. Orszag (2018), ‘A Firm Level Perspective on the Role of Rents in the Rise in Inequality’ in M. Guzman, ed., Towards a Just Society: Joseph Stiglitz and Twenty-First Century Economics, New York: Columbia University Press: 19–47. Gale, W.G. and S.I. Thorpe (2022), ‘Rethinking the Corporate Income Tax: The Role of Rent Sharing’, Urban-Brookings Tax Policy Center, 10 May. Gentry, W.M. and R.G. Hubbard (1997), ‘Distributional Implications of Introducing a Broad-Based Consumption Tax’ 11 Tax Policy and the Economy: 1–47. Gordon, R., L. Kalambokidis, and J. Slemrod (2004), ‘Do We Now Collect Any Revenue from Taxing Capital Income?’ 88(5) Journal of Public Economics: 981–1009. Graetz, M.J. (1997), The Decline (and Fall?) of the Income Tax: How to Make Sense of the American Tax Mess and the Flat Tax Cures that are Supposed to Fix It, New York: W.W. Norton and Company. Gravelle, J.C. (2013), ‘Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis’ 66(1) National Tax Journal: 185–214. Gravelle, J.G. and L.J. Kotlikoff (1989), ‘The Incidence and Efficiency Costs of Corporate Taxation When Corporate and Noncorporate Firms Produce the Same Good’ 97(4) Journal of Political Economy: 749–80. Gravelle, J.G. and K.A. Smetters (2006), ‘Does the Open Economy Assumption Really Mean that Labor Bears the Burden of a Capital Income Tax?’ 6(1) Advances in Economic Policy and Analysis. Harberger, A.C. (1962), ‘The Incidence of the Corporate Income Tax’ 70(3) Journal of Political Economy: 215–40. Harberger, A.C. (2008), ‘Corporate Tax Incidence: Reflections on What Is Known, Unknown, and Unknowable’ in J.W. Diamond and G.R. Zodrow, eds, Fundamental Tax Reform: Issues, Choices, and Implications, Cambridge, MA: MIT Press: 283–307. Hassett, K. and A. Mathur (2006), ‘Taxes and Wages’, AEI Working Paper #128, American Enterprise Institute, June. Joint Committee on Taxation (2013), ‘Modeling the Distribution of Taxes on Business Income’, JCX-14-13, 16 October. Kleinbard, E.D. (2011), ‘The Lessons of Stateless Income’ 65 Tax Law Review: 99–172. Kleinbard, E.D. (2017), ‘Capital Taxation in an Age of Inequality’ 90 Southern California Law Review: 593–682. Krueger, A.B. and L.H. Summers (1988), ‘Efficiency Wages and the Inter-Industry Wage Structure’ 59(2) Econometrica: 259–93. Li, H. and K. Pomerleau (2018), ‘The Distributional Impact of the Tax Cuts and Jobs Act over the Next Decade’, Tax Foundation, Washington, DC. Liu, L. and R. Altshuler (2015), ‘Measuring the Burden of the Corporate Income Tax under Imperfect Competition’ 66(1) National Tax Journal 215–238. Nunns, J.R. (2012), ‘How TPC Distributes the Corporate Income Tax’, Urban-Brookings Tax Policy Center, 13 September. Ohrn, E. (2022), ‘Corporate Tax Breaks and Executive Compensation’, Working Paper, Grinnell College. Penn-Wharton Budget Model (2020), ‘The Biden Platform’ (14 September): footnote to Table 2, accessed 2 November 2022 at https://​budgetmodel​.wharton​.upenn​.edu/​estimates/​2020/​9/​14/​the​-biden​ -platform. Power, L. and A. Frerick (2016), ‘Have Excess Returns to Corporations been Increasing over Time?’ 69(4) National Tax Journal: 831–845.

The incidence of the corporate tax  55 Randolph, W.C. (2006), ‘International Burdens of the Corporate Income Tax’, Congressional Budget Office, Washington, DC. Rosenthal, S.M. (2017), ‘Slashing Corporate Taxes: Foreign Investors Are Surprise Winners’ 157(4) Tax Notes: 559–64. Rosenthal, S.M. and L.S. Austin (2016), ‘The Dwindling Taxable Share of U.S. Corporate Stock’ 151(May) Tax Notes: 923–34. Smith, K.E., E.J. Toder, and H.M. Iams (2003), ‘Lifetime Distributional Effects of Social Security Retirement Benefits’ 65(1) Social Security Bulletin: 33–61. Stansbury, A. and L.H. Summers (2020), ‘The Declining Worker Power Hypothesis: An Explanation for the Recent Evolution of the American Economy’, Brookings Papers on Economic Activity: 1–96. Toder, E. (2020), ‘Does the Federal Income Tax Law Favor Entrepreneurs?’ 73(4) National Tax Journal: 1219–32. Toder, E. and K. Rueben (2007), ‘Should We Eliminate Taxation of Capital Income?’ in H.J. Aaron, L.E. Burman, and C.E. Steuerle, eds, Taxing Capital Income, Washington, DC: Urban Institute Press: 89–141.

PART II CORPORATE OPERATIONS

5. Corporate/shareholder tax integration George K. Yin

Governments are everywhere confronted by the question how to reach the taxable capacity of the holders of [corporate] securities, or of the associations themselves. Whom shall we tax and how shall we tax them in order to obtain substantial justice? Perhaps no question in the whole domain of financial science has been answered in a more unsatisfactory or confused way. Edwin R.A. Seligman, ‘The Taxation of Corporations I,’ 5 Poli. Sci. Q. 269, 269 (1890)

Professor Seligman referred mainly to the U.S. attempts throughout the 19th century to tax corporate wealth for state property tax purposes but, as it turns out, virtually identical words summarize the nation’s 160-year experience taxing corporations under the federal income tax. Whether the income of a corporation should be taxed, and how any such tax should be integrated with the tax on shareholders to ensure there is one, but only one, tax on corporate-source income, are questions that have plagued the U.S. throughout its history of federal income taxation. As Voltaire said, ‘history never repeats itself. Man always does.’ Section I of this chapter briefly reviews the nation’s efforts to achieve corporate/shareholder tax integration, focusing especially on the Civil War years when enduring problems first surfaced and Congress approved four integration approaches in three years. Section II then identifies some lessons from the historical experience. Somewhat counterintuitively, the evidence suggests the most feasible way to satisfy Professor Seligman’s quest for ‘substantial justice’ may be to retain two moderate and comparable, though separate, taxes on corporate-source income.

I.

U.S. APPROACHES TO CORPORATE/SHAREHOLDER TAX INTEGRATION

The extraordinary expenditures of the Civil War led Congress to enact many new taxes including the nation’s first federal income taxes.1 An income tax balanced other mostly consumption-based levies and enabled Congress to reach the wealthy, especially those who did not just ‘live by the work of their own hands.’2 The 1862 Act, the first income tax to be put into operation, generally taxed individuals at a rate of 3 or 5 percent of their ‘gains, profits, or income … from any … source whatever’ exceeding $600.3

1 For a description of the Union’s financial woes even prior to the disastrous first battle at Bull Run, see Roger Lowenstein, Ways and Means: Lincoln and His Cabinet and the Financing of the Civil War 44–46, 52–53 (Penguin Press, 2022). 2 Cong. Globe, 37th Cong. 1196 (Mar. 12, 1862) (Rep. Morrill (R.-Vt.)); see Steven A. Bank, Kirk J. Stark and Joseph J. Thorndike, War and Taxes 41–43 (The Urban Institute Press, 2008). Congress generally assumed the corporate tax was borne by shareholders and this chapter follows suit even though the issue is unresolved. See Chapter 4. 3 Act of July 1, 1862, ch. 119, § 90, 12 Stat. 432, 473.

57

58  Research handbook on corporate taxation Consistent with Congress’s objective, the levy also taxed the income of corporations. In describing the 1862 tax proposal, House Ways and Means Committee chair Thaddeus Stevens (R.-Pa.) mentioned the difficulty avoiding ‘double taxation.’4 While it is not clear what he was referring to – given the wide range of taxes included in the committee’s bill, there were many actual or claimed instances of ‘double taxation’5 – one objectionable type was taxing both corporations and shareholders on the same income. Senate Finance Committee chair William Fessenden (R.-Me.), soon to be Treasury Secretary, characterized as ‘ridiculous’ an amendment producing that result,6 presumably due to the inequity and inefficiency of taxing incorporated and unincorporated businesses differently. The 1862 Act generally imposed a 3 percent tax on the profits of corporations engaged in railroad, banking, and insurance businesses but excluded their dividends from shareholder income.7 This ‘dividend exclusion’ approach was a straightforward way of avoiding double taxation. The corporate tax was a ‘simple and speedy’ substitute for the shareholder tax on the same income8 and was similar, but not identical, to a withholding tax. The Act was silent on the treatment of corporations not engaged in the named industries. Arguably, their shareholders had to report their share of corporate income, whether distributed or undistributed, under the general rule mandating the reporting of income from any source. Early administrative guidance required limited partners to report partnership income in precisely that manner even though no statutory rule so provided.9 In the 1864 Act, Congress made this ‘passthrough’ approach to corporate integration explicit: corporations (other than those in the named industries) were not taxed, but their income – distributed and undistributed – had to be passed through and taxed to their shareholders.10 Four days after the 1864 Act became law, the President approved a congressional joint resolution imposing a special 5 percent tax retroactively on all 1863 income (amounts that had already been taxed under the 1862 Act).11 Importantly, this special tax applied only to individuals; corporations in the named industries were not taxed again on their 1863 income. Instead, their 1863 dividends, excluded from shareholder income under the 1862 Act, had to be added back and included in shareholder income for purposes of the special levy. The net result was a third, ‘corporate exclusion’ approach to corporate integration – shareholders, but

Cong. Globe, 37th Cong. 1577 (Apr. 8, 1862). See Edwin R.A. Seligman, Essays in Taxation 97–107 (5th ed., MacMillan & Co., 1905). 6 Cong. Globe, 38th Cong. 2739 (Jun. 4, 1864). 7 1862 Act, note 3, §§ 81, 82, 91, 12 Stat. at 469–71, 473–74. The singling out of enterprises in these industries followed patterns first developed in the states. See Steven A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present 9–11 (Oxford U. Press, 2010). 8 Treasury Dept., Annual Report of the Secretary of the Treasury on the State of the Finances for the Year Ending June 30, 1863 (GPO, 1864), at 63, https://​fraser​.stlouisfed​.org/​title/​annual​-report​-secretary​ -treasury​-state​-finances​-194/​report​-secretary​-treasury​-state​-finances​-year​-ending​-june​-30​-1863​-5507/​ report​-commissioner​-internal​-revenue​-77768​?start​_page​=​70 (last visited Feb. 28, 2023); see Joseph A. Hill, ‘The Civil War Income Tax,’ 8 Q. J. Econs. 416, 427 n.* (1894) (describing corporations as ‘convenient objects of taxation’). For a contemporary dividend exclusion proposal, see Treasury Dept., General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals 11–22 (2003) [hereinafter Treasury 2003]. 9 Decision No. 110 (May 1863) in Decisions Published by the Office of Internal Revenue to January (1871), at 59. 10 Act of Jun. 30, 1864, ch. 173, § 117, 13 Stat. 223, 282. 11 Jt. Res. No. 77 (July 4, 1864), 13 Stat. 417. 4 5

Corporate/shareholder tax integration  59 not corporations, were taxed on corporate income. Unlike the passthrough approach, however, shareholders of corporations in the named industries were taxed only on distributed corporate income under the special levy. Undistributed 1863 income of those corporations escaped the additional tax. Since Congress taxed undistributed corporate income, uncommon during that era, in part to discourage avoidance of dividend taxes if corporations retained their earnings,12 a possible explanation for the omission was the pointlessness of including a preventive measure in a retroactive tax. But it is unclear whether policy logic controlled in what was essentially a desperate grab for revenue. Perhaps just as likely, the omission was simply oversight, as the joint resolution, approved on the frantic, last day of the congressional session, was developed very quickly to finance compensation for soldiers and the bounties owed to their recruiters.13 Finally, in 1865, Congress addressed a deficiency inherent in the dividend exclusion approach approved in 1862 and continued in 1864. As shown in Table 5.1, the direct tax imposed on certain corporations was not necessarily a good surrogate for the shareholder tax when tax rates were considered. Table 5.1

Corporate and shareholder income tax rates, 1862–64 Corporate tax rate

Shareholder tax rates

1862 Act

3 percent

0, 3, or 5 percent

1864 Act

5 percent

0, 5, 7.5, or 10 percent

If corporate integration meant taxing corporate income once and only once at the shareholder’s tax rate, then dividend exclusion both over- and undertaxed it. Zero-bracket shareholders included those without income over the $600 exemption amount. In 1865, Congress ended one undertaxation possibility by replacing dividend exclusion with a fourth, ‘shareholder credit,’ approach to corporate integration.14 Under this prototype, corporations were taxed on their income and shareholders were taxed on the dividends from those corporations. To prevent double taxation, shareholders reduced their tax liability by receiving credit for the tax paid by the corporation. The corporate tax was thus closer to a true withholding tax paid on behalf of the shareholders. Importantly, like tax withholding on wages under current law, shareholders had to ‘gross up’ the amount of their dividends to include any tax withheld. For example, if a corporation paid and withheld a 5 percent tax, or $5, on a $100 12 See Harold Q. Langenderfer, II The Federal Income Tax: 1861–1872 (Arno Press, 1980), at 556; Bank, note 7, at 21. 13 See Cong. Globe, 38th Cong. 3527–28 (July 2, 1864) (Morrill); Harry Edwin Smith, The United States Federal Internal Tax History from 1861 to 1871 (Houghton Mifflin, 1914), at 64, https://​ tertulia​.com/​book/​the​-united​-states​-federal​-internal​-tax​-history​-from​-1861​-to​-1871​-harry​-edwin​-smith/​ 9781278064611 (last visited Feb. 28, 2023). The joint resolution also arose during a stressful time following Treasury Secretary Chase’s resignation and initial word of Confederate General Jubal Early’s surprise attack that ended within 5 miles of the White House. See Noah Brooks, Mr. Lincoln’s Washington 347, 352–56 (P.J. Staudenraus, ed., Thomas Yoseloff, 1967); James M. McPherson, Battle Cry of Freedom 756–57 (Oxford U. Press, 1988). 14 Act of Mar. 3, 1865, ch. 78, 13 Stat. 469, 479 (amending § 116 of 1864 Act). For a contemporary shareholder credit proposal, see Federal Income Tax Project: Integration of the Individual and Corporate Income Taxes – Reporter’s Study of Corporate Tax Integration by Alvin C. Warren, Jr., Reporter 92–113 (The American Law Institute, Philadelphia, Pa., March 31, 1993) [hereinafter Warren].

60  Research handbook on corporate taxation gross dividend and therefore distributed $95 to a shareholder, the shareholder had to report the full $100 as income, unreduced by the tax withheld, and then received a $5 credit for the tax already paid. Interestingly, this longstanding feature of U.S. income tax law arose from a floor amendment offered by a junior legislator not on the Ways and Means Committee who wanted to prevent undertaxation.15 In the foregoing example, a shareholder in the 10 percent tax bracket paid directly and indirectly only $5 under dividend exclusion but $10 under shareholder credit. Shareholder credit took into account information – shareholder tax differentials – that dividend exclusion ignored. Unfortunately, this remedy curbed undertaxation only for distributed corporate income. If a corporation retained income that would have been distributed to a shareholder in the 10 percent bracket, only a $5 tax was collected under the 1865 amendment. Congress was aware of the retained earnings opportunity and denied it for passthrough corporations but not for those directly taxed. As we shall see, integration’s failure to prevent this tax avoidance possibility would be a continuing problem. Congress also did not stop overtaxation – the collection of corporate tax even though the shareholder was in the zero-bracket – despite repeated legislator complaints concerning the plight of poor widow-and-orphan shareholders. Tax bill leaders insisted that any remedy presented ‘insuperable’ difficulties although it is unclear why.16 After all, under shareholder credit, overtaxation could have been ended by refunding any withheld corporate taxes exceeding the shareholder’s tax liability. Perhaps tax leaders did not understand this (their committees had not devised shareholder credit) or were wary of permitting refunds from tax returns, something very common today but virtually unheard of then.17 The refunds should have alleviated the nuisance to shareholders having to file otherwise unnecessary returns. Shareholder credit may not have been well understood. Although administrative guidance explained its operation, one of the few commentators to note the guidance seems not to have understood its effect.18 In the 1867 Act, Congress reinstated dividend exclusion presumably because that Act’s single tax rate for individuals matched the corporate rate and therefore eliminated the undertaxation possibility (though potential overtaxation persisted).19 To summarize: Congress enacted four approaches to corporate tax integration between 1862 and 1865: ‘dividend exclusion,’ which taxed corporations but not shareholders on corporate-source income; ‘passthrough,’ which taxed shareholders on both distributed and undistributed corporate income and did not tax corporations; ‘corporate exclusion,’ which taxed shareholders only on distributed corporate income and did not tax corporations; and

15 See Cong. Globe, 38th Cong. 836 (Feb. 16, 1865) (Rep. Wilson (R.-Iowa)). Wilson had been in Congress for only about three years but had previously chaired the Ways and Means Committee of the Iowa General Assembly. See Edward H. Stiles, Recollections and Sketches of Notable Lawyers and Public Men of Early Iowa 112–13 (The Homestead Publishing Co., 1916). 16 Cong. Globe, 39th Cong. 2786 (May 23, 1866) (Morrill). 17 In those years, there were no estimated taxes or refundable credits and the only other withholding provision was generally limited to taxpayers with more than the exempt amount of income. 1864 Act, note 10, § 123, 13 Stat. at 285. 18 See Langenderfer, note 12, at 465 (noting guidance), 475 (stating progressive tax rates did not apply to dividend income in 1865 and 1866). 19 Act of Mar. 2, 1867, ch. 169, § 13, 14 Stat. 471, 477–78 (amending §§ 116 and 117 of 1864 Act, as amended).

Corporate/shareholder tax integration  61 ‘shareholder credit,’ which taxed corporations on their income and shareholders on corporate dividends but gave the latter a nonrefundable credit for the tax previously paid on their behalf. We have already mentioned some of the flaws in dividend exclusion, corporate exclusion, and shareholder credit. Passthrough, perhaps the most intuitively appealing prototype, was also flawed because of the difficulty allocating undistributed corporate income among shareholders. While that problem may not have been very evident during the Civil War years when retained earnings were few, tax rates low and only slightly graduated, corporate stock not frequently traded, and corporate ownership arrangements fairly straightforward, the same would not be true once those conditions no longer existed. Finally, each approach other than corporate exclusion presented one further problem unaddressed by the Civil War income tax laws. Each taxed undistributed corporate income so double taxation was possible if shareholders sold their stock and realized gains reflecting in part the accumulated, already taxed, corporate earnings. Corporate exclusion escaped this difficulty because it did not tax undistributed (or any) corporate income. Instead, it had the opposite, potentially more serious, problem of letting undistributed income avoid tax altogether. Some legislators may have ignored this issue, believing that like British tax law, non-recurring capital gains (as opposed to regular, recurring gains from business activities) were not included in income.20 Thus, no double tax would arise if a shareholder sold corporate stock at a gain. But the statute and administrative guidance were clearly to the contrary.21 Although the law limited the taxation of real estate gains to property purchased within a year of sale, the rule did not apply to other types of property such as corporate stock.22 Considering the novelty of the income tax in the U.S., the wartime conditions, and the common belief that the levy would be only temporary, we may well excuse all these congressional oversights. But, as we shall see, even under less challenging legislative conditions, Congress would continue to find integration’s goals elusive. In 1894, Congress enacted another income tax that followed closely the laws approved during the Civil War. Individuals paid a 2 percent tax on their gains, profits, and income over $4,000.23 All for-profit corporations also paid a 2 percent tax on income and their dividends were excluded from shareholder income.24 Thus, Congress exclusively used the ‘dividend exclusion’ approach to corporate integration. Partnerships were not taxed but followed the ‘passthrough’ approach. Much of the income tax debate focused on the overtaxation problem in dividend exclusion. Critics again denounced the unfairness to widow-and-orphan shareholders whose income did 20 See Lawrence H. Seltzer, The Nature and Tax Treatment of Capital Gains and Losses 25–30 (National Bureau of Economic Research, Inc., 1951); Cong. Globe, 38th Cong. 2516 (May 27, 1864) (Fessenden) (explaining that increased property value was additional capital and not income). 21 1864 Act, note 10, § 117, 13 Stat. at 282 (taxing ‘all income or gains derived from the purchase and sale of stocks or other property’); ‘Taxation on Profits of Stock Sales’ (Apr. 22, 1865) in Digest of Decisions and Regulations Made by the Commissioner of Internal Revenue 33 (1906). 22 1864 Act, note 10, § 116, 13 Stat. at 281; ‘Taxation on Profits of Stock Sales,’ note 21. In Gray v. Darlington, 82 U.S. 63 (1872), the Court held that under the 1867 Act, gain from the sale of bonds owned for four years was not income but a mere increase in capital. The Court focused on prior statutory language taxing only ‘annual gains, profits, and income’ even though the 1867 Act had dropped the preceding word, ‘annual,’ from that provision. 1867 Act, note 19, § 13, 14 Stat. at 478 (amending § 116 of 1864 Act). 23 Tariff Act of 1894, ch. 349, § 27, 28 Stat. 509, 553. 24 Id., §§ 28 (last proviso), 32, 28 Stat. at 554, 556.

62  Research handbook on corporate taxation not exceed the exemption amount and highlighted the inequitable treatment of corporations compared to unincorporated ventures.25 They offered several fixes – all rejected – including crude versions of ‘passthrough’ and ‘corporate exclusion’ and a new ‘dividends-paid deduction’ prototype that allowed corporations to deduct part of the dividends they paid with the dividends then included in shareholder income.26 Each proposed solution reduced in whole or in part the tax on corporations. The shareholder credit approach, which would have left the corporate tax intact and could have easily prevented overtaxation, did not come up. In contrast to the Civil War debates, tax bill leaders did not oppose the proposals to prevent overtaxation merely because of unspecified administrative difficulties. Rather, they defended the corporate tax in part based on the entity’s legal rights and privileges.27 The corporate tax was beginning to be viewed as not simply a convenient surrogate for the shareholder tax but rather a proper tax in its own right.28 Congress’s refusal to end overtaxation, thus taxing indirectly shareholders who would otherwise have been exempt, was consistent with the latter view. On the other hand, its retention of dividend exclusion, conditioned on payment of tax by the corporation distributing the dividend, also showed the corporate and shareholder taxes were not completely separate and distinct. Corporate integration policy was alive and well in 1894.29 The corporate tax may have played a role in the Supreme Court’s Pollock decision striking down the 1894 income tax as an unapportioned direct tax.30 When the tax became law in late August, 1894, those wanting to challenge its constitutionality faced at least two major hurdles. One was precedent. Just 14 years earlier, the Court had unanimously held in Springer v. U.S.31 that the 1864 income tax was not a direct tax. As noted, the 1894 income tax closely resembled the Civil War income taxes including the 1864 tax. In addition, the Anti-injunction Act, enacted in 1867 and still law today, barred lawsuits enjoining the collection of taxes by the government.32 This meant any challenge to the validity of the 1894 tax would ordinarily have had to await payment of the tax followed by a suit to recover the purportedly illegal levy. Mr. Springer had followed this procedure and his case had not been decided until 14 years after the contested tax assessment.33 A challenge to the 1894 tax, therefore, might not be resolved until well after the initial filing of tax returns, payment of taxes, and implementation of the law’s administrative apparatus. That situation might have further deterred a court from invalidating the tax. 25 See 26 Cong. Rec. 6705 (Jun. 22, 1894) (Sen. Platt (R.-Conn.)); id. at 6767 (Jun. 23, 1894) (Sen. Hill (D.-N.Y.)). 26 See id. at 6868, 6876 (Jun. 27, 1894) (Hill). 27 See 26 Cong. Rec. Appx. 420 (Jan. 29, 1894) (Rep. McMillin (D.-Tn.)); 26 Cong. Rec. 6866 (Jun. 27, 1894) (Sen. Vest (D.-Mo.)). 28 See W. Eliot Brownlee, Federal Taxation in America: A History 81–82 (Cambridge U. Press, 3rd ed., 2016). 29 See Marjorie E. Kornhauser, ‘Corporate Regulation and the Origins of the Corporate Income Tax,’ 66 Ind. L. J. 53, 87–90 (1990); Bank, note 7, at 50–51. 30 See Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1895), modified on reh’g, 158 U.S. 601 (1895). 31 102 U.S. 586 (1880). 32 1867 Act, note 19, § 10, 14 Stat. at 475 (amending 1864 Act, § 19, as amended); 26 U.S.C. § 7421. 33 Springer later served in Congress and sponsored an amendment to include in income the value of property acquired by gift or devise. See Randolph E. Paul, Taxation in the United States 61 (Little, Brown & Co., 1954).

Corporate/shareholder tax integration  63 An early lawsuit enjoining the government from collecting the tax was dismissed in part because of the Anti-injunction Act. William Guthrie, an enterprising attorney, devised a different strategy. Instead of trying to stop collection of the tax, Guthrie found shareholders willing to sue their corporations to enjoin payment of the corporate tax and it was those suits that the Supreme Court resolved. Thanks to expedited procedures, the Court invalidated a portion of the law on April 8, 1895, seven days before first tax returns were due.34 Because one justice’s illness had resulted in the Court’s deadlock on some key issues, it quickly granted rehearing and declared the entire law unconstitutional on May 20, 1895, over a month before first tax payments were due. Thus, the ingenious strategy essentially stopped the law before it took effect.35 Fourteen years after Pollock, Congress passed the 1909 Act initiating a brief but unique period in U.S. income tax history. Because of Pollock, the nation did not impose an income tax on individuals but, thanks to the 1909 Act, did impose one on corporations. Congress approved a 1 percent tax – termed a ‘special excise tax’ to enhance its constitutional prospects – on corporate income over $5,000.36 The absence of a tax on individuals eliminated any double tax problem. As in 1894, there was some uncertainty regarding the function of the 1909 corporate tax. In recommending it to Congress, President Taft explained how taxing the entity promoted federal supervision of corporations.37 Among other things, Taft believed public disclosure of corporate tax return information would help achieve that end.38 But Taft also described the tax as if it were a mere withholding device for collecting the shareholder tax. Though there was no individual income tax to collect, there was much support for one and some may have seen the corporate tax as a constitutional, second-best way of reaching the income of individuals who were shareholders.39 The $5,000 exemption amount was similarly ambiguous: crude relief for shareholders with limited income or a device to let small corporations avoid the regulatory impact of the law such as tax return disclosure.40 Following ratification of the Sixteenth Amendment and passage of the first Act of the modern income tax in 1913, the nation once again had both an individual and corporate income 34 Congress had delayed the first filing date to April 15, 1895. Jt. Res. No. 18 (Feb. 21, 1895), 28 Stat. 971. 35 See Edward B. Whitney, ‘The Income Tax and the Constitution,’ 20 Harv. L. Rev. 280, 283–86 (1907); Robert T. Swaine, I The Cravath Firm and Its Predecessors, 1819–1947 (Ad Press, Ltd., 1946), at 520–22; Sidney Ratner, Taxation and Democracy in America 195–208 (Octagon Books, 1980); Peter S. Canellos, The Great Dissenter: The Story of John Marshall Harlan, America’s Judicial Hero 313–14 (Simon & Schuster, 2021). 36 Tariff Act of 1909, ch. 6, § 38, 36 Stat. 11, 112. 37 44 Cong. Rec. 3344 (Jun. 16, 1909) (Taft statement); see Reuven Avi-Yonah, ‘Corporations, Society, and the State: A Defense of the Corporate Tax,’ 90 Va. L. Rev. 1193, 1219–25 (2004). 38 See Kornhauser, note 29, at 97. The 1909 Act treated tax returns as public records ‘open to inspection as such,’ but only very limited public inspection ever occurred. 1909 Act, note 36, § 38, cl. 6, 36 Stat. at 116; see George K. Yin, ‘Preventing Congressional Violations of Taxpayer Privacy,’ 69 Tax Law. 103, 157–58 (2015). 39 See 44 Cong. Rec. 4006 (July 1, 1909) (Sen. Root (R.-N.Y.)) (describing the levy as taxing the ‘possessors of the stored-up wealth of the country’); Ratner, note 35, at 289–90. Root, however, used the argument to dampen interest in an individual income tax proposal. See Paul, note 33, at 95–96. 40 Only taxable corporations were required to file tax returns. 1909 Act, note 36, § 38, cl. 3, 36 Stat. at 114. As shareholder relief, the benefit was crude since all shareholders, not just low-bracket ones, were advantaged and those owning shares in more than one corporation obtained multiple benefits.

64  Research handbook on corporate taxation tax. Individuals paid a 1 percent ‘normal tax’ on income over $3,000 and an ‘additional tax,’ or surtax, up to 6 percent on income exceeding $20,000.41 Corporations paid a 1 percent income tax and withheld it from their dividends, which were excluded from shareholder income only for purposes of the normal tax.42 Congress, therefore, partially integrated the corporate and shareholder income taxes. The corporation in effect paid the shareholder’s normal tax on dividend income and the shareholder paid any surtax if there were distributions. Exempt shareholders could file refund claims with the government or submit exemption certificates (and tax returns in certain cases) to the corporation to prevent withholding in the first instance.43 Congress, therefore, sought to make its partial dividend exclusion have the same effect as a refundable shareholder credit. Congress generally continued this basic structure until 1936 but five major developments undermined its effectiveness at satisfying corporate integration goals. First, the 1913 refund procedure, applicable to many categories of income on which taxes had been withheld, proved very cumbersome for both taxpayers and withholding agents. Taxpayers also objected to sharing tax information with third parties.44 As a result, Congress in 1917 generally replaced withholding with information reporting and ended the procedures for refunds and the submission of exemption certificates to the withholding agent.45 This change foreclosed the ability of exempt shareholders to claim tax overpayments.46 Second, from 1917 on (except 1918), the corporate tax rate exceeded the highest normal tax rate on individuals.47 By 1934, the corporate rate was over three times the top normal tax rate.48 Since dividends were excluded from shareholder income only for purposes of the normal tax, part of the corporate tax became an extra levy or, as some legislators claimed, a partial substitute for the shareholder’s surtax.49 This justification was, of course, small consolation for those shareholders not subject to the surtax. Third, for five years during and after the nation’s involvement in the Great War, certain corporations paid an additional, ‘excess profits tax’ (EPT) on income at rates as high as 80 percent.50 The EPT initially applied to corporations, partnerships, and proprietorships but because the latter two were taxed as individuals, their income was already taxed at maximum rates of

Tariff Act of 1913, ch. 16, § II.A, 38 Stat. 114, 166. Id., § II.D and G(a), 38 Stat. at 168–69, 172. 43 Id., § II.E, 38 Stat. at 170; see 50 Cong. Rec. 509–11 (Apr. 26, 1913) (Rep. Hull (D.-Tn.)); Revenue Act of 1916, ch. 463, § 9(b), 39 Stat. 756, 763–64. 44 See Roy G. Blakey and Gladys C. Blakey, The Federal Income Tax 101 (Longmans, Green & Co., 1940). 45 See George K. Yin, ‘James Couzens, Andrew Mellon, the “Greatest Tax Suit in the History of the World,” and the Creation of the Joint Committee on Taxation and Its Staff,’ 66 Tax L. Rev. 787, 791 n.27 (2013). Withholding (without refunds) was continued for nonresident alien shareholders. War Revenue Act of 1917, ch. 63, § 1205(1), 40 Stat. 300, 332 (amending 1916 Act, note 43, § 9(b)). 46 Although withholding was generally ended, the direct corporate tax, which played a role analogous to a withholding tax, was retained. Id., § 1206(1), 40 Stat. at 333–34 (amending 1916 Act, note 43, § 10). 47 See, e.g., id., §§ 1, 4, 1206(1), 40 Stat. 300, 302, 333–34 (amending 1916 Act, note 43, §§ 1(a), 10(a)). In 1918, both rates were 12 percent. Revenue Act of 1918, ch. 18, §§ 210(a), 230(a)(1), 40 Stat. 1057, 1062, 1076. 48 Revenue Act of 1934, ch. 277, §§ 11, 13, 48 Stat. 680, 684, 686. 49 See 55 Cong. Rec. 5966 (Aug. 11, 1917) (Sen. Simmons (D.-N.C.)). 50 1917 Act, note 45, Title II, 40 Stat. at 302; 1918 Act, note 47, Title III, 40 Stat. at 1088. 41 42

Corporate/shareholder tax integration  65 67 and 77 percent in 1917–20. To avoid such income being taxed at over 100 percent, beginning in 1918, Congress limited the EPT to corporations. Congress, however, did not mitigate, through integration or otherwise, the tax burden on corporations subject to both the corporate tax and EPT and whose shareholders were taxed at the same high individual income tax rates.51 Fourth, some corporations paid a third income tax. This levy, applicable generally to corporations whose purpose was to retain earnings and enable shareholders to avoid high surtaxes on dividends, attacked the tax avoidance strategy not fully addressed during the Civil War and not needed in 1894 because of its flat tax. As in the Civil War years, partial integration did not prevent this problem so in 1913, Congress added a new restriction requiring shareholders, for purposes of the surtax, to report corporate income on a passthrough basis if the corporation was ‘formed or fraudulently availed of’ for the improper purpose.52 Subsequently, with sharply increasing surtax rates making the problem even more challenging, Congress switched to imposing a penalty tax on the income of such corporations at flat rates as high as 50 percent in 1924.53 This penalty was especially severe since it was not limited to undistributed income and exceeded the highest surtax rate potentially avoided in that year (40 percent).54 Serious implementation problems made the penalty provision largely unenforceable.55 But mere enactment of corporate and penalty taxes at rates higher than the top normal tax and surtax, respectively, combined with an EPT without any integration relief, showed how far Congress had strayed from corporate integration principles. Beginning in 1934, Congress added another penalty, taxing undistributed income of personal holding companies (PHCs) at rates between 30 and 40 percent without regard to any improper purpose for the accumulation.56 A final important development was enactment in 1921 of preferential tax treatment of capital gains.57 Other than a short period after the Tax Reform Act of 1986, such a preference has remained in the U.S. tax system and further complicated the goal of corporate integration. Among other things, it has made corporate retention rather than distribution of earnings more attractive. In 1936, Congress repealed dividend exclusion, thus ending corporate tax integration and introducing the ‘classical system’ of corporate taxation – treatment of the corporate and shareholder income taxes as separate and distinct – that the nation has maintained ever since. Individuals paid a 4 percent normal tax on income over $1,000 plus a surtax up to 75 percent on income over $4,000.58 Corporations paid a normal tax of 8 to 15 percent on income plus 51 For background on the EPT, see Yin, note 45, at 795–801. Subsequent EPTs enacted during the 1930s, 1940s, and 1950s were all limited to corporations. 52 1913 Act, note 41, § II.A (subdiv. 2), 38 Stat. at 166. 53 Revenue Act of 1924, ch. 234, § 220(a), 43 Stat. 253, 277. 54 Id., § 211(a), 43 Stat. at 267. In 1926, Congress retained the 50 percent rate even though the top surtax rate was only 20 percent but let shareholders elect passthrough treatment of corporate income in lieu of the tax. Revenue Act of 1926, ch. 27, § 220(a), (e), 44 Stat. 9, 34–35. In 1934, the tax base for this provision was limited to the undistributed income of the corporation. 1934 Act, note 48, § 102(a), (c), 48 Stat. at 702. 55 See Jt. Comm. on Int’l Rev. Tax’n, ‘Report on Evasion of Surtaxes by Incorporation (Section 220),’ JCT-10-12 (Jan. 22, 1927), at 38 (reporting ‘astonishing fact that not one dollar of revenue’ had been collected through 1926 from the anti-accumulation penalty tax), 54. 56 1934 Act, note 48, § 351, 48 Stat. at 751–52. For additional congressional proposals to prevent surtax avoidance and corporate opposition to them, see Bank, note 7, at 93–95, 98–108. 57 Revenue Act of 1921, ch. 136, § 206(b), 42 Stat. 227, 233. 58 Revenue Act of 1936, ch. 690, §§ 11, 12, 25(b)(1), 49 Stat. 1648, 1653–55, 1663.

66  Research handbook on corporate taxation a sliding-scale undistributed profits tax (UPT) on undistributed income (less the corporate normal tax). The UPT’s design allowed corporations to pay less tax the more they distributed their income.59 Importantly, repeal of dividend exclusion meant that all corporate-source income was potentially taxed at least twice. The 1936 Act also retained the EPT and penalty taxes on PHCs and corporations whose purpose was to accumulate income. The end of corporate integration, though a milestone in U.S. income tax history, represented only an incremental change from prior years. Since 1913, Congress had met integration’s goals with considerable imprecision. Exempt and low-bracket shareholders generally paid a higher direct and indirect tax on corporate-source income than that dictated by their tax rate. Some middle- and high-bracket shareholders did as well although most paid less and some paid much less. Repealing dividend exclusion simply shifted these consequences slightly, generally making low-bracket shareholders worse off but potentially taxing some middle- and high-bracket shareholders a bit more appropriately. Confronted by a sudden budgetary shortfall, the Roosevelt Administration in 1936 made the ‘sensational suggestion’60 of essentially flipping the role of the corporate tax. Since the Civil War years, the tax had generally been a surrogate for the base or normal tax owed by shareholders. Given the tremendous difficulty collecting shareholder surtax on dividends once its tax rate skyrocketed, Roosevelt proposed a graduated-rate UPT to serve roughly as a surtax substitute. The original proposal repealed the regular corporate tax, the shareholder’s exclusion of dividends for normal tax purposes, and the EPT.61 Shareholders would pay directly the normal tax on dividends and the surtax if there were distributions. If not, shareholders paid the surtax indirectly through the surtax-surrogate UPT paid by the corporation. The weapon chosen to combat surtax avoidance was powerful but blunt. No doubt, some corporations retained earnings for tax avoidance reasons, abetted by self-interested preferences of their managers for internal corporate financing.62 But the UPT applied equally to corporations with legitimate reasons for accumulation, such as younger enterprises in their growth phase, businesses with irregular income and capital needs, expanding ventures, debt-heavy corporations, and those with limited access to other capital.63 The proposal advantaged prior bad actors that had accumulated unnecessarily large surpluses and disadvantaged prior good actors without such cushions. Also, all shareholders, not just those in high surtax brackets, suffered the burden of the UPT. Finally, the absence of any integration relief meant that shareholders of corporations paying the surtax-substitute UPT potentially had to pay another surtax when distributions ultimately occurred. Very generally, the proposal extended the PHC penalty – intended for a limited group of closely held corporations whose predominantly passive income gave suspicion of improper accumulations – to all corporations without regard to the nature of their ownership or income.

Id., §§ 13, 14, 27(a), 49 Stat. at 1655–56, 1665. Paul, note 33, at 190. 61 See H.R. Rep. No. 2475, 74th Cong., 2d Sess. 3 (1936). 62 See Treasury 2003, note 8, at 4; Jennifer Arlen and Deborah M. Weiss, ‘A Political Theory of Corporate Taxation,’ 105 Yale L. J. 325, 348–51 (1995) (describing managerial preference for internal financing to reduce monitoring and enhance compensation). 63 See Steven A. Bank, ‘Is Double Taxation a Scapegoat for Declining Dividends? Evidence from History,’ 56 Tax L. Rev. 463, 533 (2003) (‘retained earnings [are] not, by themselves, an indication of manager misconduct, they are a necessary and prudent method of finance’). 59 60

Corporate/shareholder tax integration  67 Unable to defeat the proposal, corporations lobbied to reduce the UPT so that any distribution incentive would be offset by the disincentive of a shareholder tax on the distribution. From that vantage point, ending dividend exclusion furthered the objective of corporate opponents.64 They eventually succeeded in moderating the UPT, aided by Roosevelt’s Treasury Secretary who worried about the revenue effect of the initial proposal. To compensate for the revenue loss from reducing the UPT, corporations accepted continuation of the regular corporate tax because its amount was not dependent upon corporate distribution policy.65 Following 1936 and repeal of the UPT in 1939, there was a 45-year period when the maximum tax rate on individuals (as high as 94 percent in 1944–45) greatly exceeded the maximum corporate tax rate, the same relationship that had generally existed between 1913 and 1936. The rate structure gave corporations a strong tax incentive to retain earnings. From 1981 until 2018, except for a brief period after the Tax Reform Act of 1986, the top ordinary income tax rate continued to exceed the top corporate rate although the two were much closer. But that proximity was misleading because of increased corporate tax preferences during that same period. Corporations essentially traded off rate relief for tax base relief. Since 2018, the rate relationship has reverted to the historical norm, with the highest ordinary income tax rate (40.8 percent)66 almost twice the corporate tax rate (21 percent), and with no meaningful reduction in corporate preferences. Since 1936, there have been two important integration developments and both remain in the law today. One occurred in 1958 when Congress permitted certain corporations to be taxed as passthroughs.67 Under subchapter S, corporations with just one class of stock, a limited number of shareholders, and meeting certain other conditions may elect to have their shareholders report their share of corporate income, distributed or undistributed. The corporation generally pays no tax and shareholders obtain stock basis adjustments from the passthrough to minimize or eliminate any further tax upon a disposition of corporate shares. Congress carved out of the corporate sector a group of corporations (numbering about 5 million in 2019 or 75 percent of all corporations) whose straightforward organizational structure makes the passthrough approach feasible. The other development was in 2003 when Congress broke the historic link between dividends and ordinary income and instead taxed dividends like capital gains at graduated rates (presently up to 23.8 percent).68 This change recognized the distinction between dividends and other income because of the underlying corporate tax. Matching dividends with capital gains allowed the two ways shareholders realize corporate-source income to be generally taxed alike. The 2003 change grew out of a Treasury proposal to achieve corporate integration through dividend exclusion.69 The growth of corporate tax preferences, however, made implementing this approach more challenging than in earlier periods. To ensure collection of one full tax on corporate income, the proposal excluded dividends from shareholder income only if See Bank, note 7, at 176, 179. See id. at 175, 179, 182. 66 This includes the net investment income tax (‘NIIT’) (presently, 3.8 percent). 67 Technical Amendments Act of 1958, Pub. L. No. 85-866, § 64, 72 Stat. 1606, 1650. 68 Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No. 108-27, § 302(a), 117 Stat. 752, 760. The rate includes the NIIT. 69 See Treasury 2003, note 8. The proposal built on a similar Treasury proposal a decade earlier. See Treasury Dept., A Recommendation for Integration of the Individual and Corporate Tax Systems (1992). 64 65

68  Research handbook on corporate taxation distributed out of fully taxed corporate income. To extend relief to undistributed income, the proposal allowed corporations to elect constructive dividends and reinvestments. If distributed out of the corporation’s fully taxed income, the constructive dividends would be exempt to shareholders and the election’s only effect would be to increase the stock basis of shareholders. The initiative triggered a frenzy of lobbying from disparate members of corporate and shareholder groups and third parties. Among other things, there were concerns that the proposal would spur too much shareholder pressure for dividends and against corporate tax preferences (to augment the pool from which exempt dividends could be drawn).70 There were also unresolved technical issues, such as the extent to which cross-border income would qualify as ‘fully-taxed income,’ the allocation of basis increases from the dividend reinvestment election,71 and the possible need for corporate basis adjustments to reflect prior realizations by shareholders.72 The latter two issues were among the reasons the passthrough approach had generally not been considered viable for public corporations. Ultimately, 2003 proved to be similar to 1936 – in each year, Congress compromised by initiating, or continuing, double taxation rather than retaining, or adopting, a form of integration with more worrisome consequences.

II.

SOME LESSONS

The foregoing review has highlighted the important role of corporate distribution policy in solving the integration puzzle. By distributing or retaining earnings, corporations can either advance or block integration objectives. The passthrough approach avoids this difficulty but its feasibility for corporations beyond those meeting the subchapter S conditions is unproven. Thus far, Congress has attacked the retained earnings problem in three ways. One – imposing a penalty if an improper accumulation purpose is established – has been largely unenforceable. A second effort – the short-lived 1936 UPT – was arguably too blunt, potentially discouraging legitimate retentions as well as those motivated by tax avoidance or other improper purposes. Finally, a third approach, also not purpose-based, is the PHC penalty that relies upon objective attributes – stock ownership structure and type of income – to indicate the likelihood of improper accumulations. It is doubtful that Congress could expand the PHC approach and identify workable, objective factors that fairly assess the legitimacy of accumulations by all corporations. Moreover, the nation’s culture may not permit that degree of government involvement in corporate affairs. Perhaps the best the tax law can do is to be neutral towards the corporate distribution decision.73 70 For additional views of supporters and opponents, see Michael Doran, ‘Managers, Shareholders, and the Corporate Double Tax,’ 95 Va. L. Rev. 517, 565–85 (2009). 71 See George K. Yin, ‘Corporate Tax Integration and the Search for the Pragmatic Ideal,’ 47 Tax L. Rev. 431, 470–71 (1992) (describing, among other things, possible need for corporations to maintain capital accounts). 72 For an argument that such adjustments would not be needed, see Chris William Sanchirico, ‘Pass-Through, Public Trading, and the Dubious Obstacle of Inside Basis Adjustments,’ 74 Tax L. Rev. 129 (2020). 73 See Scott A. Taylor, ‘Corporate Integration in the Federal Income Tax: Lessons from the Past and a Proposal for the Future,’ 10 Va. Tax Rev. 237, 285 (1990); cf. Steven A. Bank, ‘Dividends and

Corporate/shareholder tax integration  69 Neutrality, unfortunately, is impeded by structural features in the law. The level of the corporate tax is effectively capped by globalization pressures and corporate defense of tax preferences. In contrast, there is somewhat greater flexibility in the level of the ordinary income tax. That tax is presently only moderately graduated by historical standards but revenue needs and inequality concerns could change that in the future. Historically, the top ordinary income tax rate has almost always been higher – sometimes much higher – than the top corporate tax rate and there is little reason to think that pattern will change. Thus, so long as shareholders are taxed on dividends at ordinary income rates, the two-tier corporate tax system generally provides a structural bias favoring retentions. As we have seen, the more the top shareholder tax exceeds the corporate tax, the less effective is an integration approach, such as partial dividend exclusion or shareholder credit, at overcoming that bias. If, notwithstanding contrary pressures, the integration method included raising the corporate tax rate equal to the highest ordinary income tax rate so that all shareholders receiving dividends would either be completely exempt or entitled to refunds, the approach might induce too much shareholder pressure for dividends. A constructive dividend and reinvestment election would relieve that pressure but its successful implementation by public corporations without excessive complexity has not been established.74 Because its relief is provided to the corporation, the dividends-paid deduction could in theory avoid this problem if corporations balanced their interest in relief (by distributing income) against their need to accumulate capital. But corporations were given that precise choice in 1936 and strongly rejected it, perceiving it to favor distributions too much.75 The deduction also creates a permanent book-tax difference since it is not treated as a charge against earnings for financial accounting purposes.76 Though touted by some, this feature might be a further reason to reject the approach as the prospect of many more corporations reporting little or no taxable income, or tax losses, while also reporting robust earnings for financial purposes, may not be very appealing to some policymakers.77 Breaking the link between dividends and ordinary income in 2003 provided an alternate way of avoiding the tax system’s structural straitjacket. Although not an integration prototype as traditionally conceived because of the continued presence of two separate taxes, the change is roughly similar to a partial dividend exclusion. But by allowing the ‘taxable portion’ of dividends to be taxed at a moderate and largely flat rate comparable to the corporate rate, the 2003

Tax Policy in the Long Run,’ 2007 U. Ill. L. Rev. 533, 571–72 (making same suggestion for corporate governance purposes). 74 See Yin, note 71. 75 See Taylor, note 73, at 282–85; Staff of Jt. Comm. on Tax’n, ‘Tax Policy and Capital Formation,’ JCS-14-77 (Apr. 4, 1977) at 17 (reporting substantial increase in dividends following 1936 change); cf. Reuven S. Avi-Yonah and Amir C. Chenchinski, ‘The Case for Dividend Deduction,’ 65 Tax Law. 3, 13 (2011) (‘[d]ividend deduction … would create a very powerful incentive for management to distribute earnings’). 76 See Christopher H. Hanna, ‘Corporate Tax Integration: Past, Present, and Future,’ 75 Tax Law. 307, 327 (2022). 77 The dividends-paid deduction would also allow multinationals distributing repatriated earnings purportedly ‘permanently’ reinvested abroad to avoid the expected adverse impact of the repatriation on their financials. See Michael J. Graetz and Alvin C. Warren, Jr., ‘Integration of Corporate and Shareholder Taxes,’ 69 Nat’l Tax J. 677, 684 (2016); Edward D. Kleinbard, ‘The Trojan Horse of Corporate Integration,’ 152 Tax Notes 957, 968–69 (2016).

70  Research handbook on corporate taxation change may have a more neutral effect on distributions than other options78 and without their complications.79 It also reduced the classical system’s bias favoring corporate debt financing and share buyback transactions. Finally, although comparing the taxation of corporate and noncorporate ventures is complicated (unless both are taxed as passthroughs or corporations), the 2003 change arguably brought their tax consequences closer together. What is important is not the number of times a stream of income is taxed but rather the overall effect of the resulting arrangement.80 Some claim the 2003 legislation was ‘not a coherent approach’ to integration because it granted dividend relief to underlying income that may not have been fully taxed.81 Yet the proper treatment of tax preferences under integration is a matter of dispute with the passthrough paradigm supporting preservation and passthrough of preferences to shareholders.82 Though the 2003 compromise failed to curtail preferences at the corporate level, it partially prevented their passthrough as long as the preference item is included in earnings and profits. If policymakers are so inclined, the 2003 structure could easily incorporate reforms to the corporate tax base. One final integration idea that avoids the retained earnings problem is to impose a mark-tomarket tax on the shares of public corporations. This approach, popular with theorists83 but never tried, would be a very major change and raises too many issues to be fairly considered in this short chapter. Among other things, policymakers would need to decide the tax rate of the levy, whether shareholders, the corporation, or both would pay it, the treatment of the many exempt shareholders of public corporations,84 the treatment of interim stock transactions, the proposal’s compatibility with international tax norms, and transitional matters.

78 Among other things, the result may depend upon the expected stability of tax rates, the extent the double tax is capitalized in share price, and the effect of reduced dividend tax on the shareholder’s reinvestment of amounts distributed. Cf. Warren, note 14, at 37–38 n.23; George K. Yin, ‘A Different Approach to the Taxation of Corporate Distributions: Theory and Implementation of a Uniform Corporate-Level Distributions Tax,’ 78 Geo. L. J. 1837, 1854–61 (1990). Evidence of increased dividends after 2003 is somewhat inconclusive due to factors such as the temporary nature of the original law. See Bank, note 7, at 254–56. 79 See Michael L. Schler, ‘Taxing Corporate Income Once (or Hopefully Not at All): A Practitioner’s Comparison of the Treasury and ALI Integration Models,’ 47 Tax L. Rev. 509 (1992); Yin, note 71, at 445–49, 466–68. 80 See id. at 433, 482–83 (recommending integration approach retaining two separate taxes with dividends taxed like capital gains); Seligman, note 5, at 98, 106. 81 Graetz and Warren, note 77, at 680. 82 See Warren, note 14, at 58–63. Professor Warren’s ALI Reporter’s Study anticipated passthrough of some preferences. See id. at 109. 83 See, e.g., Victor Thuronyi, ‘The Taxation of Corporate Income: A Proposal for Reform,’ 2 Am. J. Tax Pol. 109 (1983); Taylor, note 73, at 298–99; Joseph M. Dodge, ‘A Combined Mark-to-Market and Pass-Through Corporate-Shareholder Integration Proposal,’ 50 Tax L. Rev. 265 (1995); Joseph Bankman, ‘A Market-Value Based Corporate Income Tax,’ 68 Tax Notes 1347 (1995); Michael S. Knoll, ‘An Accretion Corporate Income Tax,’ 49 Stan. L. Rev. 1 (1996); Eric Toder and Alan D. Viard, ‘Replacing Corporate Tax Revenues with a Mark-to-Market Tax on Shareholder Income,’ 69 Nat’l Tax J. 701 (2016). 84 See Steven M. Rosenthal and Lydia S. Austin, ‘The Dwindling Taxable Share of U.S. Corporate Stock,’ 151 Tax Notes 923 (2016).

Corporate/shareholder tax integration  71

III. CONCLUSION This chapter has described the nation’s long history of frustration trying to achieve the objectives of corporate tax integration. Somewhat counterintuitively, the historical experience suggests the most feasible way to satisfy Professor Seligman’s quest for ‘substantial justice’ may be to retain two moderate and comparable, though separate, taxes on corporate-source income. Under this approach, reform of the corporate tax base would be an easily incorporated option for the future.

6. Tax aspects of incorporations Gregg Polsky

This chapter discusses the United States federal income tax issues that arise in connection with the formation of a new corporation (Newco). When a Newco is formed, the initial owners may contribute cash, property, or services in exchange for shares of Newco stock. Because there is no built-in gain or loss inherent in cash, the acquisition of stock for cash does not result in any immediate tax consequences. Contributions of property or services, on the other hand, raise far more interesting tax issues. Section I of this chapter examines the tax issues relating to contributions of property, while Section II discusses contributions of services.

I.

CONTRIBUTIONS OF PROPERTY

When a taxpayer exchanges property for other property, any inherent gain or loss in the property relinquished is generally recognized.1 Thus, if the relinquished property has a fair market value (FMV) higher than its basis, the taxpayer will typically be required to pay tax on the appreciation just as if she had sold the property for cash. However, in certain types of property exchanges, nonrecognition rules apply to defer this tax. Where a nonrecognition rule applies, the gain or loss inherent in relinquished property is not immediately recognized; instead, the gain or loss is preserved in the basis of the property received. As a result, nonrecognition rules operate to defer the gain or loss until the replacement property is subsequently sold (or exchanged in a transaction that does not qualify for nonrecognition). A.

Section 351

One such nonrecognition rule is section 351, which applies when a taxpayer transfers property to a corporation in exchange for its stock if a control requirement is satisfied. The control requirement is satisfied if the property transferor, together with other property2 transferors in the same transaction, control the corporation after the property transfers.3 For this purpose, control means the ownership of both (i) voting stock that possesses at least 80 percent of the total voting power of outstanding voting stock and (ii) at least 80 percent of any class of outstanding non-voting stock.4 Because the shares held by property transferors are aggregated in determining whether control is attained, it is necessary to determine when shares held by multiple property transferors are grouped for this purpose. The regulations explain that simultaneous exchanges are not necessary to create a property transferor group; instead, grouping See IRC §1001(a)–(c). For this purpose, cash is treated as property, so that shares held by a cash contributor are counted in favor of control. 3 See IRC §351(a). 4 See IRC §368(c). 1 2

72

Tax aspects of incorporations  73 is allowed ‘where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure.’5 Therefore, if taxpayers A, B, and C enter into a shareholders’ agreement where they agree to contribute specified properties to newly formed ABC, Inc. in exchange for stock, the shares received by A, B, and C are aggregated in determining control even if the property contributions are not simultaneous so long as they were made in a sufficiently expeditious manner. Because of this aggregation rule, for Newcos the control requirement is often easily satisfied by the initial shareholder group because the only shareholders whose shares do not count in favor of control are shareholders who acquire their shares exclusively for services.6 However, in the context of an existing corporation, the control requirement can be quite difficult to satisfy because the previously issued outstanding shares do not count in favor of control. In the example above involving ABC, Inc., if in a subsequent transaction unrelated to the initial property contributions, D contributes property in exchange for ABC stock, the only property transferor in that transaction is D, so only D’s shares are counted in favor of control. Accordingly, unless D owns at least 80 percent of ABC stock after D’s contribution, the transaction will not qualify under section 351, and D will recognize gain (or loss) in the same manner as if she had sold her property for cash.7 B.

Legislative Purpose behind Section 351

The basic approach of section 351 has been included in the Code for over 100 years, with only relatively minor technical tweaking through the years.8 Nevertheless, the legislative purpose underlying section 351 and its predecessors remains debatable. The legislative history is unhelpful in this regard, so the purpose must be surmised from other sources.9 The conventional wisdom is based on the notion that property-for-stock exchanges that qualify under section 351 constitute a mere change in the form of the taxpayer’s investment; therefore, the argument goes, it would be inappropriate to impose immediate tax on the transaction.10 Treas. Reg. §1.351-1(a)(1). See IRC §351(d)(1) (confirming that services are not considered property for section 351 purposes). 7 To help D qualify for nonrecognition, A, B, and C might transfer small amounts of cash or property for additional stock in connection with D’s transfer. The goal would be to try to characterize A, B, and C as property transferors in the same transaction as D’s contribution. If successful, then all of A, B, and C’s stock would count in favor of control, not just the new stock received by them. However, the regulations under section 351 provide that A, B, and C’s transfers will be ignored in the section 351 analysis of D’s transaction if (i) the property that they contribute ‘is of relatively small value of the stock already owned’ by them and (ii) ‘the primary purpose of the transfer[s] is to qualify’ D’s transfer under section 351. Treas. Reg. §1.351-1(a)(1)(ii). 8 See Ronald H. Jensen, Of Form and Substance: Tax-Free Incorporations and Other Transactions under Section 351, 11 Va. Tax Rev. 349, 381–7 (1991). 9 See id. at 387 (noting ‘the paucity of legislative history’ regarding the section 351 control requirement). 10 See Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025, 1033–4 (1976) (‘We note also that the basic premise of section 351 is to avoid recognition of gain or loss resulting from transfer of property to a corporation which works a change of form only …’); Charlotte Crane and Linda McKissack Beale, Corporate Taxation (LexisNexis 2012) 49 (noting the ‘similarity of a substantial continuing interest in property where a taxpayer changes from a direct ownership interest to an indirect ownership interest through an entity’). 5 6

74  Research handbook on corporate taxation Many section 351 transactions in fact will constitute a mere change in form. For example, the incorporation of a sole proprietorship into a corporation whose stock is owned entirely by the former sole proprietor is a mere change in form. The sole proprietor has exchanged a 100 percent direct interest in the business for a 100 percent indirect interest in the business. However, section 351 by its own explicit terms is equally available to transactions that cannot reasonably be characterized as mere changes in form. For instance, if each of ten taxpayers transfer different equal-value properties to a Newco in exchange for 10 percent stock interest in the corporation, the transaction is not a mere change in form. Each shareholder exchanged a 100 percent direct interest in their property for a 90 percent indirect interest in different property plus a 10 percent indirect interest in their property. Yet, it is indisputable that section 351 applies to this transaction.11 As Professor Ronald Jensen has explained, a better understanding of section 351’s legislative purpose is that Congress did not want to discourage taxpayers from combining their properties to form corporations.12 At the same time, there would be some concern that, absent a control requirement, public corporations could in effect use their stock as currency to acquire goods in a tax-free manner.13 Without nonrecognition, taxpayers would be loath to contribute highly appreciated property to corporations because of the significant immediate tax burden. Nonrecognition eliminates this problem. But, with unfettered nonrecognition, public companies like Apple Inc. could take undue advantage by using their stock to buy goods and other properties in ordinary course of business transactions. For example, suppliers could ‘contribute’ their goods to Apple in exchange for its highly liquid stock and benefit from tax deferral.14 The control requirement effectively precludes this strategy. Support for this theory can be found by comparing section 351 with section 721, the nonrecognition rule for partnership contributions. Under section 721, no gain (or loss) is recognized on property contributions to partnerships in exchange for partnership interests, but importantly section 721 imposes no control requirement whatsoever.15 Partnership interests are notoriously illiquid, so there is little risk that partnerships might try to use their interests as currency.16 Congress therefore sensibly did not require control in the partnership context. C.

The Evolution of Section 351: from Newco Transactions to M&A Device

For much of their history, section 351 and its predecessors were commonly used to allow taxpayers to contribute appreciated property to newly formed corporations without immediate tax cost. However, the advent of the limited liability company (LLC) in the late twentieth century meant that taxpayers could easily form entities that provided both (i) complete limited liability

See Jensen, supra note 8, at 377. See id. at 397–8. 13 See id. 14 Apple would presumably benefit indirectly from its suppliers’ tax benefits through price reductions. 15 Cf. IRC §721(a) with IRC §351(a). 16 See Jensen, supra note 8, at 402–4. While there are publicly traded partnerships and LLCs, whose interests are as liquid as publicly tradable stock, they are generally characterized as corporations for federal tax purposes. See generally IRC §7704. 11 12

Tax aspects of incorporations  75 for all of the entity’s owners17 and (ii) more favorable partnership tax treatment. Partnership tax treatment is more favorable than corporate tax for several reasons,18 especially in situations where capital is a material income-producing factor.19 Before LLCs became popular, business owners were forced to choose between the more favorable partnership tax rules or complete limited liability.20 Beginning in the 1990s, business owners could easily gain both advantages simultaneously simply by forming an LLC. Because LLCs are generally taxed as partnerships,21 section 721, rather than section 351, applies to contributions of property to these entities. In light of these developments, one might think that section 351 would have become a mostly irrelevant tax provision. In fact, the provision has been transformed into, as one prominent corporate tax law practitioner described, ‘the go-to vehicle for acquisitive reorganizations.’22 As Chapter 7 explains in greater detail, acquisitive transactions – where one corporation (‘P’) wishes to acquire another corporation (‘T’) or all or substantially all of the assets of T – must satisfy several technical requirements in order to qualify as a tax-free reorganization. Qualification as a tax-free reorganization allows the shareholders of T to roll over their T stock

17 Before LLCs became popular, owners who desired limited liability would form limited partnerships with corporate general partners. 18 While a full exploration of the income tax benefits of partnership tax treatment are beyond the scope of this chapter, a short summary of the major benefits is as follows. Income earned by partnerships is generally taxed once and only once, while income earned by C corporations is generally taxed twice, once at the entity level and again at the owner level. Losses incurred by partnerships generally flow through to the owners’ tax returns, while losses incurred by C corporations are trapped at the entity level and therefore can only be used to offset future income earned by the corporation. As discussed above, the nonrecognition rules relating to property contributions are less stringent for partnerships than for corporations. Likewise, the tax rules relating to property distributions are more favorable for partnerships than for corporations. Where a business expects to incur debt-financed losses or to make debt-financed distributions, the partnership tax rules are far more favorable. While the S corporation tax regime is similar to the partnership tax regime, S corporation status is available to entities with only one class of stock and who have (in general) only natural person owners. In addition, where they do differ the S corporation income tax rules are less favorable than the partnership tax rules. 19 In closely held service businesses where capital is not a material income-producing factor, the corporate tax regime may not be as problematic. First, closely held businesses that satisfy the eligibility requirements can elect S corporation classification. The tax rules for S corporations are similar to the rules for partnerships. However, the partnership tax rules are more favorable with respect to property contributions, property distributions, and debt-financed losses and distributions. Service businesses often will not have significant transactions that implicate these situations where the partnership tax regime is more advantageous than the corporate tax system. Second, closely held service businesses that are C corporations can ‘zero out’ the C corporation’s taxable income by distributing all of its profits in the form of wages and bonuses to its employee-owners. When the corporate form is selected by closely held service businesses, section 351 is typically not an important provision because any capital contributions not in the form of cash will be relatively small. 20 Before LLCs, entity owners could attempt to gain both advantages simultaneously by forming a limited partnership with a corporate general partner. Besides the more unwieldly structure, this strategy did not eliminate the corporate tax entirely. 21 See generally Treas. Reg. §301.7701-3 (allowing ‘eligible entities’ such as LLCs to elect their classification as partnerships or corporations, assuming they have more than one owner). Despite this general rule, publicly traded LLCs are generally taxed as corporations. See IRC §7704. LLCs with only one owner can elect to be classified as either disregarded entities or corporations. 22 Jasper L. Cummings, Jr., Incorporating Reorganizations, 174 Tax Notes 1537 (2022).

76  Research handbook on corporate taxation into P stock without recognizing gain.23 In a reorganization in which T is transferring its assets to P, reorganization status also allows T to avoid recognizing any gain on those transfers. Under the relevant reorganization rules, if (as is quite common) the parties to an acquisitive transaction desire for T to remain in existence,24 P cannot pay more than 20 percent of the purchase price in a form other than P voting stock.25 Therefore, if the plan is to both (i) keep T alive and (ii) have P pay more than 20 percent of the purchase price in cash, debt, or any other property other than P voting stock, tax-free reorganization status would be unavailable. Beginning in the late 1970s, creative tax planners began to attempt to use section 351 to obtain the same benefits as a reorganization despite not qualifying as such under the technical reorganization rules.26 The government’s initial reactions to these quasi-reorganization transactions were inconsistent. In 1978, the Internal Revenue Service (IRS) blessed such a transaction with a favorable private letter ruling.27 Less than two years later, it concluded otherwise in a Revenue Ruling (though it did not revoke the 1978 ruling), determining that an acquisitive transaction that did not qualify for reorganization status could not use section 351 as a back door to achieve reorganization-like tax effects.28 Then, in 1984, the IRS issued Revenue Ruling 84-71, which ruled that the failure of ‘larger acquisitive transactions’ to satisfy the reorganization rules did not prevent those transactions from qualifying for nonrecognition under section 351.29 Despite this initial hemming and hawing of the IRS, it is now firmly settled that section 351 can apply to acquisitive transactions that do not satisfy the reorganization rules. As a result, section 351 has become a critical provision in the corporate tax lawyer’s toolkit. For example, if P wishes to acquire T, to keep T’s corporate existence alive, and to pay more than 20 percent of the purchase price in cash, the transaction cannot qualify as a reorganization.30 The parties can, however, use section 351 to achieve reorganization-like results in a so-called ‘horizontal double dummy’ transaction.31 In a horizontal double dummy, P shareholders and T shareholders effectively contribute all of their respective shares to a Newco in exchange for Newco stock. The T shareholders also receive their cash from Newco.32 This transaction qualifies as a section 351 transaction because the P and T shareholders are all property transferors to Newco and they in the aggregate control Newco after the transaction.

See IRC §354(a). If the T shareholders receive cash or other property in addition to P stock in the reorganization, then they will recognize at least part of the built-in gain inherent in their T stock. See IRC §356(a). 24 If T merges directly into P, or if T transfers its assets to P and then liquidates, T’s corporate existence will cease. 25 See Michael L. Schler, Basic Tax Issue in Acquisitive Transactions, 116 Penn St. L. Rev. 879, 902 (2012). 26 See, e.g., PLR 7839060 (ruling that acquisitive transaction that did not satisfy reorganization rules nevertheless qualified under section 351). 27 See id. 28 See Rev. Rul. 80-284, 1980-2 C.B. 117. 29 Rev. Rul. 84-71, 1984-1 C.B. 106. 30 See Schler, supra note 25, at 906. 31 See id. 32 Because Newco is a brand new corporation, it will not have any pre-existing cash to transfer to T shareholders. Newco could borrow the necessary cash, or P could distribute cash up to Newco immediately after Newco’s acquisition of P in the transaction. 23

Tax aspects of incorporations  77 Technically, the actual mechanics of horizontal double dummy transactions are a bit more complicated, and these complications give rise to its unique name.33 Because it would be impossible in the public company context to get all P and T shareholders to transfer their respective shares to Newco, reverse triangular mergers are used to effectuate the transaction. Newco sets up two new subsidiaries; these are the double dummies. Then, P merges with one subsidiary and T with the other, with P and T surviving their respective mergers. In the merger, the P shareholders receive entirely Newco stock, while the T shareholders receive the requisite mix of Newco stock and cash. After the transactions, the former P shareholders and the former T shareholders own Newco, which owns all of the stock of both P and T. Because the dummy subsidiaries are transitory corporations that were created solely for the purpose of immediately being merged out of existence, the IRS treats the transaction as if the P and T shareholders had simply contributed their shares to Newco in a valid section 351 transaction.34

II.

CONTRIBUTIONS OF SERVICES

When a service provider receives stock, or options to buy stock, as compensation, she will generally recognize ordinary income, though the timing of the taxable event and the amount of income recognized will depend on the specifics of the transaction. If the service provider is granted stock that is not subject to a substantial risk of forfeiture (i.e., ‘vested’ stock), then she will recognize ordinary income at the time of grant in an amount equal to the stock’s FMV at that time.35 If the service provider pays an amount of cash for the vested stock that is less than the FMV, she will recognize ordinary income equal to the excess of the stock’s FMV (determined at the time of grant) over the amount paid for the stock.36 A.

Stock Grants

In many cases, compensatory stock grants are subject to a substantial risk of forfeiture (SRF). A very common SRF is one that requires the service provider to work for the company for a specified period of time before the shares vest.37 For example, a service provider might receive 1,200 shares of Newco stock, with 400 shares vesting one year after grant, another 400 shares vesting two years after grant, and the final batch vesting three years after grant. If the

33 For a full discussion of the various technical issues, see Martin D. Ginsburg, Jack S. Levin and Donald E. Rocap, Mergers, Acquisitions, and Buyouts: A Transactional Analysis of the Governing Tax, Legal, and Accounting Considerations (Wolters Kluwer 2022) ¶904. 34 See e.g., IRS LTR 9143025 (24 July 1991) (ruling that such a transaction qualified under section 351). The IRS has ruled in a variety of situations that transitory subsidiaries formed merely for the purpose of being merged out of existence are disregarded for federal income tax purposes. See, e.g., Rev. Rul. 79-273, 1979-2 C.B. 125; Rev. Rul. 78-250, 1978-1 C.B. 83; Rev. Rul. 73-427, 1973-2 C.B. 301; Rev. Rul. 67-448, 1967-2 C.B. 144. 35 See Treas. Reg. §1.61-2(d)(2)(i). 36 See id. 37 See Treas. Reg. §1.83-3(c)(1) (explaining that ‘a substantial risk of forfeiture exists … if rights in property that are transferred are conditioned … upon the future performance … of substantial services’).

78  Research handbook on corporate taxation service provider leaves the employ of the company before a vesting date, then the unvested shares are forfeited back to the company.38 The tax rules governing unvested (or restricted) stock differ from the rules described above regarding vested stock. In general, a service provider that is granted restricted stock must recognize ordinary income at time of vesting in an amount equal to the stock’s FMV at that time.39 If the service provider pays cash for the restricted stock, then the amount of ordinary income that is included at the time of vesting is equal to the excess of the FMV of the stock (determined at the time of vesting) over the amount paid for the stock.40 However, if the service provider makes an election (‘section 83(b) election’) with respect to restricted stock, then the tax consequences are significantly altered. In that case, the service provider will recognize ordinary income at the time of grant equal to the FMV of the stock at that time (reduced by any cash paid for the stock).41 To be effective, a section 83(b) election must be made within 30 days from the date of grant of restricted stock.42 The advisability of a section 83(b) election depends on a variety of factors.43 On one hand, the election accelerates the recognition of income; taxpayers generally prefer to defer income. On the other hand, the election caps the ordinary income element of the transaction with reference to the FMV at the time of grant; any future appreciation in the stock will be taxed at the lower capital gains rate provided that the service provider holds the stock for more than one year prior to sale.44 These two main effects – on the timing and character of income – push in opposite directions, and it may not be readily apparent which is more significant. For example, assume that a service provider is granted for no cost 100 shares of restricted stock that will vest after one year if she continues to remain employed by the company. At the time of grant, the shares are worth $10,000. If she makes a section 83(b) election, she will report $10,000 of ordinary income in Year 1 and take a basis in the stock equal to the same amount. If the shares subsequently appreciate to $15,000 after one year and she sells the stock at that time, she will recognize $5,000 of long-term capital gain in Year 2. On the other hand, if she does not make the section 83(b) election, she will recognize $15,000 of ordinary income in Year 2 when the stock vests (and no subsequent gain or loss if she immediately thereafter sells the stock for $15,000). As Table 6.1 shows, the net effect of the section 83(b) election was to accelerate $10,000 of ordinary income from Year 2 to Year 1 and to convert $5,000 of Year 2 ordinary income into $5,000 of Year 2 capital gain.

In addition, to constitute an SRF, any transferee of the property must be subject to the same risk of forfeiture. See IRC §83(a), (c)(2). 39 See IRC §83(a). 40 See id. 41 See IRC §83(b)(1). The FMV is determined without regard to the vesting condition or any other restriction other than a restriction which by its terms will never lapse. See id. 42 See IRC §83(b)(2). 43 See generally Michael S. Knoll, Section 83(b) Election for Restricted Stock: A Joint Tax Perspective, 59 SMU L. Rev. 721 (2006). 44 Under section 1202, certain gains from the sale of qualified small business stock are excluded from gross income. To take advantage of this exclusion, numerous conditions must be satisfied by both the corporation and the shareholder, and the exclusion is subject to a cap. This chapter assumes that section 1202 does not apply to any gains. 38

Tax aspects of incorporations  79 Table 6.1

Effect of section 83(b) election No 83(b) election

83(b) election made

Net effect of election

Year 1

No income

$10k OI

+$10k OI

Year 2

$15k OI

$5k LTCG

-$15k OI/+$5k LTCG

The desirability of a section 83(b) election therefore depends in significant part on (i) the difference between the ordinary income rates and capital gains rates and (ii) the appropriate discount rate to be used to convert future tax liability to present value. Other factors may be relevant as well. For example, if the stock does not ultimately vest (because, for example, the service provider’s employment is terminated prior to vesting), the inclusion resulting from the section 83(b) election is not allowed to be reversed through a deduction;45 the result is that the service provider is in effect taxed on phantom income. A section 83(b) election will also affect the corporation. In the example above, if the election is made, the corporation will be allowed to deduct $10,000 in Year 1.46 Absent the election, the corporation will be allowed to deduct $15,000 in Year 2.47 Because of this, some corporations might seek to restrict the ability of their employees to make section 83(b) elections through provisions in the stock grant contract.48 For these reasons and others beyond the scope of this chapter,49 the issue of whether to make a section 83(b) election often requires a careful assessment of the numerous relevant facts and circumstances. That said, there are some easy cases. If the service provider pays FMV or very close to FMV for restricted stock, her cost – in the form of immediate tax liability – in making the section 83(b) election will be nil or negligible.50 This means that the service provider will pay nothing or next to nothing for the potential benefit of converting future ordinary income into capital gains. Therefore, section 83(b) elections should be made in these cases.51 On the other hand, if the service provider pays nothing for the restricted stock and if she is able to invest the avoided immediate tax liability by not making the section 83(b) election in the same stock (because, for example, the stock is publicly traded), then section 83(b) elections are typically inadvisable. In such a case, the service provider would generally be better off investing the avoided immediate tax liability in the stock.52

45 See IRC §1.83-2(a) (explaining that upon forfeiture of property that was subject to a section 83(b) election, the taxpayer recognizes a loss only to the extent the amount received upon forfeiture is less than the amount paid by the taxpayer for the property). 46 See IRC §83(h). 47 See id. 48 See Knoll, supra note 43, at 724. 49 For an extended discussion of the relevant factors, see generally Knoll, supra note 43. 50 If she pays full FMV for the restricted stock, there will be no immediate tax liability because there is no excess of FMV over the amount paid. If she pays very close to FMV, there will be negligible immediate tax liability because the excess of FMV over the amount paid is small. 51 Where the service provider pays the full FMV, the section 83(b) election is a no-brainer (at least from the employee’s perspective) because there is zero tax cost to the employee. However, the service provider still must affirmatively make the election. Cf. Alves v. Comm’r, 734 F.2d 478 (9th Cir. 1984) (holding that, where service provider paid full FMV for restricted stock but did not make a section 83(b) election, the service provider realized ordinary income at the time of vesting equal to the amount of post-grant appreciation). 52 See generally John Goldsbury, The Myth of the 83(b) Election, 21 J. of Tax’n of Investments 300 (2004).

80  Research handbook on corporate taxation B.

Stock Options

If a service provider receives stock options rather than shares of stock, a different set of tax rules applies. A stock option represents the right, but not the obligation, to purchase shares of stock for a specified price, known as the exercise or strike price, during a specified period of time, such as ten years. Under current tax law, section 409A effectively requires that the strike price be no lower than the FMV of the underlying stock at the time of grant.53 Accordingly, nearly all compensatory stock options are issued with a strike price equal to the stock’s FMV at the time of grant.54 In general, compensatory stock options are taxed upon exercise.55 At that time, the service provider generally realizes ordinary income in an amount equal to the ‘spread’ – that is, the excess of the FMV of the stock acquired over the exercise price.56 The corporation will receive a tax deduction equal to the spread at the time of exercise.57 The service provider then takes an FMV basis in the stock, so that if the stock is immediately sold after exercise (in a so-called cashless exercise), there will be neither gain nor loss. However, if the compensatory stock option qualifies as an incentive stock option (ISO), the tax rules are different if certain holding period requirements (applicable to both the option itself and the underlying stock after exercise) are satisfied.58 In that case, the service provider will not recognize ordinary income at any time and instead will recognize long-term capital gain when the underlying stock is sold.59 The amount of long-term capital gain will equal the excess of the sales proceeds from the stock sale over the exercise price of the options.60 In addition, the corporation will not receive any deduction at any time.61 Because of this disallowance, ISOs are often tax inefficient relative to non-ISOs (which are known as ‘nonqualified stock options’), and therefore ISOs tend to be disfavored.62 Table 6.2 summarizes the general tax rules applicable to compensatory stock options.63

See Gregg D. Polsky, Fixing Section 409A: Legislative and Administrative Options, 57 Villanova L. Rev. 635, 645 (2012). 54 See id. If the stock options have a lower than FMV strike price, then upon exercise section 409A will generally impose a 20 percent additional tax (above and beyond the normal tax liability) as well as certain interest costs. See generally IRC §409A(a)(1). 55 See generally Treas. Reg. §1.83-7. If the option has a readily ascertainable FMV at the time of grant, then the option is generally taxable at that time; however, the relevant rules make it highly unlikely that an option will be considered to have a readily ascertainable FMV. See Treas. Reg. §1.83-7(a), (b). 56 See Treas. Reg. §1.83-7(a). 57 See IRC §83(h). 58 See generally IRC §§421, 422. 59 See IRC §421(a). 60 See id. 61 See id. 62 Though generally tax inefficient, in certain cases ISOs may be preferable. If the corporation expects to have large losses that will preclude it from having positive tax liability for a long period of time, the lost deductions from issuing ISOs may have little or no present value. In that case, the potential tax benefits to the service provider (of tax deferral and character conversion from ordinary income to capital gain) would outweigh the cost of the lost deductions. 63 In some cases, these general rules do not apply. For instance, if the stock underlying a nonqualified option is subject to a substantial risk of forfeiture, then (unless a section 83(b) election is made upon exercise) the holder will realize ordinary income at the time of vesting, with the amount of income dependent on the FMV of the underlying stock at that time. 53

Tax aspects of incorporations  81 Table 6.2

Taxation of compensatory stock options Nonqualifieda

ISO (assuming all conditions, including holding periods, are satisfied)

Tax on grant to holder

None

None

Tax on vesting to holder

None

None

Tax on exercise to holder

OI tax imposed on spread

None

Tax on sale of stock

Capital gains tax imposed on

Capital gains tax imposed on the excess of the

post-exercise appreciation

FMV of the stock over the exercise price

Deduction equal to the spread in year

No deduction at any time

Tax consequences to corporation

of exercise

Note: a It is assumed that the option lacks a readily ascertainable FMV at the time of grant.

To summarize and contextualize these rules, consider a newly formed corporation, such as a Silicon Valley start-up, that issues the following compensatory stock rights. At the outset, founders are granted unrestricted or restricted ‘founders’ stock’ either without cost or for minimal cost.64 If the founders’ stock is restricted, founders will make section 83(b) elections because the inclusion amount will be zero or negligible due to the stock’s very low FMV before the business begins to show promise.65 Follow-on employees may also receive restricted stock and make section 83(b) elections. However, once the stock has more than insignificant value, the tax cost to making section 83(b) elections often becomes too high for employees to tolerate. At that point, the company will typically switch to issuing compensatory stock options with strike prices equal to the FMV of the stock at the time of grant. These stock options will also vest over time, but the taxable event is the ultimate exercise of the options,66 the timing of which is volitional. The holders of these options will therefore time the exercise to occur concurrently with liquidity events, such as an initial public offering or sale of the company to a strategic buyer, so that the employee can sell the underlying stock to raise the necessary funds to pay the tax.

III. CONCLUSION This chapter has described the significant United States federal income tax issues that arise in connection with incorporations of new corporations. Shareholders who contribute property to a new corporation in exchange for stock generally will not recognize any gain (or loss) pursuant to section 351. Subsequent transfers of property corporations in transactions that are If founders are granted unrestricted stock, subsequent investors will often insist on placing restrictions on their stock that would require them to continue working for the company for a specified period of time before the stock vests. Pursuant to Revenue Ruling 2007-49, 2007-2 C.B. 237, adding these restrictions onto previously vested stock does not result in any tax consequences. 65 For further discussion of the tax treatment of founders’ stock, see generally Gregg D. Polsky and Brant J. Hellwig, Examining the Tax Advantage of Founders’ Stock, 97 Iowa L. Rev. 1085 (2012); Victor Fleischer, Taxing Founders’ Stock, 59 UCLA L. Rev. 60 (2011); Ronald J. Gilson and David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 110 Harv. L. Rev. 874 (2003). 66 This assumes that the options are nonqualified rather than ISOs. If the options are ISOs and if the holding period requirements are satisfied, the tax consequences will be different, as previously described. 64

82  Research handbook on corporate taxation not related to the initial transfers of property are much harder to qualify under section 351 because the property transferors in those subsequent transfers will often not satisfy the control requirement. Founders’ stock received for services is generally received with little or no tax consequences because of the stock’s minimal value immediately after incorporation. On the other hand, follow-on employees will typically receive stock options, which generally result in ordinary income at the time of exercise.

7. Tax aspects of corporate mergers and acquisitions Heather M. Field

1. INTRODUCTION This chapter discusses the United States federal income tax consequences of corporate mergers and acquisitions (‘M&A’). Corporate M&A is understood broadly to include a wide range of transactions in which a corporation acquires some or all of another corporation’s business or in which a corporation disposes of some or all of its businesses. These transactions take various forms, and the decision about how to structure a transaction depends on many factors – both tax and non-tax. After providing brief background, this chapter discusses corporate liquidations, acquisitions, and divisions (i.e., three major corporate M&A transactions) and explains taxable and tax-free versions of each.1 Then, this chapter considers more complex corporate M&A transactions and explains that, in many circumstances, the tax treatment of corporate M&A transactions is largely elective. The chapter concludes with thoughts about the future of corporate M&A taxation.

2.

A BRIEF HISTORY

Corporations have long been subject to two levels of tax: tax at the corporate level on the corporation’s income, and tax at the shareholder level on dividends and gains from the sale of stock. Before 1986, an important exception to this double tax regime generally allowed corporations to distribute assets to shareholders without corporate-level tax on the gain inherent in those assets. This is called the ‘General Utilities doctrine,’ after a 1935 Supreme Court case that held that a corporation’s in-kind distribution of property to its shareholders did not cause the corporation to recognize the gain inherent in that property.2 This nonrecognition principle was incorporated into the 1954 Code for both operating distributions and liquidating distributions.3 Some limitations applied, but very generally, prior to 1986, only one level of tax – at the shareholder level – applied when a corporation distributed property to its shareholders

1 This chapter focuses on domestic corporations subject to tax under Subchapter C, and generally does not address S corporations, other corporations with special tax status (e.g., real estate investment trusts), or cross-border M&A. Also, this chapter assumes continuation of a realization-based income tax system in which a double tax regime applies to C corporations. All references to the Code refer to the Internal Revenue Code of 1986, as amended, except as otherwise specified. 2 296 U.S. 200, 56 S.Ct. 185 (1935). 3 IRC §311(a)(2) (1954) (operating distributions); IRC §336 (1954) (liquidating distributions); see also IRC §337(a) (1954) (nonrecognition for sales made within a year of adopting a plan of liquidation).

83

84  Research handbook on corporate taxation especially in a complete liquidation.4 Shareholders took fair market value (‘FMV’) basis in the property distributed,5 which eliminated the gain that had been inherent in the property. The General Utilities doctrine was widely criticized, and ultimately, the Tax Reform Act of 19866 (the ‘1986 Act’) repealed it. The legislative history explains the reasons for this change: [T]he General Utilities rule tends to undermine the corporate income tax. Under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. Where the General Utilities rule applies, assets generally are permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax. Thus, the effect of the rule is to grant a permanent exemption from the corporate income tax.7

The 1986 Act’s repeal of the General Utilities doctrine (‘GU repeal’) means that, today, a corporation’s distribution of property to its shareholders generally results not only in shareholder-level tax, but also tax at the corporate level.8 As the remainder of this chapter illustrates, the tax rules applicable to corporate M&A are grounded in GU repeal. The next three parts discuss the tax treatment of three major corporate M&A transactions (liquidations, acquisitions, and divisions), in each case explaining taxable and tax-free versions of the transactions.

3.

TAX TREATMENT OF CORPORATE LIQUIDATIONS

A liquidation is often thought of as marking the end of a corporation’s life, but corporate liquidations are also integral to corporate M&A transactions. A liquidation is often a step in a corporate acquisition or division, which is why this chapter discusses liquidations first. In a classic corporate liquidation, the corporation distributes all its assets and liabilities to shareholders in exchange for their stock and then dissolves under state law.9 For tax purposes, a liquidation also occurs when an unincorporated entity taxed as a C corporation makes a ‘check the box’ election to be taxed as a pass-through entity.10 A corporate liquidation is generally taxable to both the liquidating corporation and its shareholders unless the liquidating corporation is a controlled corporate subsidiary.11 4 See generally Borris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations & Shareholders para. 10.01 (7th ed., Thomson Reuters/Tax & Accounting 2020) (hereinafter, ‘Bittker & Eustice’). 5 IRC §334(a) (1954). 6 Pub. L. No. 99-514. 7 HR Rep. No. 426, 99th Cong., 1st Sess. 282 (1985). The legislative history also discussed concerns that General Utilities distorted corporations’ behavior, ‘induc[ing] corporations with substantial appreciated assets to liquidate and transfer their assets to other corporations for tax reasons, when economic considerations might indicate a different course of action.’ Id. For more about the history of the corporate tax, see Chapter 3. 8 Exceptions are discussed below in Section 3.2 (liquidations of controlled subsidiaries) and Section 5.2 (distributions of the stock of controlled subsidiaries). 9 For federal income tax purposes, dissolution under state law is not required; the corporate shell can continue to exist, for example, to wind up the enterprise’s affairs. Treas. Reg. §1.332-2(c). 10 Treas. Reg. §301.7701-3(g)(1). 11 See generally Bittker & Eustice, supra note 4, at paras 10.10–10.26.

Tax aspects of corporate mergers and acquisitions  85 3.1

In General – Taxable Corporate Liquidations

A corporation that distributes property in a liquidation generally recognizes gains and, subject to some limitations, losses inherent in the distributed property, as if the corporation sold all the properties at FMV.12 A shareholder that receives liquidating distributions generally also recognizes gain or loss, in an amount equal to the difference between the FMV of the property received in the liquidation and the shareholder’s basis in their stock.13 Each shareholder then takes FMV basis in any property received in the liquidating distribution.14 3.2

Tax-Free Liquidations of Controlled Subsidiaries

When a corporate subsidiary completely liquidates into its corporate parent, neither corporation generally recognizes gain or loss on the liquidation if two requirements are satisfied.15 First, one corporation (‘Parent’) must ‘control’ the liquidating corporation from the date of the adoption of the corporate liquidation plan until the liquidation is complete.16 Control for this purpose means ownership of at least 80 percent of the voting power and at least 80 percent of the value of the liquidating corporation’s stock.17 Second, the liquidating distributions must be completed either during the taxable year the plan of liquidation is adopted or within three years after the close of the taxable year in which the first liquidating distribution is made.18 If both the control and timing requirements are met, sections 332 and 337 provide nonrecognition treatment to Parent and the liquidating corporation, respectively. Parent’s basis in its stock of the liquidating corporation disappears, and Parent succeeds to the liquidating corporation’s basis in the assets received in the liquidating distribution (‘carryover basis’).19 Parent also succeeds to its share of the liquidating corporation’s tax attributes (e.g., earnings and profits, and net operating losses).20 Nonrecognition treatment upon the liquidation of a corporate subsidiary reflects ‘Congress’s belief that the complete liquidation of a subsidiary effects a change of form rather than a change of substance and thus should be tax neutral.’21 Congress also considered this tax treatment to be consistent with GU repeal because, upon the liquidation of a controlled corporation, that corporation’s ‘property … is retained within the [incorporated] economic unit’

12 IRC §336(a). Section 336(d) generally precludes the liquidating corporation from recognizing (1) losses on certain distributions to related persons, (2) pre-contribution losses inherent in property contributed to the corporation with a loss avoidance purpose, and (3) losses on distributions in a liquidation that is otherwise afforded nonrecognition treatment. See generally Bittker & Eustice, supra note 4, at para. 10.21. 13 IRC §1001(a); Treas. Reg. §1.331-1(b). 14 IRC §334(a). Shareholders do not succeed to the liquidating corporation’s tax attributes (e.g., unused net operating losses, earnings and profits); those attributes disappear. IRC §381. 15 IRC §§332, 337. 16 IRC §332(b)(1). 17 Id. 18 IRC §332(b)(2)–(3). 19 IRC §334(b). 20 IRC §381(a)(1). 21 IRS Chief Counsel Advisory 201114017 (summarizing the legislative history and citing Conf. Rep. No. 99-841, 99th Cong., 2d Sess. II-202 (1986)).

86  Research handbook on corporate taxation and ‘the corporate-level tax [on the gain inherent in the distributed property] will be paid if the distributed property is disposed of by the [Parent] corporation to a person outside [that unit].’22 The nonrecognition rules of sections 332 and 337, however, only apply to the extent that the distribution in the complete liquidation is made to the corporation that controls the liquidating corporation. If Parent owns less than 100 percent of the stock of the liquidating corporation, the liquidating corporation recognizes gain on the portion of the assets distributed to the non-Parent shareholder.23 In addition, the non-Parent shareholder recognizes gain or loss upon receipt of that distribution in exchange for their stock of the liquidating corporation.24 The non-Parent shareholder then takes FMV basis in the property it received in the distribution.25 3.3

Liquidations, In Sum

There are stark differences between the tax consequences of liquidating a controlled corporate subsidiary and liquidating other corporations. A corporation, however, can often choose whether a liquidation will be taxable or tax-free. In Granite Trust Co. v. U.S., the court held that, when a parent corporation sold enough stock of a subsidiary to bring the parent corporation’s ownership below 80 percent, a subsequent liquidation of the subsidiary was taxable.26 The Internal Revenue Service (IRS) generally accepts this result and respects the form of the transactions.27 Similarly, a corporation can also often plan into tax-free liquidation treatment by buying enough subsidiary stock to increase the parent corporation’s ownership to at least 80 percent before the liquidation.28 Other efforts by corporations to benefit from the tax-free corporate liquidation provisions have not been as successful. For example, the IRS has challenged (often successfully) corporate liquidations followed by reincorporations on substance over form grounds.29 In addition,

22 Id. In addition, absent the nonrecognition rule, the liquidation of a corporate subsidiary would result in three levels of tax (i.e., one to the liquidating subsidiary, one to the parent corporation, and one to the shareholders of the parent when the parent ultimately distributed proceeds of the liquidation out of corporate solution). 23 IRC §336. The liquidating corporation cannot recognize loss on the liquidating distribution to any non-Parent shareholder. IRC §336(d)(3). 24 IRC §331. 25 IRC §334(a). 26 238 F.2d 670 (1st Cir. 1956). Granite Trust treatment is not absolute. The stock sale must result in a meaningful change in economic position and cannot be transitory (setting aside the liquidation of the corporation). See Robert Rizzi, Remembering the Fictions: Granite Trust and Subsidiary Liquidations, 41 J. Corp. Tax’n 34 (2014) (citing Associated Wholesale Grocers, Inc. 927 F. 2d 1517 (10th Cir., 1991)). 27 See id.; Field Serv. Adv. 2001-48-004. 28 George L. Riggs, Inc. v. Comm’r, 64 T.C. 474 (1975); Rev. Rul. 75-521. But see Rev. Rul. 70-106 (integrating the pre-liquidation stock purchase with the liquidation where the stock purchase occurred after the adoption of a plan of liquidation). 29 See generally Bittker & Eustice, supra note 4, at para. 12.37. The liquidation-reincorporation transaction could be recharacterized in multiple ways, including as an operating distribution of the assets that were not reincorporated. Id. Post-GU repeal, however, there is very little incentive for a corporation to undertake liquidation-reincorporation transactions, but there remain limited contexts where the treatment of a liquidation-reincorporation transaction might still be relevant in the M&A context. See Richard W. Bailine, The Elucidation of the Liquidation-Reincorporation Doctrine, 30 J. Corp. Tax’n 34 (2003) (discussing private letter rulings about the application of the liquidation-reincorporation doctrine

Tax aspects of corporate mergers and acquisitions  87 in response to ‘mirror transactions,’ Congress amended the Code to prevent abuse of the tax-free liquidation rules. In a ‘mirror transaction,’ a corporation formed two subsidiaries, used those subsidiaries to purchase the stock of a target corporation, liquidated the target corporation (tax-free under sections 332 and 337), and then sold the stock of the subsidiary that, in the liquidation, received the target corporation’s unwanted assets.30 Prior to the amendment, this combination of steps enabled the acquiring corporation to dispose of the target corporation’s unwanted assets without corporate-level tax, which undermined GU repeal.31 Congress largely curtailed this result by amending section 337(c) so that most liquidations in mirror transactions no longer qualify as tax-free. Although mirror transactions are generally no longer viable, corporate liquidations remain core parts of many other multi-step M&A structures.

4.

TAX TREATMENT OF CORPORATE ACQUISITIONS

Corporate acquisitions, like corporate liquidations, are generally taxable, but can be tax-deferred in certain circumstances. 4.1

In General – Taxable Acquisitions

If a corporation (‘Acquirer’) wants to acquire the business of another corporation (‘Target’), there are two basic ways to do so: an asset acquisition and a stock acquisition. Acquisitions can be effectuated using other structures (e.g., a direct merger of Target into Acquirer, with Acquirer surviving), but taxable acquisitions are generally treated, for tax purposes, as either an asset acquisition or a stock acquisition.32 Thus, this section explains the fundamental tax consequences of those acquisition patterns.33 The tax treatment of a taxable acquisition depends on whether Target is a controlled corporate subsidiary. 4.1.1 Target is not a controlled subsidiary In an asset acquisition, Acquirer transfers consideration to Target in exchange for Target’s assets, and then Target typically liquidates, distributing the sale proceeds to Target’s shareholders.34 Where Target is not a controlled subsidiary of another corporation, the transaction generally results in two levels of tax. First, Target recognizes gains and losses from the sale of

in corporate M&A); Jasper L. Cummings Jr., The Demise of the Liquidation-Reincorporation Doctrine, 137 Tax Notes 797 (2012). 30 See Bittker & Eustice, supra note 4, at para. 10.50. 31 See id. 32 A taxable direct merger is generally taxed as an asset sale followed by a liquidation. Rev. Rul. 69-6. The same is true for a taxable forward triangular merger. A taxable reverse triangular merger is generally taxed as a stock purchase. Rev. Rul. 90-95. 33 See generally Martin D. Ginsburg, Jack S. Levin, and Donald E. Rocap, Mergers, Acquisitions, and Buyouts ch. 2–3 (Wolters Kluwer 2022) (hereinafter, ‘GLR’). 34 The order of these steps can be reversed, so Target liquidates first, and then the shareholders sell the assets to Acquirer. This structure is relatively uncommon because, among other reasons, it requires multiple conveyances of the assets. This transaction is generally subject to two levels of gain, like the asset sale discussed in the text.

88  Research handbook on corporate taxation its assets.35 Second, when Target liquidates immediately after the asset transfer, each Target shareholder generally recognizes gain or loss in an amount equal to the difference between the liquidation proceeds received and their basis in their Target stock.36 After the transaction, Acquirer generally has FMV cost basis in the assets purchased.37 If Acquirer purchases all of Target’s stock, there is generally only one level of current tax – on the Target shareholders. Each Target shareholder generally recognizes gain or loss equal to the difference between the proceeds they receive and their basis in their Target stock sold.38 Acquirer’s purchase of Target stock does not, however, trigger recognition of gain or loss by Target itself. Target remains in existence and becomes a subsidiary of Acquirer, and Target continues to hold its historic assets with their historic bases. Thus, the gain or loss inherent in Target’s assets will generally not be recognized at the time of the transaction; it will be deferred until later when Target later disposes of those assets. Thus, the tax consequences of asset purchases and stock purchases differ materially. However, in certain circumstances, taxpayers can elect to tax the latter like the former. Specifically, section 338 of the Code provides that, if Acquirer makes a ‘qualified stock purchase’ of Target’s stock (i.e., a purchase of at least 80 percent of the vote and value of Target’s stock within a 12-month period), Acquirer can elect to treat the actual stock purchase as a deemed asset purchase for tax purposes.39 This election results in two levels of tax: Target shareholders are taxed on their actual stock sale, and Target is taxed on the deemed asset sale. After the transaction, Acquirer owns the Target stock with cost basis in the stock, and Target has ‘cost’ basis in its assets, as if Target purchased the assets in the deemed transaction. This section 338 election (a ‘regular’ 338 election) turns an acquisition with one level of tax and no step-up in asset basis into an acquisition with two levels of tax and step-up basis. It is rarely worthwhile to pay tax on the gain inherent in assets just to step up their basis. Thus, regular section 338 elections are generally undesirable unless Target has significant net operating losses that it can use to offset the corporate-level gain recognized on the deemed asset sale. 4.1.2 Target is a subsidiary of another corporation If Target is a corporation controlled by another corporation (‘Parent’) and Target sells its assets to Acquirer and then liquidates into Parent, only one level of current tax is imposed. Target recognizes gains and losses from its sale of assets, but the liquidation of Target into Parent is tax-free for both corporations, as discussed above in Section 3.2.40 If Parent ultimately distributes the proceeds out of corporate solution to Parent’s shareholders, then shareholder-level tax

35 In an asset sale, the total purchase price must be allocated among the assets purchased in accordance with section 1060, and then gain and loss must be determined asset-by-asset. 36 IRC §331. See supra Section 3.1 (discussing taxable liquidations). Target is generally not taxed on this liquidation because Target has cost basis in the transaction proceeds received in the asset sale. 37 IRC §1012. 38 IRC §1001(a). 39 IRC §338; see generally GLR, supra note 33, at para. 2.05 (discussing section 338 elections in detail). This election is unidirectional; Acquirer cannot elect to tax an actual asset purchase as a deemed stock purchase. 40 IRC §§332, 337.

Tax aspects of corporate mergers and acquisitions  89 will generally be imposed on Parent’s shareholders.41 After this transaction, Acquirer has full FMV cost basis in the Target assets it purchased.42 If Parent sells its Target stock to Acquirer, Parent recognizes the gain or loss inherent in its Target stock.43 This is a corporate-level tax because Parent (like Target) is a corporation. Shareholder-level tax will be imposed on Parent’s shareholders when Parent ultimately distributes the sale proceeds out of corporate solution to Parent’s shareholders.44 After the transaction, Target is a subsidiary of Acquirer, and Acquirer has FMV cost basis in its Target stock.45 Target continues to exist with its historic bases in its historic assets, and as a result, there is another level of corporate tax lurking in Target that generally will be recognized in the future when Target disposes of its assets.46 Thus, the tax consequences of an asset purchase and a stock purchase, again, differ materially. If Target is a controlled subsidiary of Parent, a purchase of Target’s assets generally results in one level of current tax (corporate-level tax on Target) and one level of future tax (shareholder-level tax on Parent’s shareholders when Parent distributes the sale proceeds). If Target is a controlled subsidiary of Parent, a purchase of Target’s stock generally results in one level of current tax (corporate-level tax on Parent) and two levels of future tax (shareholder-level tax on Parent’s shareholders when Parent distributes the sale proceeds, and corporate-level tax on Target when Target disposes of its assets). Thus, when acquiring a controlled subsidiary in a taxable acquisition, an asset purchase often has better tax consequences than a stock purchase.47 To mitigate this difference, the Code allows a section 338(h)(10) election – a special type of section 338 election available when the target corporation is a controlled subsidiary of another corporation.48 If a section 338(h)(10) election is made, Acquirer’s qualified stock purchase of Target’s stock is taxed as a deemed asset purchase, and the actual stock purchase is ignored.49 In contrast to the regular section 338 election, which is rarely desirable, a section 338(h)(10) election is often desirable if available because it taxes the stock acquisition (which would otherwise have one level of current tax and two levels of future tax) as an asset acquisition (which is generally subject to one level of current tax and one level of future tax). A similar election is available under section 336(e) if a corporation that controls a subsidiary makes a ‘qualified stock distribution.’50 A qualified stock distribution is a transfer (whether by sale, exchange, or distribution) within a 12-month period of stock constituting control of IRC §301. IRC §1012. 43 IRC §1001. 44 IRC §301. 45 IRC §1012. 46 This assumes Target’s assets are appreciated. The rest of this discussion generally makes the same assumption. 47 A stock purchase might have better tax consequences in certain situations such as (1) where Parent’s basis in its Target stock is very close to the FMV of the Target stock such that there is basically no gain to recognize in a stock sale or (2) where an asset purchase would have reduced the basis in Target’s assets. 48 A section 338(h)(10) election is also available if the target is an S corporation. 49 See generally GLR, supra note 33, at para. 206. A section 338(h)(10) election is unidirectional; no election can be made to tax an asset purchase like a stock purchase. 50 Section 336(e) was added to the Code by the 1986 Act, but implementing regulations were not finalized until 2013. Thus, it is only since 2013 that section 336(e) elections have been available. 41 42

90  Research handbook on corporate taxation the controlled corporation.51 If a section 336(e) election is made, the stock transfer is treated as a deemed asset purchase, similar to the deemed asset purchase that occurs when a section 338(h)(10) election is made.52 In contrast to the section 338(h)(10) election, which is only available when a single corporation purchases stock of the target corporation, a section 336(e) election is available even if the acquirer includes one more persons or entities rather than a single corporation, and even if the acquisition is accomplished via a distribution of stock rather than a sale.53 4.2

Reorganizations – Tax-Free Acquisitions

Acquisitions can, in some circumstances, be accomplished without current tax. If a corporate acquisition qualifies as a ‘reorganization’ within the meaning of section 368, then generally neither Target nor Target’s shareholders recognize gain or loss because of the transaction.54 However, Target shareholders who receive cash or other non-qualifying consideration (‘boot’) in the reorganization will generally recognize gain to the extent of such consideration.55 Otherwise, gain and loss recognition is generally deferred.56 Historically, there have been three primary justifications for allowing nonrecognition for corporate reorganizations.57 First is ‘to provide nonrecognition treatment for [transactions that are] mere rearrangements or readjustments of continuing investments in what amounts to the same or a similar corporate entity.’58 Second is to facilitate economic growth by encouraging acquisitions (or at least not discouraging them).59 Third is ‘to alleviate the equitable and administrative difficulties involved in the taxation of noncash and difficult-to-value property.’60 To qualify as a ‘reorganization’ within the meaning of section 368, the transaction must satisfy requirements articulated in the statute and meet additional judicially developed requirements.61

IRC §336(e). See generally GLR, supra note 33, at para. 209. The election is also available if the target is an S corporation. Treas. Reg. §1.336-1(b)(6). 52 Treas. Reg. §1.336-2. The section 336(e) election is unidirectional. 53 Treas. Reg. §1.336-1(b)(2), (b)(6). If a transaction qualifies for both sections 338(h)(10) and 336(e), it is treated as subject to the former. 54 IRC §354 (Target shareholders); §361 (Target). 55 IRC §356 (requiring gain recognition to the extent of ‘boot’). See also IRC §357 (providing when assumption of liabilities is treated as boot). 56 The basis rules generally operate to preserve unrecognized gain for later recognition. IRC §§358, 362. 57 See generally Steven A. Bank, Mergers, Taxes, and Historical Realism, 75 Tul. L. Rev. 1 (2000); Yariv Brauner, A Good Old Habit, or Just an Old One? Preferential Tax Treatment for Reorganizations, 2004 BYU L. Rev. 1 (2004); Jerome R. Hellerstein, Mergers, Taxes, and Realism, 71 Harv. L. Rev. 254 (1957); Ajay K. Mehrotra, Mergers, Taxes, and Historical Materialism, 83 Ind. L. J. 881 (2008) (tracing the history of the reorganization provisions); Milton Sandberg, The Income Tax Subsidy to ‘Reorganizations,’ 38 Colum. L. Rev. 98 (1938). 58 Bank, supra note 57, at 12 (citing Hellerstein, supra note 57). 59 See id.; Brauner, supra note 57; Hellerstein, supra note 57. 60 Bank, supra note 57, at 12 (citing Sheldon S. Cohen, Conglomerate Mergers and Taxation, 55 ABA J. 40 (1969)). 61 See generally GLR, supra note 33, at chapters 6–8. 51

Tax aspects of corporate mergers and acquisitions  91 4.2.1 Statutory requirements for reorganizations Section 368 defines the term ‘reorganization’ and imposes different statutory requirements depending on transaction’s structure. The statutory requirements for the five basic acquisitive reorganization structures – direct mergers, stock-for-stock transactions, stock-for-assets transactions, forward triangular mergers, and reverse triangular mergers – are described below.62 A direct merger can qualify as a reorganization under section 368(a)(1)(A) (an ‘A’ reorganization) if it is a ‘statutory merger or consolidation.’ This includes a classic merger under state law where Target merges with and into Acquirer, with Acquirer surviving and Target ceasing to exist. A merger for section 368(a)(1)(A) purposes also includes a merger of Target with and into an LLC that is wholly owned by Acquirer. Because the LLC is a disregarded entity for federal income tax purposes (i.e., treated as part of Acquirer),63 a merger of Target with and into the LLC is treated for tax purposes as a merger of Target directly into Acquirer.64 A stock-for-stock acquisition can qualify as a reorganization if it meets the two key requirements of section 368(a)(1)(B) (for ‘B’ reorganizations). One, Acquirer must use solely voting stock of Acquirer (or of Acquirer’s parent corporation) as consideration in exchange for Target stock. Almost any non-stock consideration causes a stock-for-stock transaction not to qualify as a B reorganization.65 Two, immediately after the acquisition, Acquirer must ‘control’ Target. For this purpose, control means ownership of stock possessing at least 80 percent of the total combined voting power of Target and at least 80 percent of the total number of shares of nonvoting stock of Target.66 A stock-for-assets acquisition (i.e., where Acquirer acquires Target’s assets from Target in exchange for stock) can qualify as a reorganization if it meets the three key requirements of section 368(a)(1)(C) (for ‘C’ reorganizations). One, Acquirer must use solely voting stock of Acquirer (or of Acquirer’s parent corporation) as consideration for Target’s assets. Two, Acquirer must acquire ‘substantially all’ of Target’s assets. Acquisition of at least 90 percent of Target’s net asset and at least 70 percent of Target’s gross assets is generally sufficient to meet the ‘substantially all’ requirement.67 Three, Target must liquidate and distribute the transaction proceeds to its shareholders as part of the plan of reorganization.68 The ‘solely voting stock’ requirement in a C reorganization is less strict than in a B reorganization. In a C reorganization, any assumption of Target’s liabilities is generally disregarded when determining whether the consideration was solely voting stock.69 In addition, Acquirer can use some consideration other than voting stock if Acquirer acquires at least 80 percent of Section 368 describes several other types of reorganizations: ‘D’ reorganizations, which can be acquisitive or divisive, involve a corporation’s transfer of assets to another corporation, after which the former controls the latter. IRC §368(a)(1)(D). ‘E’ reorganizations are recapitalizations, ‘F’ reorganizations are mere changes in identity, form, or place of organization, and ‘G’ reorganizations involve bankruptcy transactions. IRC §368(a)(1)(E)–(G). 63 Treas. Reg. §301.7701-3. This assumes no election to treat the LLC as a corporation. 64 Treas. Reg. §1.368-2(b)(1). 65 See generally GLR, supra note 33, at paras 701.3, 703 (discussing the solely rule). There are limited exceptions including for paying cash in lieu of fractional shares. See Rev. Rul. 66-365. 66 IRC §368(c). This is different from the definition of control used for purposes of section 332. 67 Rev. Proc. 77-37 (stating the IRS’s ruling standard for ‘substantially all’). If that numerical threshold is not met, satisfaction of this requirement is determined based on facts and circumstances. See GLR, supra note 33, at 702.3. 68 IRC §368(a)(2)(G). 69 IRC §368(a)(1)(C). 62

92  Research handbook on corporate taxation the FMV of Target’s assets for voting stock.70 This is often referred to as the ‘boot relaxation rule.’ Under the boot relaxation rule, if Acquirer acquires 100 percent of Target’s assets, Acquirer can use up to 20 percent boot consideration. However, when applying the boot relaxation rule, any assumption of Target’s liabilities is treated as boot when determining whether at least 80 percent of Target’s assets were acquired for solely voting stock.71 ‘Triangular mergers,’ which use a wholly owned subsidiary of Acquirer (‘MergerSub’) to accomplish the acquisition, can also qualify as reorganizations. Triangular mergers include (1) ‘forward triangular mergers,’ in which Acquirer creates MergerSub, and Target merges with and into MergerSub with MergerSub surviving,72 and (2) ‘reverse triangular mergers,’ in which Acquirer creates MergerSub, and MergerSub merges with and into Target with Target surviving.73 Structurally, the only difference is the identity of the corporation that survives in the merger between MergerSub and Target. A forward triangular merger will qualify as a reorganization if it meets the requirements of section 368(a)(2)(D), which draws on elements of both A and C reorganizations. Specifically, (1) it must be the case that the merger would have qualified as an A reorganization if Target had merged into Acquirer rather than into MergerSub; (2) in the merger, MergerSub must acquire ‘substantially all’ of Target’s assets; and (3) the deal consideration must include Acquirer stock but cannot include MergerSub stock. A reverse triangular merger will qualify as a reorganization if it meets the requirements of section 368(a)(2)(E). Specifically, (1) after the transaction, the corporation that survives the merger (Target) must hold substantially all its assets and MergerSub’s assets and (2) Acquirer must acquire control of Target in exchange for Acquirer voting stock (or voting stock of Acquirer’s corporate parent). For this purpose, control is defined in the same way as in B reorganizations.74 Thus, if Acquirer acquires 100 percent of the Target stock in a reverse triangular reorganization, up to 20 percent boot consideration can be used. Different acquisition structures have different consequences if the transaction fails to qualify as a reorganization (i.e., is ‘busted’). A busted A, C, or forward triangular reorganization will generally be treated as a taxable asset sale followed by a liquidation and will thus be subject to two levels of current tax.75 A busted B or reverse triangular transaction will generally be treated as a taxable stock sale and will thus be subject to one level of current tax.76 4.2.2 Judicially developed requirements for reorganizations Courts imposed additional requirements to ensure that the reorganization statute applied as intended.77 These nonstatutory requirements – continuity of interest, continuity of business enterprise, and business purpose – are now reflected in Treasury regulations.

IRC §368(a)(2)(B). Id. 72 After the transaction, Acquirer owns all the stock of MergerSub, which owns the assets and liabilities of former Target. 73 After the transaction, Acquirer owns all the stock of Target, which continues to exist with its historic assets and liabilities. 74 IRC §368(c). 75 Rev. Rul. 69-6. 76 Rev. Rul. 90-95 (situation 1). 77 See Bittker & Eustice, supra note 4, at para. 12.02 (discussing the evolution of these requirements). 70 71

Tax aspects of corporate mergers and acquisitions  93 To meet the continuity of interest (‘COI’) requirement for qualification as a reorganization, Target shareholders must maintain a continuing interest in the enterprise, albeit in a different form. The regulations explain: The purpose of the continuity of interest requirement is to prevent transactions that resemble sales from qualifying for nonrecognition of gain or loss available to corporate reorganizations. Continuity of interest requires that in substance a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization.78

The COI requirement means that Target shareholders must receive equity (usually of Acquirer) as deal consideration. By receiving equity, the shareholders continue their proprietary interests in Target because, post-transaction, the shareholders own stock in Acquirer, which owns Target’s business. Qualitatively, any type of equity – voting or nonvoting, and common or preferred – generally counts for COI purposes.79 Quantitatively, the COI requirement is generally satisfied if the deal consideration is at least 40 percent equity.80 COI is determined in the aggregate – based on the total deal consideration – and not on a shareholder-by-shareholder basis. In addition, Treasury regulations finalized in 1998 provide that, when determining whether there is sufficient COI, pre-acquisition dispositions of Target stock and post-acquisition dispositions of Acquirer stock received in the transaction will generally be disregarded when measuring COI if the dispositions are to an unrelated party.81 These qualitative and quantitative parameters of the COI requirement appear relatively flexible, but the statutory requirements for some transaction structures impose stricter requirements on the type and amount of consideration. For B, C, and reverse triangular reorganizations, nonvoting stock is not qualifying consideration. Also, B reorganizations require 100 percent equity consideration, and C reorganizations and reverse triangular reorganizations require at least 80 percent equity consideration. Thus, A reorganizations and forward triangular reorganizations are generally the only acquisitive reorganization structures where any type of equity consideration is allowed and where the deal consideration can be up to 60 percent non-equity. Another judicially developed requirement for qualification as a reorganization is the continuity of business enterprise (‘COBE’) requirement. To meet the COBE requirement, the Target shareholders’ continuing proprietary interest must be in the continuing business enterprise, albeit operating in a modified corporate form. In early cases, courts concluded that nonrecognition treatment under the reorganization rules was not appropriate where Target’s historic business was, in substance, disposed of or otherwise ended.82 Regulations now provide that the COBE requirement is satisfied if either (1) Acquirer continues Target’s historic busi-

Treas. Reg. §1.368-1(e)(1)(i). Nonqualified preferred stock (‘NQPS’) counts for measuring COI and meeting the definition of reorganization but is treated as boot for gain recognition purposes. See Bittker & Eustice, supra note 4, at para. 12.11[5] (discussing NQPS). 80 This threshold is based on an example in the regulations. Treas. Reg. §1.368-1(e)(2)(v)(example 1). Some early cases allowed slightly less equity consideration, and per Revenue Procedure 77-37, the IRS’s historic ruling threshold was higher, requiring 50 percent equity consideration. However, most practitioners today are generally comfortable at or above (but not below) 40 percent equity consideration. 81 Treas. Reg. §1.368-1(e)(1). Post-acquisition stock buybacks by Acquirer can be disregarded for COI purposes if they satisfy the requirements of Revenue Ruling 99-58. 82 See, e.g., Standard Realization Company v. Comm’r, 10 T.C. 708 (1948). 78 79

94  Research handbook on corporate taxation ness (or continues at least a significant line of Target’s historic business)83 or (2) Acquirer ‘uses a significant portion of Target’s historic business assets in a business,’ even if Acquirer uses those assets in a business that is completely different from Target’s historic business.84 Acquirer is generally treated as operating the businesses operated by its controlled subsidiaries (including lower-tier controlled subsidiaries), and Acquirer can generally drop Target’s assets or stock down to lower-tier controlled entities without running afoul of the COBE requirement.85 If Target’s historic business is sold as part of the acquisition plan, however, COBE will be lacking even if Acquirer or any subsidiary uses the sale proceeds in a business.86 In addition to satisfying the COI and COBE requirements, a reorganization must also be undertaken for a bona fide non-tax business purpose.87 The caselaw and regulations make clear that the business purpose requirement for reorganizations contemplates a corporate business purpose, and not merely a business purpose of a Target shareholder.88 Also, a bona fide business purpose contemplates a non-tax objective; a tax reduction purpose is generally insufficient.89 4.2.3 Structuring acquisitive reorganizations Acquisitive reorganizations are often structured with multiple steps to accommodate the parties’ business and tax goals.90 The IRS has provided guidance about the tax consequences of many multi-step reorganizations. For example, if Acquirer acquires all of Target’s stock and then Target merges upstream with and into Acquirer (or merges with and into an LLC wholly owned by Acquirer) as part of an integrated transaction, the transaction will be an A reorganization if it qualifies.91 If the second step in that integrated transaction is a liquidation of Target into Acquirer rather than merger of Target into Acquirer, the transaction will be a C reorganization if it qualifies.92 If, however, the parties do not want the steps to be integrated, a section 338(h)(10) election can be made with respect to the first step, and that will turn off the step transaction doctrine.93 If a stock purchase followed by an upstream merger or a liquidation does not qualify as an A or C reorganization (respectively), the steps will not be integrated.94 Instead, the separate steps in the transaction will be respected, and the transaction will be taxed as a taxable stock purchase followed by an upstream merger or liquidation (as the

83 Treas. Reg. §1.368-1(d)(2). The ‘significance’ of a business line requires a facts and circumstances determination, but regulations suggest that continuing one of three equally valued business lines is sufficient. Id. at -1(d)(2)(iv), -1(d)(5)(example 1). 84 ‘Significance’ depends on the facts and circumstances including the relative importance of the assets to the business. Treas. Reg. §1.368-1(d)(3). 85 IRC §368(a)(2)(C); Treas. Reg. §1.368-1(d)(4), -2(k). Such drop downs also generally do not create concerns about the remoteness of shareholders’ continuity of interest. See Bittker & Eustice, supra note 4, at para. 12.03[4][c]. 86 Treas. Reg. §1.368-1(d)(5)(examples 3–5). 87 See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935). 88 See Treas. Reg. §1.368-1(b), -1(c), -2(g). 89 Treas. Reg. §1.368-1(c). 90 See infra Section 6.1 (discussing some business and tax goals relevant to M&A deal structuring). 91 Rev. Rul. 2001-46. 92 Rev. Rul. 67-274. 93 Treas. Reg. §1.338(h)(10)-1(c)(2); David Hasen, Section 338 and the Step Transaction Doctrine, 74 Tax Law. 105 (2020) (questioning this outcome). 94 Rev. Rul. 2008-25.

Tax aspects of corporate mergers and acquisitions  95 case may be). This tax treatment reflects Congress’s intent that section 338 be the only way for an acquirer of corporate stock to obtain step-up basis in the target’s assets.95 Given the foregoing, a two-step A reorganization (where Acquirer buys the stock of Target and then merges Target with and into an LLC wholly owned by Acquirer) is a very popular structure if the transaction will involve a significant amount of non-stock consideration.96 Benefits of this structure include that A reorganizations have the easiest requirements to meet, using an LLC for the merger protects Acquirer from direct exposure to the liabilities of Target, and doing the A reorganization in two steps rather than one means that, if the transaction fails to qualify as a reorganization, it will be taxed as a stock purchase followed by an upstream merger (subject to one level of tax) rather than as an asset sale followed by a liquidation (subject to two levels of tax). One downside to a two-step A reorganization is that Target does not survive the transaction. If Target needs to survive the transaction, a reverse triangular reorganization is generally preferred.97 If an acquisition cannot qualify as a reorganization because either (1) there is less than 40 percent equity consideration98 or (2) Target needs to survive and the deal involves more than 20 percent boot, there is another way to achieve reorganization-like tax treatment. As explained in Chapter 6, the acquisition can be structured using section 351, which generally provides nonrecognition for incorporation transactions.99 The Acquirer shareholders and the Target shareholders contribute their Acquirer and Target stock to a newly formed holding corporation (‘Newco’) in exchange for Newco stock and cash. Target shareholders (and any Acquirer shareholders) receiving cash are taxed on that cash to the extent of their gain, but the transaction otherwise generally qualifies as tax-free pursuant to section 351.100 The details can be complex,101 but section 351 is an important tool for structuring tax-favored acquisitions, especially if the acquisition cannot qualify as a reorganization. 4.3

Corporate Acquisitions, In Sum

Taxable stock and asset acquisitions are taxed differently even though, substantively, both enable Acquirer to acquire Target’s business, whether directly (by purchasing the business

95 Rev. Rul. 90-95. The enactment of section 338 effectively repealed the Kimbell-Diamond doctrine, named for a case that held that an acquiring corporation’s purchase of target stock followed by a liquidation of target into the acquirer stepped-up the basis in Target’s assets. Id. (citing legislative history for section 338). 96 Robert Willens, The Step Transaction Doctrine’s Kryptonite, 172 Tax Notes Federal 951 (2021) (explaining the popularity of merger structures that involve a merger into an LLC wholly owned by the acquirer as the last step). 97 If Target needs to survive, the only options are B reorganizations and reverse triangular reorganizations. The former allows no non-stock consideration at all, whereas the latter allows up to 20 percent. 98 This would mean that the transaction generally could not qualify as any type of reorganization. 99 See, e.g., Jasper L. Cummings Jr., Incorporating Reorganizations, 174 Tax Notes Federal 1537 (2022). 100 Rev. Rul. 84-71. 101 Typically, the transaction is structured as two reverse triangular mergers in what is sometimes referred to as a ‘double dummy’ structure. Newco creates two wholly owned corporate subsidiaries, and then one subsidiary merges into Target and one subsidiary merges into Acquirer. In the exchanges, Target shareholders and Acquirer shareholders get whatever package of Newco stock and cash the parties agreed upon. For more on the double dummy structure, see GLR, supra note 33, at para. 904.

96  Research handbook on corporate taxation assets) or indirectly (by purchasing the stock of the corporation holding the business assets). Elections pursuant to sections 338, 338(h)(10), and 336(e) can reduce the impact of this discontinuity, but differences between the tax treatment of asset and stock acquisitions remain because, among other reasons, the elections are unidirectional, and eligibility is limited. Similarly, requirements for qualifying as an acquisitive reorganization differ, often dramatically, depending on the acquisition’s structure. This is even true where the economic results of the transaction are identical, such as with a merger of Target into Acquirer (an A reorganization) and a transfer to Acquirer of all of Target’s assets and liabilities followed by a liquidation of Target (a C reorganization). After both transactions, Acquirer owns all Target’s assets and liabilities, and Target’s shareholders have the deal consideration. However, if, for example, the consideration is 50 percent stock and 50 percent cash, the former structure can qualify as a reorganization, but the latter will not.102 As another example, consider the merger of X and Y (both corporations). If, after the merger, X’s historic business will continue but Y’s will not, a merger of Y with and into X will fail the COBE requirement because the business of the target (Y) does not continue. In contrast, a merger of X with and into Y will meet the COBE requirement because the business of the target (X) does continue.103 The substance of both mergers is the same – a combination of X and Y into a single corporation,104 but the direction of the merger makes a dramatic difference in whether the merger can qualify as a reorganization.105 Commentators critique these form-driven differences among substantively similar transactions and argue that the tax rules applicable to corporate acquisitions are manipulable, arbitrary, unfair, unnecessarily complex, and unjustified as a policy matter.106 Some scholars also argue that the historic justifications for nonrecognition are unpersuasive.107 Many have made proposals for reform over several decades,108 but the tax rules applicable to corporate acquisitions – both taxable and tax-free – have largely persisted.

102 See Stephanie Hoffer and Dale A. Oesterle, Tax-Free Reorganizations: The Evolution and Revolution of Triangular Mergers, 108 Nw. U. L. Rev. 1083 (2014) (criticizing these types of form-driven differences). 103 The COBE requirement applies with respect to the target corporation, not the acquiring corporation. Rev. Rul. 81-25. The COI requirement works similarly (i.e., focusing on whether Target’s shareholders maintain a continuing interest, but not on whether Acquirer’s shareholders do). Rev. Rul. 70-223. Thus, switching the direction of an acquisition might transform an acquisition without sufficient COI into one with sufficient COI. See GLR, supra note 33, at para. 610.8. 104 Arguably, however, the change in direction of the merger could have substance because non-tax consequences (e.g., status as a public company) can turn on the identity of the surviving corporation. 105 See Lewis Steinberg, Form, Substance and Directionality in Subchapter C, 52 Tax Law. 457 (1999) (discussing directionality). 106 See, e.g., American Law Institute, Federal Income Tax Project: Subchapter C – Proposals on Corporate Acquisitions and Dispositions 26–32 (adopted 1980, published 1982) (hereinafter, ‘ALI’); Glenn E. Coven, Taxing Corporate Acquisitions: A Proposal for Mandatory Uniform Rules, 44 Tax L. Rev. 145 (1989); Hoffer & Oesterle, supra note 102. 107 See, e.g., Brauner, supra note 57; Hellerstein, supra note 57; see also Bank, supra note 57 (arguing that the nonrecognition rules for reorganizations can be justified as a compromise between the accretion and consumption models of taxing income). 108 See infra Section 7.2.

Tax aspects of corporate mergers and acquisitions  97

5.

TAX TREATMENT OF CORPORATE DIVISIONS

In a corporate division, one corporation that operates two businesses separates the businesses into multiple corporate entities each owned by the distributing corporation’s shareholders. Corporations undertaking divisions generally seek to do so without the imposition of current tax. Before explaining the requirements for tax-free corporate divisions, this section first explains the three basic structures for corporate divisions and the tax consequences of each if taxable. 5.1

Taxable Corporate Divisions

The three basic structures for corporate divisions are spin-offs, split-offs, and split-ups. In a spin-off, one corporation (‘Distributing’)109 that owns the stock of a controlled corporate subsidiary (‘Controlled’) distributes its Controlled stock to Distributing’s shareholders on account of their stock. After the spin-off, Distributing’s shareholders continue to own all the Distributing stock they owned before the spin-off, and they also directly own stock in Controlled. If a spin-off does not qualify for nonrecognition treatment, Distributing generally recognizes the gain (but not loss) inherent in the Controlled stock that Distributing distributes,110 but Controlled does not get to step up its basis in its assets unless a section 336(e) election is made to tax the stock distribution as a deemed asset sale. Distributing’s shareholders are generally taxed on the distribution as a dividend to the extent of Distributing’s corporate earnings and profits.111 Split-offs are like spin-offs except that Distributing shareholders receiving Controlled stock in the distribution surrender some or all their Distributing stock. That is, in a split-off, Distributing redeems some or all of a shareholder’s Distributing stock in exchange for Controlled stock. If a split-off does not qualify for nonrecognition treatment, Distributing’s and Controlled’s tax consequences are the same as in a spin-off. For shareholders whose Distributing stock is redeemed in exchange for the distribution of Controlled stock, tax treatment is determined under section 302. If the redemption meets any test in section 302(b), the shareholder recognizes gain or loss in their stock in an amount equal to the difference between the FMV of Controlled stock received in the distribution and their basis in their Distributing stock surrendered.112 Otherwise, shareholders are taxed on the distribution as a dividend to the extent of corporate earnings and profits.113 In a split-up, Distributing owns the stock of at least two controlled corporate subsidiaries and completely liquidates, distributing its stock of each controlled subsidiary to Distributing’s shareholders in complete liquidation. After a split-up, Distributing ceases to exist, and the former Distributing shareholders own the stock in the corporations that had been controlled by Distributing. If a split-up does not qualify for nonrecognition treatment, the split-up likely will be taxed as a taxable corporate liquidation. Thus, Distributing recognizes the gain and loss

109 This chapter generally assumes that Distributing is not a controlled subsidiary of another corporation. 110 IRC §311. 111 IRC §301. 112 IRC §302(a). 113 IRC §302(d).

98  Research handbook on corporate taxation inherent in the stock distributed, although a section 336(e) election may be able to be made to tax the distribution as an asset sale.114 Distributing’s former shareholders recognize the gain or loss inherent in their Distributing stock in an amount equal to the difference between the FMV of property received in the distribution and their basis in their Distributing stock.115 The foregoing assumes that the business(es) which Distributing plans to distribute are held in corporate subsidiaries. Sometimes, however, Distributing operates multiple business within a single corporation. In that case, prior to the corporate division, Distributing generally contributes the assets of the business being disposed of to a newly formed corporate subsidiary of Distributing. Then, Distributing can distribute the stock of that subsidiary to Distributing’s shareholders. The pre-division contribution to a new corporation is generally tax-free and typically does not alter the key tax consequences described above.116 5.2

Tax-Free Corporate Divisions

Some corporate divisions can be accomplished tax-free. If a corporate division satisfies the statutory and judicially developed requirements for nonrecognition under section 355, generally neither Distributing nor Distributing’s shareholders will recognize gain or loss as a result of the division.117 However, if Distributing distributes boot in the transaction, Distributing will recognize any gain inherent in that property,118 and shareholders will generally be taxable on boot received.119 Shareholders’ unrecognized gains and losses are generally preserved for later recognition,120 but Distributing’s gain (inherent in the Controlled stock distributed) disappears. These consequences generally apply whether the division is structured as a spin-off, split-off, or split-up. In addition, if, prior to the distribution, Distributing creates a controlled corporate subsidiary and contributes business assets to that subsidiary in anticipation of distributing the stock of that subsidiary in the division, that preliminary step will also generally be tax-free as part of a ‘divisive D reorganization.’121 When originally enacted, the nonrecognition rules for corporate divisions were motivated by concerns like those that motivated nonrecognition for reorganizations – that a corporate restructuring that results in shareholders having a continuing investment in continuing businesses, albeit in different corporate forms, ought not to trigger the imposition of tax.122 In the General Utilities era (when corporations could often distribute assets out of corporate solution IRC §336. Some losses may be limited under section 336(d). IRC §331. 116 IRC §351 (in an otherwise taxable transaction); see also Bittker & Eustice, supra note 4, at 11.14[3] (discussing possible alternative treatment for transactions involving split-ups). 117 IRC §355(a)(1), (c)(1); IRC §361(c)(1) (for divisive D reorganizations). Also, Controlled generally will not recognize any gain or loss because of the corporate division. See Candace A. Ridgeway, Corporate Separations, 776-4th Tax Management Portfolio at XA (Bloomberg Law 2023). 118 IRC §355(c)(2); IRC §361(c)(2) (for divisive D reorganizations). 119 The exact details about how the shareholder is taxed on boot received depend on the structure of the division. See Bittker & Eustice, supra note 4, at para. 11.10. 120 IRC §358. If a shareholder owns stock of both Distributing and Controlled after the division, their total basis is divided among their stock based on the relative FMVs of the stock. Treas. Reg. §1.358-2(a) (2)(iv). 121 IRC §368(a)(1)(D). See generally GLR, supra note 33, at para. 1002.4. 122 See Charles S. Whitman III, Draining the Serbonian Bog: A New Approach to Corporate Separations under the 1954 Code, 81 Harv. L. Rev. 1194 (1968) (tracing the history of section 355). 114 115

Tax aspects of corporate mergers and acquisitions  99 without the recognition of corporate-level tax), the most important consequence of nonrecognition treatment for qualifying corporate divisions was non-taxation for the shareholders receiving the distribution.123 The nonrecognition provisions for corporate divisions were not materially changed in 1986 when General Utilities was repealed. After GU repeal, the importance of being able to avoid corporate-level tax in qualifying divisions increased significantly because GU repeal eliminated most other ways for a corporation to distribute appreciated assets without corporate-level tax. In the decades since GU repeal, Congress has amended section 355 multiple times to try to prevent the use of section 355 to undermine GU repeal.124 The Treasury Department and IRS are working on revisions to the rules applicable to tax-free corporate divisions, so there are likely some changes ahead.125 The requirements for nonrecognition treatment for corporate divisions – as those requirements apply today – are discussed below. 5.2.1 Statutory requirements for tax-free corporate divisions under section 355 For a corporate division to qualify as a nonrecognition event for both the distributing corporation and its shareholders, section 355 imposes the following requirements. Distributing must control (i.e., own at least 80 percent of the voting power and at least 80 percent of the number of nonvoting shares of) Controlled immediately before the distribution.126 In the corporate division, Distributing generally must distribute all of its stock and securities of Controlled to Distributing’s shareholders on account of, or in exchange for, their Distributing stock.127 The distribution must not be ‘used principally as a device for the distribution of [corporate] earnings and profits.’128 This requirement, which dates to the General Utilities era, is primarily concerned with the possibility that a shareholder who would otherwise receive a fully taxable dividend in a corporate division could instead receive a distribution of stock tax-free and then sell that stock, thereby recognizing capital gain (i.e., with basis offset and, at that time, preferential rates).129 Whether a distribution is used principally as a device requires a facts and circumstances analysis.130 The regulations provide guidance, including by identifying factors that tend to indicate that the transaction is a device (e.g., pro rata distribution, subsequent sale of Distributing or Controlled stock (particularly if prearranged), and the existence of assets unrelated to the active business) and factors that tend to indicate that the transaction is not See Bret Wells, Reform of Section 355, 68 Am. U.L. Rev. 447, 457–8 (2018). See, e.g., id. (discussing changes to section 355, including since GU repeal); Herbert N. Beller, Section 355 Revisited: Time for a Major Overhaul?, 72 Tax Law. 131 (2018); see also infra Section 5.2.3. 125 See, e.g., Chandra Wallace, Changes Are Underway for Leveraged Spin Guidance, IRS Says, 175 Tax Notes Federal 1904 (2022); Chandra Wallace, Seeking a Holistic Guide for Spinoff Letter Rulings, 174 Tax Notes Federal 18 (2022). 126 IRC §355(a)(1)(A), §368(c). 127 Distributing may retain some Controlled stock if (1) Distributing still distributes stock constituting control and (2) Distributing establishes to the IRS’s satisfaction that the retention of some Controlled stock does not have a principal purpose of tax avoidance. IRC §355(a)(1)(A), (D). 128 IRC §355(a)(1)(B). 129 Treas. Reg. §1.355-2(d)(1). Today, dividends and long-term capital gains are taxed at the same rates, but taxpayers still have an incentive to seek long-term capital gain treatment to accelerate basis recovery. 130 Treas. Reg. §1.355-2(d)(1). 123 124

100  Research handbook on corporate taxation a device (e.g., corporate business purpose, Distributing is publicly traded and widely held, distribution is to domestic corporate shareholders).131 In addition, both Distributing and Controlled must be engaged in the active conduct of a trade or business immediately after the division.132 Each such trade or business must have been actively conducted throughout the five-year period ending on the date of the division, and the businesses must not have been acquired in a taxable transaction in that five-year period.133 The purpose of this active trade or business requirement is ‘to prevent taxpayers from bailing out corporate profits by dumping marketable assets not required for the conduct of their corporations’ business into new corporations [or using such assets to purchase an operating business] and spinning off those incorporated assets [or the operating business recently purchased with those assets].’134 5.2.2 Judicially developed requirements for tax-free corporate divisions To qualify for nonrecognition, corporate divisions, like corporate reorganizations, must also meet judicially developed requirements that help ensure the statute applies as Congress intended. These requirements – continuity of interest, continuity of business enterprise, and business purpose – are now included in the regulations. To qualify as a tax-free corporate division, Distributing’s historic shareholders must have sufficient continuing equity interests in each post-division corporation.135 Whether Distributing’s historic shareholders maintain sufficient COI in the post-division corporations is measured in the aggregate. Thus, different historic shareholders can have continuing interests in different post-division corporations, if enough stock of each post-division corporation is owned by Distributing’s historic shareholders. Quantitatively, the regulations make clear that 50 percent COI is sufficient, but 20 percent is not.136 COI levels slightly below 50 percent might also suffice.137 For purposes of measuring COI in the division, pre-division purchases of Controlled stock and post-division sales of Distributing or Controlled stock could, depending on the facts and circumstances, be integrated with the division, possibly causing the division to fail the COI requirement.138 ‘Section 355 [also] contemplates the continued operation of the business or businesses existing prior to the separation.’139 This requirement is largely the same as for acquisitive reorganizations, and if a corporate division satisfies the ‘active conduct of a trade or business’ requirement, COBE will typically be satisfied because the former is generally more restrictive.140

Treas. Reg. §1.355-2(d)(2), -2(d)(3). IRC §355(a)(1)(C), (b). For a split-up, this requirement applies to both controlled corporations. 133 IRC §355(b)(2). 134 Ridgeway, supra note 117, at VI.B. 135 Treas. Reg. §1.355-2(c). 136 Id. at -2(c)(2). 137 See Bittker & Eustice, supra note 4, at para. 11.09, note 347. 138 See, e.g., Treas. Reg. 1.335-2(c)(2). When the COI regulations for acquisitive reorganizations were liberalized in 1998, the Treasury Department declined to do the same for section 355 purposes, deferring the question for further study. Treas. Dec. 8760 (1998); see also supra note 81 and accompanying text (discussing the liberalized COI requirement for reorganizations). 139 Treas. Reg. §1.335-1(b). 140 See Ridgeway, supra note 117, at VII.B. 131 132

Tax aspects of corporate mergers and acquisitions  101 In addition, section 355 only applies to divisions motivated in whole or in substantial part, by a bona fide corporate business purpose.141 The taxpayer must affirmatively establish ‘a real and substantial non-Federal tax purpose germane to the business.’142 It is insufficient to demonstrate that the corporate division is not a device to distribute corporate earnings and profits. Examples of qualifying business purposes for a tax-free corporate division include (1) complying with a legal requirement, (2) facilitating capital raising, (3) providing equity to key employees, and (4) reducing costs.143 5.2.3 Anti-abuse rules for tax-free corporate divisions Creating parameters that strike an appropriate balance between (1) providing tax-free treatment for divisions that are mere changes in form of business ownership and (2) preventing abuse (i.e., bailouts of corporate earnings and profits and inappropriate circumvention of GU repeal), has proven challenging. As a result, Congress amended section 355 several times, commonly to add anti-abuse rules in response to transactions where taxpayers used section 355 in ways that were believed to avoid corporate-level gain inappropriately. Two such provisions are section 355(d), added in 1990, and section 355(e), added in 1997.144 Sections 355(d) and 355(e) apply in slightly different situations, but very generally, both deny tax-free treatment to Distributing if an otherwise tax-free corporate division is accompanied by certain pre- or post-transaction acquisitions that make the aggregate transaction tantamount to a disguised sale of stock.145 ‘Section 355(d) requires Distributing to recognize gain (but not loss) if a shareholder holds a 50%-or-greater interest (by vote or value) in either Distributing or Controlled immediately after the distribution, and that interest is attributable to [Distributing] stock purchased within the five-year period ending on the date of the distribution.’146 Section 355(e) provides that: if one or more persons acquire a 50%-or-greater interest in Distributing or Controlled pursuant to a plan or arrangement of which the spin-off is a part, then Distributing must recognize gain (but not loss) as if Distributing sold the stock of Controlled for its fair market value as of the date of distribution.147

Regulations provide guidance for both. For section 355(d), the statutory language was widely viewed as overbroad when enacted, and in response, ‘Treasury has … developed standards Gregory v. Helvering, 293 U.S. 465 (1935); Treas. Reg. §1.355-2(b)(1). Treas. Reg. §1.355-2(b)(1). 143 Id. at -2(b)(5)(examples); see also Rev. Proc. 96-30, Appendix A (business purposes acceptable under the IRS’s prior ruling guidelines). 144 Bittker & Eustice, supra note 4, at para. 11.11[2] and [3]. Section 355(d) was added in response to transactions like the one in Esmark, Inc. v. Comm’r., 90 T.C. 171 (1988), aff’d 886 F.2d 1318 (7th Cir.) (purchase of more than 50 percent of the stock of the distributing corporation, after which that purchased stock was redeemed in exchange for the stock of a subsidiary of the distributing corporation). Section 355(e) was added to prevent corporate-level nonrecognition for transactions like the one in Comm’r v. Morris Trust, 367 F.2d 794 (4th Cir. 1966) (spin-off followed by an acquisition of the distributing corporation). Congress added other anti-abuse rules as well including section 355(g), which denies all benefits of section 355 for ‘cash rich split offs.’ 145 Bittker & Eustice, supra note 4, at para. 11.11[2] and [3]; Ridgeway, supra note 117, at IX.D and E. 146 Ridgeway, supra note 117, at IX.D. 147 Id. at IX.E. 141 142

102  Research handbook on corporate taxation to limit the consequences of a literal application of the statute that would attain results inconsistent with congressional intent.’148 For section 355(e), regulations articulate factors that tend to show the presence or absence of a ‘plan’ and establish safe harbors pursuant to which a distribution and acquisition will not be treated as part of a plan.149 These regulations are ‘generally quite helpful in enabling taxpayers and their advisers to determine, with a fair degree of confidence, whether a proscribed plan does or does not exist.’150 These anti-abuse rules limit the tax-free treatment of some divisions that are accompanied by acquisitions, but these rules are navigable in the right circumstances. For example, a post-spin acquisition of Distributing or Controlled generally will not cause an otherwise tax-free spin to be taxable to Distributing (1) if there is no ‘plan’ or (2) if the acquiring corporation is less valuable than the corporation (Distributing or Controlled) being acquired (i.e., such that Distributing’s historic shareholders retain more than 50 percent of the stock of both Distributing and Controlled).151 Ultimately, even with limitations from section 355(d), section 355(e), and other provisions, tax-free corporate divisions remain central to corporate M&A activity and can be part of multi-step transactions that also involve acquisitions.152 5.2.4 Tax-free corporate divisions, in sum Despite many amendments to section 355 since GU repeal, commentators continue to call for changes to the section 355 requirements. Criticisms of section 355 abound and include arguments that the rules are poor fit for an era with unified rates for longer term capital gains and qualified dividends;153 that the COI requirement is too lax and allows nonrecognition where not warranted;154 that the requirements for nonrecognition otherwise undermine GU repeal;155 and that the rules are unnecessarily complex, and in some cases, uncertain.156 Perhaps these concerns will be addressed in the IRS’s current efforts to revise rules for tax-free corporate divisions, including to the active trade or business requirement and the device requirement.

W. Eugene Seago and Edward J. Schnee, Spinoffs and Split-Offs: Rules and Presumptions, 171 Tax Notes Federal 179, 189 (2021); see Treas. Reg. § 1.355-6. 149 Treas. Reg. §1.355-7; see generally Bittker & Eustice, supra note 4, at para. 11.11[3]. 150 Beller, supra note 124, at 148. 151 See Bittker & Eustice, supra note 4, at para. 11.11[3]. 152 See Jasper L. Cummings Jr., Spinning, Acquiring, and Disposing, 158 Tax Notes 101 (2018) (discussing strategies for transactions involving a tax-free division and an acquisition, and highlighting the importance of section 355 to broader M&A activity). 153 See Peter C. Canellos, The Section 355 Edifice: Spinoffs Past, Present, and Future, 104 Tax Notes 419, 420 (2004). 154 See Wells, supra note 123. 155 See id.; Beller, supra note 124. 156 See Beller, supra note 124; Canellos, supra note 153; Michael L. Schler, Simplifying and Rationalizing the Spinoff Rules, 56 SMU L. Rev. 239 (2003); Lewis R. Steinberg, Selected Issues in the Taxation of Section 355 Transactions, 51 Tax Law. 7 (1997); Wells, supra note 123; George K. Yin, A Different Approach to the Taxation of Corporate Distributions: Theory and Implementation of a Uniform Corporate-Level Distributions Tax, 78 Geo. L.J. 1837, 1924 (1990). 148

Tax aspects of corporate mergers and acquisitions  103

6.

TAXATION AND THE REALITIES OF CORPORATE M&A

In practice, corporate M&A transactions and their tax analyses can be more complex than the prior three sections suggest.157 6.1

Complex Corporations with Multiple Goals

The corporations discussed in the prior three sections were relatively simple, but corporations engaging in M&A transactions are often more complex. Many corporations have capital structures that include preferred stock in addition to common, multiple classes of common stock with different voting rights, debt instruments, employee stock options, and more. Deal consideration can include a similarly complex mix of instruments, and some consideration might be escrowed or otherwise contingent. The M&A transaction might also involve multi-national corporations, complex consolidated groups, S corporations, REITs, or distressed companies. One corporation in an acquisition might already own an interest in the other, or the parties involved might otherwise have overlapping interests. These factors and others make the tax analysis more challenging. Corporations involved in the M&A deal often have complex business goals – beyond just completing a liquidation, acquisition, or division. These goals also influence the deal structure. Often corporations want to dispose of unwanted assets in connection with the deal. A corporation involved in a deal might need to survive the transaction because, for example, it has assets or contracts that are nontransferable. One corporation might want to avoid direct exposure to another corporation’s liabilities. A corporation might want to borrow to fund the transaction. Sometimes shareholder conflicts must be addressed. For example, the presence of recalcitrant minority shareholders might require a structure that squeezes out that shareholder. These factors, plus securities laws, antitrust laws, financial accounting considerations, and other business issues can all affect the choice of deal structure. In addition, parties’ tax goals affect the structure of corporate M&A transactions. Common tax goals in M&A transactions include deferring the recognition of gain, triggering the recognition of losses, and if possible, selectively doing both in the same transaction. Even better than deferring gain would be to make gain disappear by extracting assets from corporate solution with little to no corporate-level tax. That is, however, often quite difficult after GU repeal. Additional tax goals in M&A deals include minimizing tax liability if gain must be recognized, stepping up basis, and using or preserving corporate tax attributes. 6.2

Creative Deal Structures

Expert lawyers generally try to structure each corporate M&A deal to achieve (as best as possible) a client’s business and tax objectives simultaneously. When doing so, they have created innovative corporate M&A structures.158 One example mentioned above and in Chapter 6 One issue is the sheer volume and complexity of the technical tax rules. This chapter leaves those details for more in-depth resources. See, e.g., GLR, supra note 33 (a five-volume treatise that is widely regarded as the ‘bible’ for M&A tax practitioners). 158 Analysis of corporate M&A structures, especially creative structures, must consider the possibility of overlaps, where multiple Code sections might apply and yield different tax results for the same trans157

104  Research handbook on corporate taxation involves structuring an acquisition as a corporate contribution, which can be tax-free under section 351.159 These ‘contribution’ structures afford reorganization-like tax treatment to some acquisitions that are unable to qualify as reorganizations within the meaning of section 368. Another example involves M&A deal structures using LLCs. These structures became popular after the adoption of the elective entity classification rules that provided certainty about the tax treatment of LLCs.160 Now, A reorganizations using LLCs are very popular acquisitive reorganization structures.161 A recent example of a creative deal structure is the ‘Up-C.’ Up-C structures use an LLC and the partnership tax rules to effectuate tax-favored corporate acquisitions with fewer restrictions than imposed by section 368 and with opportunities for step-ups in asset basis that are generally not available with corporation-only structures.162 The foregoing are just examples, and there are many additional creative, complex M&A deal structures.163 The tax benefits of some such structures that were perceived as abusive have been curtailed by statutory amendments,164 and the tax benefits from some other complex structures have been successfully challenged by the IRS.165 Generally, however, the tax bar has proven quite adept at complex M&A structuring that achieves both business and tax goals. 6.3

The Relevance of Judicial Doctrines

When designing and analyzing creative M&A deal structures, judicially developed anti-abuse doctrines must be considered. These doctrines include the ‘substance over form’ doctrine and two doctrines derived therefrom: the ‘economic substance doctrine’ and the ‘step transaction doctrine.’ 6.3.1 Substance over form Fundamental to the federal income tax system is the principle that tax consequences should be based on the substance rather than form of a transaction.166 If the form of a transaction is inconsistent with its economic reality, the substance over form doctrine allows the transaction action. Overlaps must be resolved before the tax consequences of a transaction can be determined. See, e.g., NYSBA, Report on Characterizing Overlap Transactions in Subchapter C (2011). 159 See supra notes 99–101 and accompanying text. 160 Treas. Reg. §301.7701-3 (effective 1 Jan. 1997). 161 See Willens, supra note 96. 162 See Gregg D. Polsky and Adam H. Rosenzweig, The Up-C Revolution, 71 Tax L. Rev. 415 (2018). 163 Another example is a bootstrap acquisition, where Target redeems some shareholders’ stock, and the Acquirer purchases the rest. This structure enables Acquirer to finance much of the purchase price using Target’s assets or borrowing power, and by stepping together the redemption and the stock purchase, the shareholders whose stock is redeemed can generally achieve capital gain rather than dividend treatment. See Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954); Rev. Rul. 54-458 (acquiescing to the result in Zenz). 164 See, e.g., supra Section 3.3 (discussing the curtailment of mirror transactions); Section 5.2.3 (discussing anti-abuse rules added to section 355). 165 For example, the IRS has been successful when challenging ‘Midco’ transactions. A Midco transaction is a multi-step transaction involving an asset purchase by an intermediary corporation followed by the liquidation of that corporation, intended to enable the sale of the assets without payment of tax on the gain inherent in those assets. See Bittker & Eustice, supra note 4, at para. 10.51, note 793. 166 See generally Bittker & Eustice, supra note 4, at para. 1.05[2][b]; see also generally Gregory v. Helvering, 293 U.S. 465 (1935) (often regarded as the origin of the substance over form doctrine).

Tax aspects of corporate mergers and acquisitions  105 to be taxed according to its substance. That can deny a taxpayer a tax benefit available based on the transaction’s form if that tax benefit would not be available based on the transaction’s substance.167 Substance, however, does not always triumph. Sometimes, tax consequences depend on form, especially in corporate M&A, as illustrated in the above discussions of liquidations, mergers, and divisions. As ‘M&A tax guru’168 Lewis Steinberg pointed out in an article published more than 20 years ago, ‘there are two fundamental principles in Subchapter C of the Code: “‘Substance controls, form does not’ and ‘form controls, substance does not.’”169 This observation remains true. 6.3.2 Economic substance doctrine Courts developed the economic substance doctrine as part of applying the substance over form principle, and in 2010, Congress codified the economic substance doctrine by enacting section 7701(o).170 Very generally, the economic substance doctrine, where relevant, disallows purported tax benefits of a transaction and imposes penalties unless the transaction both meaningfully alters the taxpayer’s non-tax economic position and has a substantial non-tax business purpose.171 This chapter generally discusses corporate M&A transactions that meaningfully restructure the enterprises and are undertaken for business reasons. Accordingly, and given the intended scope of section 7701(o),172 the economic substance doctrine is unlikely to apply to change the tax consequences of most of the transactions discussed in this chapter.173 Thus, the discussion of the economic substance doctrine is left for Chapter 22. 6.3.3 Step transaction doctrine When substance prevails over form in the taxation of corporate M&A, it is often because of the step transaction doctrine.174 If the step transaction doctrine applies, one or more formal steps are generally disregarded, and the transaction is typically treated for tax purposes as a single integrated transaction reflecting the transaction’s overall substance.175 If the step transaction

The substance over form doctrine is typically invoked by the IRS to challenge a tax benefit claimed by a taxpayer. Taxpayers, however, generally cannot disavow their form. Comm’r v. Danielson, 378 F.2d 771 (3d Cir., 1967), cert. denied, 389 U.S. 858 (1967). 168 Liz Hoffman, Credit Suisse’s M&A Tax Guru to Join BofA, Wall St. Journal (2 March 2015). 169 Lewis Steinberg, Form, Substance and Directionality in Subchapter C, 52 Tax Law. 457 (1999). 170 Health Care and Education Reconciliation Act of 2010, P.L. 111-152 §1409 (enacted 3 March 2010). 171 IRC §7701(o). 172 The legislative history explains section 7701(o) was ‘not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. [including] … the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C.’ Joint Comm. on Taxation, Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010’ as amended (JCX-18-10). 173 See GLR, supra note 33, at para. 608.2 (reaching the same conclusion). 174 See, e.g., Treas. Reg §1.368-1(a) (explicitly providing that the step transaction applies for purpose of determining whether a reorganization occurs). 175 Bittker & Eustice, supra note 4, at para. 12.02[5]. 167

106  Research handbook on corporate taxation does not apply, the multiple formal steps are generally respected and given independent significance for tax purposes. Courts generally use three tests to determine whether the step transaction doctrine applies. The narrowest is the ‘binding commitment’ test, under which separate steps are integrated only ‘if, when the first step is taken, there is a binding commitment to take the later steps.’176 The ‘end result’ test is broader and integrates separate steps when they appear to be ‘really prearranged parts of a single transaction intended from the outset to reach the ultimate result.’177 In between is the ‘mutual interdependence’ test, which integrates steps if they ‘are so interdependent that the legal relations created by one transaction would be fruitless without a completion of the series.’178 Regardless of the formulation of the step transaction tests, the step transaction doctrine generally cannot be used to invent additional steps.179 In addition, ‘where there are two or more straight paths to the same end result,’ the step transaction doctrine does not ‘require [the taxpayer] to take the most expensive route.’180 The application of the step transaction doctrine requires careful analysis of the facts and circumstances of the transactions. However, many cases, regulations, revenue rulings, revenue procedures, and more181 provide guidance about how the step transaction doctrine and the substance over form doctrine, more generally, apply.182 The consequence of this guidance is that lawyers have insight into (1) what steps are generally ‘safe’ to take and will not be integrated with a larger transaction;183 (2) how particular steps, if integrated, will be treated for tax purposes;184 (3) when and how taxpayers can ‘turn off’ the step transaction doctrine;185 and (4) how to avoid the application of anti-abuse provisions applicable to multi-step transactions.186 Many questions remain despite the very useful guidance. However, when possible, lawyers typically try to structure M&A deals to fit cleanly into existing guidance. Doing so provides a lot of confidence about the tax consequences. For corporate M&A structures that are not directly addressed by existing guidance, the guidance still provides insights that might help practitioners exercise judgment about the likely tax consequences despite some uncertainty.

Stephen S. Bowen, The End Result Test, 72 Taxes 722, 722 (1994). Id. 178 Id. 179 Esmark, Inc. v. Comm’r, 90 T.C. 171 (1988). 180 Bittker & Eustice, supra note 4, at para. 12.02[5]. 181 Taxpayers cannot rely on other taxpayers’ private letter rulings (‘PLRs’), but PLRs can nevertheless provide insight into how the IRS might apply the step transaction doctrine in a specific situation. 182 For an excellent overview of such guidance, see Eric Solomon, Application of the Step Transaction Doctrine in the Corporate Setting, The Corporate Tax Practice Series – Strategies for Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations, & Restructurings (2d ed., Practising Law Institute 2020). 183 For example, pre-liquidation sales of stock intended to cause the liquidation to be taxable rather than tax-free will generally be respected, and pre-acquisition sales of Target stock and post-acquisition of Acquirer stock generally will not adversely affect continuity of interest if the sales are made to third parties. See supra notes 26–8, 81, and accompanying text. 184 See, e.g., supra notes 91–5 and accompanying text (discussing authorities specifying the tax treatment of multi-step acquisitions). 185 See, e.g., supra note 93 and accompanying text (discussing how a section 338(h)(10) election can turn off the step transaction in a multi-step acquisition). 186 See, e.g., supra notes 151–2 and accompanying text (discussing options for structuring around the limitations imposed by sections 355(d) and 335(e)). 176 177

Tax aspects of corporate mergers and acquisitions  107 6.4

Tax (Quasi-)Electivity for the Well-Advised

Ultimately, well-advised taxpayers have a lot of flexibility when choosing how their complex corporate M&A transactions will be taxed. Some of that flexibility is explicitly provided by Congress. For example, taxpayers can elect to tax certain qualified stock purchases and qualified stock distributions as asset purchases instead. Most of that flexibility is implicit, making the tax consequences of many corporate M&A transactions ‘quasi-elective.’187 Taxpayers can often ‘elect’ the tax treatment of their transaction by structuring it in a way that meets (or fails to meet) the formal requirements for nonrecognition (depending on whether the parties want tax-free or taxable treatment), often without material changes to the substance of the transaction. These choices are available largely because of the tax law’s respect for form in corporate M&A in many cases, guidance about the taxation of multi-step transactions, and tax lawyers’ creativity and expertise. Commentators have observed this quasi-electivity across multiple types of corporate M&A transactions. For corporate liquidations, the tax treatment has been described as elective ‘in the sense that with advance planning and property structured transactions, a corporation should be able to render §332 applicable or inapplicable.’188 For corporate acquisitions, commentators explain that electivity is implicit in the rules and that the rules thereby create ‘transactional elections’ (i.e., where taxpayers elect their tax treatment by choosing the form of their transaction).189 The tax treatment of corporate divisions is somewhat less elective because section 355 is somewhat less form-driven than section 368.190 Nevertheless, there is still some optionality, including ways to structure around the anti-abuse limitations in section 355.191 Indeed, spin-offs have been described as ‘remarkably flexible and friendly to taxpayers,’ despite the complexity of section 355.192 Also, taxpayers who want their multi-step transactions integrated for tax purposes can generally achieve that result by entering into a binding commitment to undertake all the steps before any step is taken. It can, however, be more difficult to ensure that multiple steps are not integrated.193 The flexibility to choose the tax treatment of a corporate M&A deal is not, however, limitless. Requirements for nonrecognition must still be satisfied. For example, an all cash acquisition of a corporation cannot qualify as a reorganization, and a corporate division lacking a non-tax business purpose cannot qualify as tax-free under section 355. And the step Rizzi, supra note 26. Id. (quoting Riggs v. Comm’r, 64 T.C. 474, 489 (1975) acq. 1976-2 C.B. 2, and referring the principle derived from Granite Trust). 189 ALI, supra note 106, at xviii, 7, 10 (also calling the tax consequences of corporate acquisitions ‘easily manipulated’); Hoffer & Oesterle, supra note 102, at 1111; Coven, supra note 106, at 156–8. 190 For example, section 355 applies equally to spin-offs, split-offs, and split-ups. 191 See supra notes 151–2 and accompanying text. 192 J. William Dantzler, Spinoffs: Still Remarkably Tax Friendly, 129 Tax Notes 683 (2010); see also Jasper L. Cummings Jr., Buying and Spinning Subsidiaries, 171 Tax Notes Federal 1587 (2021) (‘in most cases, those limits [on “a tax-free spin of a recently purchased C”] either don’t really exist or can be overcome’); Jasper L. Cummings Jr., Regular Order in Tax Guidance, 103 Tax Notes State 787 (2022) (‘it seems impossible to incur tax in an attempted section 355 transaction if the taxpayer makes any sort of reasonable effort to comply,’ noting, among other things, that ‘section 355(e) was neutered by the safe harbors in reg. section 1.355-7’). 193 See generally Jasper L. Cummings Jr., Avoiding Linked Events: How Long Must We Wait?, 148 Tax Notes 781 (2015). 187 188

108  Research handbook on corporate taxation transaction doctrine might apply to a multi-step transaction unless guidance makes it clear that the form of the transaction will be respected. Thus, there are constraints on the ability to make an implicit election about the tax treatment of an M&A transaction. The partial optionality inherent in the tax treatment of corporate M&A transactions highlights the importance of good advice. Many tax rules applicable to corporate M&A are quite complicated, so an expert is needed to design a transaction structure that has a high likelihood of yielding the taxpayer’s desired tax and non-tax results. Moreover, if a corporation’s public shareholders must vote on the transaction or if a party to the transaction otherwise wants more assurance about the deal’s tax treatment, the tax adviser might be asked to render a formal legal opinion about the tax consequences of the transaction. Legal opinions, however, are not binding on the IRS. As a result, where the tax consequences are more uncertain and where the stakes are particularly high, a taxpayer might want an IRS private letter ruling about the transaction’s tax consequences before proceeding. There are, however, many issues on which the IRS will not rule,194 in which case a taxpayer generally must rely on their tax adviser for comfort about the transaction’s tax consequences.195

7.

CONCLUSION: THE FUTURE OF CORPORATE M&A TAXATION

This chapter discussed the material U.S. federal income tax consequences of corporate M&A transactions. The discussion explained not only the technical tax rules and how they apply to a variety of M&A transactions, but also key policy critiques of those rules. In addition, the discussion highlighted the impact of the tax rules – as they exist today – on strategic structuring choices for M&A deals. The tax rules applicable to corporate M&A transactions, however, will likely change over time. Changes might be to the rules that specify the tax treatment of corporate transactions like liquidations, acquisitions, and divisions.196 Changes outside of the corporate tax rules themselves (e.g., to tax rates) can also alter the tax consequences of corporate M&A transactions.197

194 For tax-free corporate liquidations and reorganizations, the IRS will generally only rule on ‘significant issues.’ Rev. Proc. 2022-2, §3.01(60). The IRS also will not rule on stock transfers intended to enable a liquidation to be taxable. Id. at §3.01(48). For corporate divisions, the IRS’s ruling position has changed repeatedly during the past decade. Today, the IRS will rule on section 355 issues, but only with respect to ‘significant issues’ that are ‘legal issues and … not inherently factual in nature,’ and that relate to the active conduct of a trade or business requirement, the device prohibition, and in limited circumstances, whether the distribution and an acquisition are part of a plan for purposes of section 355(e). Rev. Proc. 2022-2, §3.01(63). The IRS is actively working on ‘an updated, comprehensive guide to obtaining letter rulings blessing spinoff transactions,’ so there are likely more changes forthcoming for the IRS’s ruling policy for corporate divisions. Wallace, Seeking, supra note 125. 195 A corporation might also consider getting tax insurance for low-risk, high magnitude tax risk. 196 This would include most of the provisions in subchapter C of the Code (i.e., IRC §§301–85). 197 Change could also include fundamental tax reforms such as corporate integration, the abandonment of the realization requirement, or the adoption of a federal consumption tax. These changes would certainly have a significant impact on the tax treatment of corporate M&A. Corporate integration, for example, would likely diminish the discontinuity between tax treatment of asset and stock transactions. At this point, however, fundamental changes seem relatively unlikely to occur soon. Thus, this chapter has, from the beginning, set the possibility of fundamental change aside. See supra note 1.

Tax aspects of corporate mergers and acquisitions  109 7.1

Changes to the Tax Rules Governing Corporate Transactions

One possible response to the policy concerns about complexity and about the inconsistent form-driven tax treatment of acquisitions is to make the tax treatment of corporate acquisitions explicitly elective. In 1980, the American Law Institute proposed an elective regime, pursuant to which corporations participating in an acquisition could elect to treat the acquisition as either a non-taxable carryover basis acquisition or a taxable cost-basis acquisition.198 The shareholder-level treatment would be determined independently based on the type of consideration received by the shareholder.199 The ALI explained that tax electivity was ‘implicit in existing [acquisition] rules, and the main effect of the proposals is just to bring those characteristics out in the open’ so that the tax treatment of an acquisition did not depend on the choice of ‘corporate procedure.’200 An explicitly elective regime arguably treats substantively similar transactions similarly, in that the same elective tax consequences would be available for all such transactions. In addition, elective tax treatment arguably simplifies the acquisition transaction and provides more certainty about the tax treatment. The staff of the Senate Finance Committee, also in the 1980s, suggested an elective approach like the ALI’s.201 Ultimately, however, nothing came of these proposals. Scholars suggest several other responses to the policy critiques of the tax treatment of corporate acquisitions. For example, the tax treatment of taxable stock and asset acquisitions could be unified either by (1) imposing a corporate-level tax on stock sales (i.e., taxing all stock sales like asset sales are currently)202 or (2) eliminating the corporate-level tax on asset sales and providing mandatory carryover basis treatment for the acquired assets (i.e., taxing all asset sales like stock sales are currently).203 The tax treatment of taxable acquisitions and non-taxable acquisitive reorganizations could be unified, for example, by removing section 368 from the Code and treating all corporate stock and asset acquisitions as taxable stock and asset acquisitions, respectively, regardless of whether cash or stock is used as consideration.204 Treating all acquisitions as fully taxable both at the corporate level and shareholder level could unify both the tax treatment of asset and stock acquisitions and the tax treatment of acquisitions that qualify as reorganizations and those that do not.205 The tax rules applicable to corporate divisions arguably also merit an overhaul. Reforming the section 355 rules could respond to commentators’ extensive criticisms, including about the complexity of the current rules and about the poor fit between the rules and today’s post-GU repeal world with unified rates for long-term capital gains and qualified dividends.206 Some ALI, supra note 106, at 6–9. Id. at 9. 200 Id. at 10. 201 Staff of Senate Comm. on Finance, 99th Cong., 1st Sess., Final Report on the Subchapter C Revision Act of 1985, 50–58 (Comm. Pr int 1985); see al so Daniel Q. Posin, Taxing Corporate Reorganizations: Purging Penelope’s Web, 133 U. Pa. L. Rev. 1335 (1985) (discussing the Senate Committee on Finance proposal and arguing against its adoption). 202 See, e.g., James B. Lewis, A Proposal for a Corporate Level Tax on Major Stock Sales, 37 Tax Notes 1041 (1987). 203 See, e.g., Coven, supra note 106. 204 See, e.g., Brauner, supra note 57 (arguing for deleting section 368); Hellerstein, supra note 57 (ar guing for l imit ing r eor ganizat ions t o onl y nonpubl icl y t r aded companies). 205 See, e.g., David J. Shakow, Wither, ‘C’!, 45 Tax L. Rev. 177 (1990). 206 See supra notes 153–6 and accompanying text. 198 199

110  Research handbook on corporate taxation commentators have offered multi-pronged recommendations for overhauling the tax rules applicable to corporate divisions,207 and the IRS is undertaking a ‘comprehensive reworking of the rules for corporate spinoff transactions.’208 Less comprehensive, more targeted change is also an option. Individual tax provisions applicable to corporate M&A transactions could be modified to respond to specific concerns. For example, the COI regulations applicable to tax-free corporate divisions could be tightened to limit nonrecognition to circumstances more aligned with legislative intent of providing nonrecognition where continuing shareholders have a continuing interest in a continuing enterprise. That could be done without also overhauling the other section 355 requirements.209 This type of incremental approach would be consistent with the pattern of prior changes to the M&A tax rules since 1986, but that approach has drawn critics.210 7.2

Broader Tax Changes

Tax law changes can affect the tax consequences of corporate M&A even if the changes do not directly alter the tax law provisions specifically applicable to corporate liquidations, acquisitions, or divisions. For example, changes made by the Tax Cuts and Jobs Act in 2017,211 including the reduction in the corporate tax rate, the limitation on the deductibility of interest, changes to the rules about net operating loss carrybacks, and of course, the overhaul of the U.S. international tax system, altered the tax consequences and strategies for corporate M&A even though none of these provisions directly changed subchapter C of the Code.212 The recent changes made by the Inflation Reduction Act of 2022 (the ‘IRA’) could have similar effect.213 The adoption of the corporate book minimum tax,214 which increases income taxes for large corporations with material book-tax differences, could, for example, (1) dampen merger activity if corporations are trying to stay small enough to avoid becoming subject to the corporate book minimum tax and (2) affect the structure of a transaction where different formal deal structures could have different financial accounting consequences. In addition, the enactment of the 1 percent excise tax on certain redemptions of corporate stock215 207 See, e.g., Beller, supra note 124, at 148; Canellos, supra note 153; Schler, supra note 156; Steinberg, supra note 156; Wells, supra note 123. 208 Wallace, Seeking, supra note 125. 209 See Wells, supra note 123; see also Steinberg, supra note 156 (discussing several specific issues). 210 See, e.g., Charlene D. Luke, Continuity as the Key to Reform of Section 355, 69 Am. U.L. Rev. F. 39 (2019). Incremental changes could also be made to allow non-abusive steps that are currently disallowed. An historic example of this is the 1998 liberalization of the COI requirements in acquisitive reorganizations. See supra note 81 and accompanying text. 211 P.L. 115-97. 212 See, e.g., Sarah-Jane Morin, Mergers, Acquisitions, and Integration in Light of Tax Reform, 159 Tax Notes 1469 (2018). 213 One provision that was proposed but not ultimately included in the IRA was a change that would limit the recognition of losses between related parties in liquidations. See Build Back Better Act, H.R. 5376, 117th Cong. §138142(b) (as passed by the House in 2021, proposing to add IRC §267(h)). This provision, had it been enacted, generally would have deferred the use losses recognized by the corporate ‘parent’ in Granite Trust transactions until the corporation disposes of the property received in the liquidation. 214 Inflation Reduction Act of 2022, P.L. 117-169 at §10101 (primarily amending IRC §§55, 59 and enacting new IRC §56A). 215 Id. at §10201 (enacting new IRC §4501).

Tax aspects of corporate mergers and acquisitions  111 could encourage corporations that may be subject to this tax to try to structure their M&A deals to avoid redemptions. It is too early to tell exactly how the IRA’s changes will affect the structuring and tax consequences of corporate M&A, but the IRA’s changes are certain to have some impact. More tax changes will occur over time, and at least some of those changes will affect the tax treatment of corporate M&A. Whatever those changes are, however, tax lawyers will likely respond with creative structuring ideas to try to maximize tax benefits and minimize tax detriments for clients while helping clients achieve their business goals. Then, Congress and the IRS will likely respond to try to curtail abuses, and the tax laws relevant to corporate M&A will continue to evolve.

8. International aspects of US corporate taxation J. Clifton Fleming, Jr.

1.

GOVERNING LAW

The US regime for taxing corporations on international income is contained in the Internal Revenue Code of 1986, as amended, which is codified in Title 26 of the United States Code. Critically important implementing regulations are found in part 1 of Title 26 of the Code of Federal Regulations. In addition, the Internal Revenue Service (IRS) provides important interpretive guidance in the form of Revenue Rulings published in an IRS periodical called the Cumulative Bulletin. The citation forms used in this chapter for these sources are: Internal Revenue Code: IRC § ___. Regulations: Reg. § 1.___. Revenue Rulings: Rev. Rul. ___, ___C.B. ___. The US also has bilateral income tax treaties with almost 60 countries. Under the US Constitution, these treaties and the Internal Revenue Code have equal standing with the result that when there is a conflict between a treaty and an Internal Revenue Code provision, the one that was ‘last in time,’ that is, most recently put into effect, prevails. Thus, new US legislation can override pre-existing treaties but a tax treaty that is later in time trumps pre-existing Internal Revenue Code provisions that conflict with the treaty. US courts follow a practice of giving interpretations to US income tax treaties and Internal Revenue Code provisions that avoid conflicts to the greatest extent possible.1

2. INTRODUCTION The US follows the prevailing international pattern of applying separate income tax regimes to resident and nonresident corporations. The US taxes the former on their worldwide income (i.e. the sum of their US-source and foreign-source income)2 while allowing a credit against US tax liability for foreign income taxes.3 In principle, the credit cannot exceed the US tax on the foreign-source income4 but with careful planning, this limitation can be avoided.5 In contrast, nonresident corporations are subject to US income tax only on US-source income6

1 See generally, Robert J. Peroni, Karen B. Brown, and J. Clifton Fleming, Jr., Taxation of International Transactions: Materials, Text, and Problems 79–81 (5th ed, West Academic Publishing 2021). 2 See IRC §§ 11(a), 61(a), 63(a). 3 IRC § 901. 4 See IRC § 904. 5 See generally Peroni, Brown, and Fleming, supra note 1, at 627–65. 6 See IRC §§ 11(d), 881, 882.

112

International aspects of US corporate taxation  113 and no US credit is allowed for foreign taxes on this income.7 Source rules are employed to distinguish US-source income from foreign-source income for purposes of calculating the amount of foreign tax credit available to US corporations and for computing the US tax base of foreign corporations.8

3.

DEFINITION OF RESIDENT AND NONRESIDENT

Obviously, the definitions for US resident and nonresident corporations are critically important because they control whether a corporation is taxed by the US on its worldwide income or on only its US-source income. The Internal Revenue Code treats a corporation as a US resident if it is a domestic corporation9 and as a nonresident if it is a foreign corporation.10 A corporation is ‘domestic,’ and a US resident, if it is formed under US law (including the law of the District of Columbia) or under the laws of any of the 50 US states.11 All other corporations are foreign and, therefore, nonresidents.12 Note that the location of a corporation’s headquarters, assets, employees, shareholders, and business activities are all irrelevant under these definitions. Thus a corporation formed, for example, under the laws of the US state of Delaware is a US resident for US income tax purposes even if none of its shareholders are resident in or located in the US and even if the corporation has no assets, place of management, employees, or business activities in the US.13 Conversely, a corporation formed under foreign law is a nonresident of the US even if all of its management, employees, assets, and business activities are located in the US and even if all of its shares are owned by US residents.14 This means that the residence of corporations for US tax purposes is substantially elective15 although there are ways for the US to make corporate residence non-elective if the political will were present to enact appropriate amendments to the Internal Revenue Code.16

4. SOURCE As noted above, nonresident corporations only pay US tax on their US-source income and US resident corporations may receive a credit against their US tax liability for foreign tax paid on their foreign-source income. Consequently, the Internal Revenue Code contains rules that specify the source of income. The principal approach taken in these rules is to divide income

9

See IRC § 904(a). See IRC §§ 861, 862, 865. See IRC §§ 11(a), (d). 10 See IRC §§ 11(d), 881(a), 882(a). 11 IRC § 7701(a)(4). 12 IRC § 7701(a)(5). 13 See IRC § 7701(a)(4). 14 See IRC § 7701(a)(5). 15 See Daniel N. Shaviro, Fixing U.S. International Taxation 32–6 (Oxford University Press 2014). 16 See J. Clifton Fleming, Jr., Robert J. Peroni, and Stephen E. Shay, ‘Defending Worldwide Taxation with a Shareholder-Based Definition of Corporate Residence,’ 2016 BYU L. Rev. 1681 (2017). 7 8

114  Research handbook on corporate taxation into two categories: (i) ‘income from sources within the United States’ (US-source income)17 and (ii) ‘income from sources without the United States’ (foreign-source income),18 the assumption being that the source of particular income items can be assigned to either inside or outside the US.19 The Internal Revenue Code provides source rules for significant income items. The most important of these are shown in Table 8.1.

5.

TAXATION OF NONRESIDENT CORPORATIONS: INBOUND TAXATION

5.1 Introduction The US follows the general international income tax pattern of applying separate regimes for taxing the business and non-business income of nonresident corporations. This section begins with an explanation of the non-business income taxation regime and then moves to a consideration of the US approach to taxing the business income of nonresident corporations. 5.2

Income Not Effectively Connected with a Trade or Business Conducted in the US

The Internal Revenue Code refers to most non-business income as ‘fixed or determinable annual or periodical gains, profits, and income … not effectively connected with the conduct of a trade or business in the United States.’20 American tax practitioners have chosen to shorten this lengthy name to ‘FDAP income,’ which is derived from the previously quoted words and generally pronounced ‘fuhdap.’ The principal FDAP income items are interest, dividends, rents, and royalties. There are others but they are of lesser importance to corporate taxpayers. A 30 percent US tax is applied to the gross amount of US-source FDAP items received by a nonresident corporation.21 No deductions are allowed.22 The tax is generally collected by means of a withholding obligation imposed on the party making payment of a FDAP item.23 5.2.1 Portfolio interest The portfolio interest exemption is an important exception to the 30 percent tax on FDAP items. The exemption provides that the tax does not apply to US-source interest paid to a nonresident on a debt obligation with registered ownership so long as (i) the interest is not received by a bank pursuant to a loan agreement (other than a US government debt) entered into in the ordinary course of the bank’s business, (ii) the recipient is not a 10 percent or greater IRC § 861(a). IRC § 862(a). 19 The general source rules are in IRC §§ 861, 862. However, IRC § 865 provides a narrow set of source rules that uses the phrase ‘sourced in the United States’ to identify US-source income and the phrase ‘sourced outside the United States’ to identify foreign-source income. 20 IRC § 881(a). 21 Reg. § 1.881-2(b)(1). 22 Reg. § 1.881-2(a)(3). 23 IRC § 1442. Failure to withhold makes the payer personally liable for the tax. IRC § 1461. 17 18

These are sourced to the country in which legal protection is provided for the intangible

These are sourced in the US if the corporate seller is a US resident,b unless the US resident seller maintains an office or other fixed place of business in a foreign country and an income

Gains, profits, and income from the sale of non- inventory tangible personal property. IRC §§

865(a), 865(e)

have a US source

profits, and income from sales attributable to the US office or other fixed place of business shall

unless the nonresident maintains a US office or other fixed place of business. In that case, gains,

a foreign source. If the seller is a nonresident, the gains, profits, and income are foreign source

profits, and income attributable toc the foreign office or other fixed place of business will have

tax of at least 10 percent of the sale income is paid to a foreign country. In that case, the gains,

These are sourced to the location of the property

Gains from Sales or Exchanges of Real Property. IRC §§ 861(a)(5), 862(a)(5)

trademarks, franchises, goodwill, trade secrets, and other intangibles

source. The same principle applies to rents and royalties paid for the use of copyrights,

royalties paid for use of a patent granted under the law of any other country have a foreign

property.a Thus, royalties paid for use of a patent granted under US law have a US source and

These are sourced to the physical location of the property

Rentals and Royalties from Intangible Property. IRC §§ 861(a)(4), 862(a)(4)

satisfied

(i) the compensation does not exceed a total of $3,000 and (ii) certain other requirements are

individual temporarily present in the US for less than 91 days during the year in question if

exception from US source characterization for compensation earned by a nonresident alien

Labor income is sourced to the place where the work was done except that there is a de minimis

There are special rules for interest earned by foreign branches and foreign partnerships

a noncorporate US resident, or a domestic corporation. Other interest has a foreign source.

Interest has a US source if the debtor is the United States government, the District of Columbia,

business income was US source to a significant degree

Rentals and Royalties from Tangible Property. IRC §§ 861(a)(4), 862(a)(4)

Personal Services. IRC §§ 861(a)(3), 862(a)(3)

Interest. IRC §§ 861(a)(1), 862(a)(1)

Generally, the source is the dividend-paying corporation’s residence country except that dividends from a foreign corporation will have partial US source if the foreign corporation’s

Geographic Source

Dividends. IRC §§ 861(a)(2), 862(a)(2)

US source rules

Item

Table 8.1

International aspects of US corporate taxation  115

The gains, profits, and income are generally sourced to the location of the sale. The sales location is the place where right, title, and interest in the goods passed to the buyer.e This makes sales location and source effectively elective.f However, if a nonresident maintains an office

Gains, profits, and income from the sale of tangible inventory property that was purchasedd by

the seller outside the US and sold inside the US, purchased by the seller inside the US and sold

outside the US, purchased by the seller outside the US and sold outside the US or purchased by

took place partially inside and partially outside the US, the gains, profits, and income are allocated between US source and foreign source on the basis of the average adjusted bases of

US resident seller outside the US and sold outside the US. IRC § 863(b)(2)

If the nonresident seller produces inventory wholly or partly outside the US and sells the

US source

and when both production and sale occurred inside the US, the gains, profits, and income are

production and sale occurred outside the US, the gains, profits, and income are foreign source

or other fixed place of business generally has a US source and the remainder is sourced to the location of the production assets. If no US office or other fixed place of business of the seller is involved, gains, profits, and income from sales of inventory produced by the seller shall be

by the nonresident seller wholly inside the US and sold inside the US, and produced by the

nonresident seller wholly outside the US and sold outside the US. IRC §§ 863(b), 865(e)(2);

Reg. §§ 1.863-3(a)(2), 1.865-3

US will have a US source

property produced by a non- resident seller entirely inside the US and sold entirely inside the

source. Conversely, gains, profits, and income from sales of tangible personal inventory

nonresident seller entirely outside the US and sold entirely outside the US usually have a foreign

Gains, profits, and income from sales of tangible personal inventory property produced by the

adjusted bases of tangible and intangible production assets located inside and outside the US.

assets will be allocated between US source and foreign source on the basis of the average

are located both inside and outside the US, gains, profits, and income sourced to production

entirely sourced in relation to the location of the production assets. When production assets

US, the portion of the gains, profits, and income from the sale that is attributable to the office

in whole or in part, by the nonresident seller outside the US and sold inside the US, produced

was produced by the seller, in whole or in part, inside the US and sold outside the US, produced, inventory through a US office or other fixed place of business maintained by the seller in the

Gains, profits, and income from a nonresident seller’s sale of tangible inventory property that

sale occurred outside the US, the gains, profits, and income have a US source. When production

produced by the US resident seller inside the US and sold inside the US, and produced by the

both tangible and intangible production assets located inside and outside the US. When both

profits, and income are foreign source. When production took place entirely inside the US and

that was producedg by the seller, in whole or in part, inside the US and sold outside the US,

When production took place entirely outside the US and sale occurred in the US, the gains,

then the gains, profits, and income from the sale shall have a foreign source

a foreign office or other fixed place of business of the seller materially participated in the sale,

the inventory personal property is sold for use, disposition, or consumption outside the US and

attributable to the office or other fixed place of business shall have a US source except that if

produced, in whole or in part, by the US resident seller outside the US and sold inside the US,

Gains, profits, and income from a US resident seller’s sale of tangible inventory property

(2); Reg. § 1.861-7

the seller inside the US and sold inside the US. IRC §§ 861(a)(6), 862(a)(6), 863, 865(b), 865(e) or other fixed place of business in the US, income from sales of inventory personal property

Geographic Source

Item

116  Research handbook on corporate taxation

income to the extent that it results from adjustments to the property’s basis for depreciation

deductions. IRC §§ 865(c), 865(e)(2); Reg. § 1.865-3(d)(4)

rule for royalties, supra

gain resulting from depreciation or amortization adjustments to basis, shall be sourced under the

disposition of the intangible, income that is (i) attributable to such payments and (ii) in excess of

However, if payments of purchase consideration are contingent on the productivity, use, or

including the rule dealing with gains attributable to depreciation and amortization deductions.

Gains from sales of all other intangibles are sourced according to the rules detailed above,

Gains from sales of goodwill are sourced to the country in which the goodwill was generated.

865(e)(2)

of the depreciation adjustments to basis is treated as inventory gain and sourced under IRC §

allocable to the US office or other fixed place of business and given a US source. Gain in excess

used in the US for a particular tax year, all gain not in excess of the depreciation for that year is

basis adjustments reflecting depreciation deductions. But if the property was predominantly

place of business. IRC § 865(c)(1) applies to determine the source of gain to the extent of prior

the sale of depreciable personal property is attributable to the seller’s US office or other fixed

supra, apply. The preceding rules are modified where the seller is a nonresident and gain from

attributable to depreciation or amortization deductions, the source rules for inventory property,

foreign-source income, the sale gain has a foreign source. For sale gain that exceeds gain

results from basis adjustments for depreciation or amortization deductions claimed against

Notes: a See Rev. Rul. 68-443, 1968-2 C.B. 304; Rev. Rul. 80-362, 1980-2 C.B. 208. b For this purpose, a corporation is a US resident if the corporation is a domestic corporation. IRC §§ 865(g)(1)(A)(ii), 7701(a)(30). c Rules are provided for determining the amount of gains, profits, and income attributable to an office or other fixed place of business. See IRC § 865(e)(3). d This category deals with personal property that is inventory and that was purchased rather than produced by the seller. There are extensive rules for determining whether property is produced or purchased and resold by the seller. See Reg. §§ 1.863-3(c)(1)(i), 1.954-3(a)(4). e Reg. § 1.861-7(c). f See A.P. Green Export Co. v. United States, 284 F.2d 383 (CtCl 1960). g There are detailed rules for determining whether the seller purchased or produced the property. See Reg. § 1.954-3(a)(4).

Gains from sales of intangible property. IRC § 865(d)

When a resident or nonresident sells such property, sale gain will be treated as US-source

Sales of tangible personal property previously subject to depreciation or amortization deductions previously claimed against US-source income. To the extent that the sale gain

Geographic Source

Item

International aspects of US corporate taxation  117

118  Research handbook on corporate taxation shareholder of the debtor, (iii) the interest is not received by a controlled foreign corporation from a related person, and (iv) the interest is not contingent on the receipts, sales, or certain other financial indicators of the debtor or a related person.24 5.2.2 Interest on certain accounts in US banks The 30 percent withholding tax does not apply to US-source interest paid on bank deposits and certain other deposit accounts.25 5.2.3 Treaty shopping The 30 percent withholding tax rate is often reduced, sometimes to zero, by bilateral income tax treaties to which the US is a party. However, the US has such treaties with fewer than one-third of the world’s countries. Thus, a corporate resident of a non-treaty country will sometimes organize a controlled subsidiary in a treaty country. The subsidiary will then make investments in the US and claim the benefit of treaty reductions to the withholding tax rate on US-source receipts even though the ultimate owner of the controlled subsidiary is a corporation that is a resident of a non-treaty country. This is an example of treaty shopping. US bilateral income tax treaties usually contain a so-called limitation of benefits provision that attempts to disqualify the controlled subsidiary from obtaining treaty concessions in this and other scenarios that are considered inappropriate for such benefits.26 In spite of their complexity, these provisions have not been completely effective in preventing successful treaty shopping.27 5.2.4 Branch profits tax If a foreign corporation controls a US subsidiary that carries on a profitable US business, there will be a US corporate profits tax on the subsidiary’s US business net income28 and also a withholding tax on dividends distributed by the subsidiary to its foreign parent corporation.29 However, if the foreign corporation operates the US business through a US branch and there is no legislative intervention, only one tax will apply – the corporate profits tax on the branch’s net income. Distributions from the branch to the foreign corporation’s headquarters will be regarded as transfers within a single entity that are disregarded for income tax purposes. The US Congress supplied the requisite legislative intervention in the form of a so-called branch profits tax.30 It generally provides that branch net earnings will bear an additional 30 percent (or lesser treaty rate) tax on branch earnings (computed after the regular corporate profits tax) that are either not invested in branch assets or are withdrawn from those investments.

IRC § 881(c). IRC § 881(d), 871(i)(3). 26 See United States Model Income Tax Convention, Article 22 (2016). 27 See J. Clifton Fleming, Jr., ‘Searching for the Uncertain Rationale Underlying the US Treasury’s Anti-Treaty Shopping Policy,’ 40 Intertax 245 (2012). 28 IRC § 882(a). 29 IRC § 881(a). 30 IRC § 884. The name ‘branch profits tax’ is misleading because rather than being a levy on a branch’s net income, this tax is actually a substitute for the 30 percent withholding tax that would apply to distributions from the branch to the foreign corporate headquarters if the branch were a separately incorporated US subsidiary of the foreign corporation that owns the branch. See Peroni, Brown, and Fleming, supra note 1, at 258. 24 25

International aspects of US corporate taxation  119 5.2.5 Property sale exception Generally, US-source gains from property sales or exchanges by nonresidents are not FDAP income31 and, therefore, these gains are not subject to the 30 percent withholding tax. However, the 30 percent withholding regime does apply to gains from sales or exchanges of patents, copyrights, secret processes and formulas, goodwill, and other income-producing intangibles to the extent that the gains are contingent on the productivity, use, or disposition of the property.32 5.2.6 Gains from sales or exchanges of US real property interests IRC § 897 provides that gain or loss realized by a foreign corporation on the disposition of a ‘US real property interest’ will generally be treated as if the gain or loss were effectively connected with a US trade or business even if the real property interest is, in fact, purely an investment and not involved in a US trade or business conducted by the seller.33 This characterization of the sale gain means (i) for a corporate seller the taxing provision is IRC § 882(a) so that the tax rate is 21 percent34 and (ii) except where the sold property is stock in a US real property holding corporation,35 the 30 percent branch profits tax, explained above, applies. For purposes of IRC § 897, the term US real property interest includes direct ownership of land or a fractional interest therein, stock in a US corporation that is heavily invested in US real property (a US real property holding corporation),36 and certain other real property connected assets.37 There are complex rules for applying the preceding principles to distributions by foreign corporations.38 The buyer of a US real property interest is required to withhold 15 percent of the amount realized (not the gain or profit) by the seller and pay that amount to the IRS.39 The amount realized is the sum of the cash and fair market value of other property received by the seller plus any liability assumed by the buyer or to which the property was subject. Thus, the withholding obligation may exceed the cash paid by the seller.40 5.2.7 Earnings stripping – interest payments Interest paid by a US subsidiary to a foreign corporate parent is generally deductible41 and, therefore, not subject to the 21 percent Section 11 corporate profits tax that applies to the subsidiary’s net earnings. Of course, the withholding tax applies to these interest payments42 but a zero corporate profits tax on the payments plus a withholding tax is a better result than suffering a combined profits tax and withholding tax burden, as would be the case if the US subsidiary paid dividends to the foreign parent. In short, interest payments on debt owed by

33 34 35 36 37 38 39 40 41 42 31 32

Reg. § 1.1441-2(b)(2)(i). IRC § 881(a)(4). See IRC § 897(a)(1). See IRC § 882(a)(1). See IRC § 884(d)(2)(C). See IRC § 897(c)(2). See IRC Reg. § 1.897-1(b), (c). See IRC § 897(d). IRC § 1445. See Reg. § 1.1445-1(b)(1). See IRC § 163(a). See IRC § 881(a).

120  Research handbook on corporate taxation a US subsidiary to a foreign corporate parent, or a party related thereto, can be used to reduce the US tax burden without experiencing any economic sacrifice. This strategy is often referred to as earnings stripping. IRC § 163(j) places a limit on this strategy. It provides that the deduction for business interest expense in any tax year is limited to the sum of the debtor’s (i) business interest income for the year, (ii) 30 percent of taxable income for the year (increased by certain adjustments), and (iii) floor plan financing interest income for the year (interest earned from financing an auto dealer’s inventory acquisitions).43 Interest expense deductions in excess of amounts allowed by IRC § 163(j) can be carried forward for use in future years, subject to the application of IRC § 163(j) in those years.44 5.2.8 Earnings stripping – the BEAT The earnings stripping strategy explained in section 5.2.7 can also be implemented by having a US subsidiary make deductible rent, royalty, and services fees payments to its foreign parent. In addition, US withholding tax does not apply to fees for services rendered from foreign locations and US bilateral income tax treaties often reduce or eliminate US withholding tax on royalty payments. To that extent, earnings stripping through these kinds of payments is a more powerful strategy than earnings stripping effected by means of interest payments. IRC § 59A is intended to limit this strategy. It imposes a penalty tax, known as the base erosion and anti-abuse tax (BEAT), that is separate from the income tax, on large corporations making substantial payments to related foreign entities that are deductible for US income tax purposes. The BEAT does not apply to corporations that have average annual gross receipts of less than $500 million for the three years ending with the immediately preceding tax year.45 Calculation of the BEAT penalty tax is a highly complex matter that is outside the scope of this chapter. 5.3

Income Effectively Connected with a Trade or Business Conducted in the US

The US usually taxes the US-source active business income of foreign corporations at the regular corporate tax rate.46 The tax is a net-basis tax, that is, the tax base is gross income minus deductions.47 A tax return is filed at the regular time for filing corporate income tax returns48 and the tax is usually paid at that time. Withholding usually does not apply. The Internal Revenue Code refers to income covered by the foregoing regime as ‘income which is effectively connected with the conduct of a trade or business within the United States’ (effectively connected income).49 The existence of effectively connected income is dependent on compliance with four requirements.

45 46 47 48 49 43 44

IRC § 163(j)(1). IRC § 163(j)(2). IRC § 59A(e)(1)(B). IRC § 882(a)(1). IRC § 882(c)(1). IRC § 882(c)(2). IRC § 882(a)(1).

International aspects of US corporate taxation  121 5.3.1 The four requirements Application of the US regime for taxing effectively connected income of nonresidents depends on satisfying four requirements. If any of these requirements is not met, the regime is inapplicable and if the FDAP regime does not apply, there is no US income tax. The four requirements, as they apply to corporations, are: (i) The taxpayer must be a foreign corporation,50 (ii) The taxpayer must be engaged in an activity in the US that constitutes a trade or business,51 (iii) The income in question must be effectively connected with the taxpayer’s US trade or business,52 and (iv) The income must have a US source53 unless the taxpayer has an office or other fixed place of business in the US to which the income is attributable54 and the income falls into certain specified categories, the most important of which is gain from the sale of inventory personal property when the sale occurs outside the US, but is made through the US office or other fixed place of business.55 The principles that determine whether a corporation is foreign are discussed in section 3, supra. The rules that specify whether income has a US source are explained in section 4, supra. 5.3.2 Engaged in a trade or business The judicial decisions hold that the corporate taxpayer is not engaged in a trade or business unless it is carrying on profit-seeking activity that is ‘considerable, continuous, and regular.’56 The decisions indicate that this requires a distinction between passive investing and conducting business activity57 that is more ongoing than occasional isolated transactions.58 This has proven to be an easily satisfied standard that is met by most corporate income-producing activities. Moreover, if a foreign corporation sends an employee into the US to perform services, the employee’s activities will cause the corporation to satisfy the ‘engaged in a trade or business’ requirement with respect to income produced for the corporation by the employee’s services no matter how brief or sporadic the employee’s service period was.59 When one of the bilateral income tax treaties to which the US is a party applies, the requirement that the taxpayer be engaged in a trade or business in the US is replaced by the more rigorous standard that the taxpayer must be carrying on business in the US ‘through a permanent establishment situated therein.’60

Id. Id. 52 Id. 53 IRC § 864(c)(4)(A). 54 IRC § 864(c)(4)(B). 55 IRC § 864(c)(4)(B)(iii). 56 See Lewenhaupt v. Commissioner, 20 T.C. 151, aff’d per curiam, 221 F.2d 227 (9th Cir 1955). 57 Id. 58 See Pasquel v. Commissioner, 12 T.C.M. (CCH) 1431 (1954). 59 See IRC § 864(b). 60 See United States Model Income Tax Convention, Article 7.1 (2016). The term ‘permanent establishment’ is defined in Article 5 of the US Model Convention. 50 51

122  Research handbook on corporate taxation 5.3.3 Effectively connected For purposes of US taxation of a foreign corporation’s active business income, FDAP income61 is not considered effectively connected to a US trade or business of the corporation unless there is an actual connection, such as where the income is derived from assets of the business or the activities of the business were a material factor in producing the income.62 If a foreign corporation is carrying on a US trade or business, all of the corporation’s US-source income that is not FDAP income is deemed to be effectively connected with the US trade or business regardless of whether that trade or business and the income have any economic nexus.63 This rule of automatic compliance with the effectively connected requirement is known as the ‘force of attraction principle.’ To appreciate the reach of the force of attraction principle, it is important to remember that business income from personal property sales made outside the US by a foreign corporation is usually considered US-source income to the extent that it is attributable to a US office or other fixed place of business maintained by the corporation.64 The force of attraction principle is not contained in the bilateral income tax treaties to which the US is a party. Those treaties specify that the US cannot tax the US business income of a foreign corporation unless the income is earned by carrying on the business through a US permanent establishment.65 This means that the treaties do not employ the force of attraction principle and that, when a treaty applies, US taxation cannot occur with respect to business income unless the income is derived from the assets or activities of the permanent establishment or from its assumed risks.66

6.

TAXATION OF RESIDENT CORPORATIONS: OUTBOUND TAXATION

6.1 Introduction The US taxes US resident corporations on their worldwide income, that is, on the sum of their US-source and foreign-source income.67 To avoid double taxation, the US allows a foreign tax credit for foreign income tax imposed on foreign-source income. Because income of US resident corporations is taxed regardless of its source, the principal purpose of the source rules68 in this area is to identify the foreign-source income with respect to which a US foreign tax credit may be available. Although the US taxes foreign-source income of corporate residents, it applies preferential rates to that income in certain circumstances.

See section 5.2, supra. IRC § 864(c)(2). If this connection requirement is satisfied, then the FDAP income is taxed under the net-basis regime of IRC § 882(a) instead of the IRC § 881(a) gross-basis withholding system. 63 See IRC § 864(c)(3); Reg. § 1.864-4(b). 64 See IRC § 865(e)(2) and supra section 4. 65 United States Model Income Tax Convention, Articles 7.1, .2 (2016). 66 See US Treasury Dept, Technical Explanation, 2006 United States Model Income Tax Treaty, Article 7. 67 See IRC §§ 61(a), 63(a). 68 See section 4, supra. 61 62

International aspects of US corporate taxation  123 6.2

Creditable Foreign Taxes

The US does not allow a foreign tax credit for non-tax amounts paid to foreign countries, such as rents for the use of facilities, fines and penalties, fees for services, and interest.69 Moreover, even if an amount paid to a foreign country is clearly a tax, the foreign tax is considered ‘non-creditable,’ and no US foreign tax credit is allowed with respect to it, unless the foreign tax bears a substantial resemblance to the US federal income tax. This requirement is explained in lengthy, complex regulations.70 Fortunately, mainstream taxes on corporate net profits usually comply with these rules. In addition, the US allows a credit for foreign taxes on gross income if the foreign tax is a substitute for a generally imposed income tax on net profits and not levied as an additional tax on net profits.71 This exception means that foreign gross-basis withholding taxes are usually creditable taxes. 6.3

Limitations on the Foreign Tax Credit

If the US allowed a credit against US income tax for the entire amount of a US resident corporation’s foreign tax payments, then when foreign tax payments exceeded the US corporation’s US tax liability with respect to its foreign income, the US would effectively be giving up US tax to subsidize the US corporation’s excess foreign tax liabilities. This result goes beyond the double tax mitigation purpose of the foreign tax credit. Consequently, the US has addressed this matter by imposing a general limitation that prevents the foreign tax credit from exceeding the total US tax on a US resident taxpayer’s aggregate foreign-source income.72 However, this general limitation would permit cross-crediting. That is, it would allow tax imposed by high-tax countries in excess of the US tax on income earned in those countries by a US resident corporation to be credited against the US tax due, after allowance of the US foreign tax credit, on income earned by the corporation in low-tax foreign countries. This would also go beyond the double tax mitigation purpose of the foreign tax credit. To prevent this outcome, the Internal Revenue Code requires that the general foreign tax credit limitation, explained above, must be applied separately to ten different categories, or ‘baskets,’ of income.73 Credits for excess foreign taxes in a particular basket cannot be applied against the post-credit US tax due on low-taxed foreign income in a different basket. This basket regime substantially limits, but does not eliminate, opportunities for cross-crediting. The basket system is extremely complex and a description of those complexities is outside the scope of this chapter.74

71 72 73 74 69 70

Reg. § 1.901-2(a)(2)(i). Customs duties are specifically identified as not taxes for this purpose. Id. See Reg. § 1.901-2. See IRC § 903; Reg. § 1.903-1. IRC § 904(a). IRC §§ 904(j), 245(a)(10), 865(h)(10). For a discussion of these complexities, see Peroni, Brown, and Fleming, supra note 1, at 627–60.

124  Research handbook on corporate taxation 6.4

Significance of Separate Taxpayer Treatment

Foreign-source interest, royalties, passive rents, or services fees received by a US resident corporation and foreign-source profits of a business that is owned by a US resident corporation and operated as an unincorporated branch are all taxed to the corporation when realized under the corporation’s accounting method.75 US tax practitioners often refer to the foregoing items as being subject to immediate or current taxation. Results are different when a US resident corporation earns foreign-source income through a controlled foreign subsidiary. The US federal income tax generally treats corporations and shareholders as separate taxpayers, even where only a single shareholder owns all of the corporation’s shares.76 This means that if a US resident corporation operates a foreign business or investment activity through a controlled foreign subsidiary corporation, the baseline US rule is that no US tax will apply to the subsidiary’s foreign-source income until the subsidiary distributes dividends to its US parent corporation or until the US parent sells shares of the subsidiary at a price that reflects foreign profits accumulated in the subsidiary. This baseline rule is known in the US as the deferral principle or privilege. 6.5

Reduced Significance of the Deferral Principle

The baseline deferral principle has been largely abolished for domestic corporations by US legislative developments. 6.5.1 The 2018 deemed dividend out of accumulated earnings The 2017 Tax Cuts and Jobs Act generally required US parent corporations to include in their 2018 income all profits accumulated after 1986 by their controlled foreign corporations (CFCs) that had not previously been subject to US tax.77 Moreover, this income can now be distributed to a US parent corporation that owns at least 10 percent of the vote or value of the CFC’s stock without incurring any additional US tax.78 Thus in almost all US parent-foreign subsidiary scenarios, no US tax is deferred if a US parent corporation continues to accumulate 1987–2017 income in its respective CFCs and there is no tax barrier to repatriation of this income. 6.5.2 The Subpart F regime Since 1962, the US has limited the deferral principle by maintaining a controlled foreign corporation regime known as Subpart F.79 This regime imposes an immediate US tax, at regular rates, on US parent corporations that are 10-percent-or-more shareholders of subsidiaries that are more than 50 percent owned by 10-percent-or-more shareholders (hereinafter referred to as CFCs).80 The tax is levied on the US parent by requiring it to include in income its pro rata share (100 percent in the case of a wholly owned CFC) of certain types of foreign income

See Reg. § 1.446-1(c)(1). See Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438–9 (1943). 77 See IRC § 965. 78 IRC §§ 951(b), 959(a). 79 See IRC §§ 951–65. 80 IRC §§ 951(a)(1), 957(a). 75 76

International aspects of US corporate taxation  125 earned by the CFC,81 principally passive income82 and business income generated by using a CFC in a low-tax country as a platform for selling goods produced, or services performed, in a foreign country other than the CFC’s country of incorporation.83 To be caught by this feature of the Subpart F regime, sales must be of products purchased from or on behalf of a related person or sold to or on behalf of a related person84 and services income must be from services performed for or on behalf of a related person and outside the CFC’s country of incorporation.85 Profits from sales of goods manufactured by the CFC are generally excepted from the Subpart F regime.86 Thus, there are large gaps in the coverage of the US Subpart F regime but to the extent that it bites, an immediate US tax is due from the US parent corporation and the CFC can distribute the affected income without any further US tax liability for the parent.87 Consequently, in most US parent-CFC scenarios, there is no US tax for a US parent to defer with respect to the affected income of a CFC and the deferral principle is meaningless regarding this income. 6.5.3 The GILTI regime The 2017 Tax Cuts and Jobs Act provided that if a US parent corporation owns, or is considered as owning, at least 10 percent of the voting power or value of a CFC’s stock,88 then the US parent is immediately taxed on its share (100 percent in the case of a wholly owned CFC) of the CFC’s global intangible low-taxed income (GILTI).89 The tax is imposed at an effective rate of 10.5 percent (13.125 percent after 2025).90 The tax is levied by requiring the US parent to include in income its pro rata share of the CFC’s GILTI.91 Generally speaking, GILTI is most of a CFC’s foreign-source income that is neither foreign-source income bearing an effective foreign income tax rate higher than 18.9 percent nor Subpart F income.92 Thus, the GILTI regime reaches most CFC income that escapes the Subpart F regime. However, this residual income is GILTI only to the extent it exceeds certain losses and only to the extent that it exceeds an exemption amount equal to 10 percent of the subsidiary’s investment in tangible depreciable business property.93 This exemption amount is

81 IRC § 951(a)(1)(A). An indirect or ‘deemed paid’ credit is provided by IRC § 960 for foreign income taxes attributable to Subpart F inclusions of US domestic corporations that satisfy the at-least-10-percent-or-more-of-the-vote-or-value ownership requirement with respect to the CFC. IRC §§ 960, 78. 82 IRC § 954(c). 83 IRC §§ 954(d), (e). 84 IRC § 954(d)(1)(A). 85 IRC § 954(e)(1). For these purposes, IRC § 954(d)(3) provides a complex definition of ‘related person.’ 86 Reg. § 1.954-3(a)(4)(i). 87 IRC § 959(a). 88 IRC §§ 951(b), 957(a). 89 IRC § 951A(a). 90 The 10.5 percent effective rate is achieved by allowing the parent corporation to deduct 50 percent of the CFC’s income attributed to the parent under this new regime. 91 IRC § 951A(a). An indirect or ‘deemed paid’ credit is provided by IRC § 960 for 80 percent of foreign income taxes attributable to GILTI inclusions of US domestic corporations that satisfy the at-least-10-percent-of-the-vote-or-value ownership requirement with respect to the CFC. IRC §§ 960, 78. 92 IRC §§ 951A(c)(2)(A). 93 IRC §§ 951A(b), (c).

126  Research handbook on corporate taxation referred to as ‘net deemed tangible income return’ (NDTIR).94 Neither the Subpart F regime nor the GILTI regime causes NDTIR to be taxed. CFC income that bears an immediate tax under the GILTI regime, plus zero-taxed NDTIR, can be distributed to the US resident parent corporation that is a 10 percent-or-more shareholder without any additional US tax.95 Thus, there is usually no US tax for a US resident parent to defer with respect to its share of a CFC’s GILTI and the deferral principle is usually inapplicable to such income. 6.5.4 The section 245A dividends-received deduction Where a US resident corporation owns, directly or by attribution, at least 10 percent of the vote or value of a CFC’s shares, IRC § 245A generally allows the US corporation to deduct 100 percent of the foreign-source portion of any dividend received from the CFC that is paid out of any residual income (including zero-taxed NDTIR) that was not a 2018 deemed dividend inclusion, a Subpart F inclusion, or a GILTI inclusion.96 Because the CFC’s income will usually be entirely foreign source, the foreign-source requirement is not a meaningful restraint on the IRC § 245A deduction. Since the residual income to which the IRC § 245A deduction applies can be distributed to a CFC’s US parent corporation that owns at least 10 percent of the vote or value of the CFC’s stock without incurring any US tax, the deferral principle is irrelevant in that context. 6.5.5

What remains of the deferral principle with respect to US domestic corporations that hold stock in CFCs? As indicated in sections 6.5.1–6.5.4, where a US domestic corporation owns, actually or by attribution, at least 10 percent of the vote or value of a CFC’s shares, the deferral principle only applies to CFC income that was not included in the 2018 deemed dividend or in Subpart F or GILTI inclusions and that is ineligible for the IRC § 245A deduction. This appears to be a relatively small amount of the income earned by CFCs that are substantially owned by US domestic corporations. 6.6

Foreign Derived Intangible Income

IRC § 250(a) has limitation and qualification provisions that involve a level of complexity beyond the scope of this chapter.97 However, where this provision applies to its full extent, it gives a US resident corporation an income tax deduction equal to 37.5 percent (21.875 percent after 2025) of its ‘foreign derived intangible income’ (FDII). In highly simplified terms, FDII is the portion of a US resident corporation’s export income that exceeds a normal or routine return, which is defined as 10 percent of the corporation’s investment in tangible depreciable business assets. The deduction reduces the effective US tax rate on FDII from 21 percent to 13.125 percent for pre-2026 years and to 16.41 percent for post-2025 years. The GILTI regime generally provides a more favorable tax rate.

96 97 94 95

IRC § 951A(b)(2). IRC §§ 245A, 951A(f)(1)(A), 959(a). IRC §§ 245A(a), 959(d). For an explanation, see Peroni, Brown, and Fleming, supra note 1, at 931–6.

International aspects of US corporate taxation  127

7.

TRANSFER PRICING

When US resident corporations engage in transactions with related foreign parties on the basis of non-arm’s-length terms, IRC § 482 gives the IRS broad authority to tax the parties on the basis of adjusted terms that adhere to the arm’s length standard. Importantly, this provision allows the IRS to adjust contractual prices and other terms between related parties whenever adjustment is necessary to ‘prevent evasion of taxes or clearly to reflect the income’98 of related parties. Thus, the IRS may make adjustments that are required to achieve clear reflection of income even if no tax avoidance motive is present.99 7.1

Who Can Use IRC § 482?

IRC § 482 is, for all practical purposes, a tool reserved to the IRS. Taxpayers cannot use it in an amended return or refund claim to avoid the income tax consequences of their actual transactional terms and the taxpayer cannot compel the IRS to invoke IRC § 482.100 A taxpayer can, however, use IRC § 482 on a timely filed income tax return, where no prior return was filed for the year, to report results of related-party transactions that differ from the actual contractual terms.101 Obviously, this creates minimal room for taxpayer action. 7.2

Overcoming an IRC § 482 Adjustment by the IRS

A taxpayer who wishes to defeat an IRS § 482 adjustment to price or other contractual terms must prove that the adjustment is arbitrary, capricious, or unreasonable.102 It is not sufficient for the taxpayer to show that the taxpayer has a ‘better’ approach to setting the contractual price or other terms or that an IRS approach that produces a reasonable overall result nevertheless has one or more flaws.103 7.3

Collateral Adjustments

When the IRS makes an IRC § 482 adjustment with respect to a taxpayer, it generally must make an appropriate collateral adjustment with respect to the tax results of related parties so that both sides of a related-party transaction will have consistent tax results.104 This is highly problematic when one or more of the related parties are nonresidents because the residence country of a foreign related party may decline to accept the IRS adjustment. In such a case, over- or under-taxation may result. If, however, the US and the related party’s residence country are bound by an income tax treaty based on the US Model, then the two countries may utilize the mutual agreement procedure provided by Article 25 of the treaty to possibly create an outcome that is acceptable to both countries.

IRC § 482. See Reg. § 1.482-1(a)(2). 100 Reg. § 1.482-1(a)(3). 101 Id. 102 American Terrazzo Strip Co. v. Commissioner, 56 T.C. 961 (1971). 103 See E.I. Du Pont de Nemours Co. v. United States, 608 F.2d 445, 454–5 (Ct. Cl. 1979). 104 Reg. § 1.482-1(g). 98 99

128  Research handbook on corporate taxation 7.4

Transfer Pricing Methods

Transfer pricing enforcement usually requires the application of various transfer pricing methods to data regarding comparable transactions and taxpayers. The transfer pricing methods used by the IRS are broadly consistent with those outlined in the OECD Transfer Pricing Guidelines, but not identical. The IRS’s transfer pricing methods are detailed in Reg. §§ 1.482-2–1.482-9. 7.5

Advance Pricing Agreements

The IRS has developed an advance pricing agreement process under which the US and treaty partner countries can negotiate prices for international transactions between related parties that are acceptable to the US and other involved countries.105

REFERENCES American Terrazzo Strip Co. v. Commissioner, 56 T.C. 961 (1971) A.P. Green Export Co. v. United States, 284 F.2d 383 (CtCl 1960) E.I. Du Pont de Nemours Co. v. United States, 608 F.2d 445, 454–5 (CtCl 1979) J. Clifton Fleming, Jr. ‘Searching for the Uncertain Rationale Underlying the US Treasury’s Anti-Treaty Shopping Policy,’ 40 Intertax 245 (2012) J. Clifton Fleming, Jr., Robert J. Peroni, and Stephen E. Shay, ‘Defending Worldwide Taxation with a Shareholder-Based Definition of Corporate Residence,’ 2016 BYU L. Rev. 1681 (2017) Lewenhaupt v. Commissioner, 20 T.C. 151, aff’d per curiam, 221 F.2d 227 (9th Cir 1955) Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438–9 (1943) Pasquel v. Commissioner, 12 T.C.M. (CCH) 1431 (1954) Robert J. Peroni, Karen B. Brown, and J. Clifton Fleming, Jr., Taxation of International Transactions: Materials, Text, and Problems (5th ed., West Academic Publishing 2021) Rev. Rul. 68-443, 1968-2 C.B. 304 Rev. Rul. 80-362, 1980-2 C.B. 208 Revenue Procedure 2015-41, 2015-35 I.R.B. 263 Daniel N. Shaviro, Fixing U.S. International Taxation (Oxford University Press 2014) United States Model Income Tax Convention (2016) US Treasury Department, Technical Explanation, 2006 United States Model Income Tax Convention

Revenue Procedure 2015-41, 2015-35 I.R.B. 263.

105

PART III COMPARATIVE CORPORATE TAXATION

9. Corporate taxation in the EU Christiana HJI Panayi

I. INTRODUCTION Up until recently, taxation and especially corporate taxation was an area where there was very little harmonisation at EU level. Technically, there is no ‘EU corporate tax law’ or ‘EU income tax law’ as direct taxation has remained within the exclusive powers of Member States. There are numerous reasons for this, the most important one being the lack of Union competence in direct tax matters and as a corollary the fiscal veto enjoyed by all Member States. Under the principle of attribution of powers,1 an important constitutional principle under EU law, the Union and its institutions only enjoy competence in the areas of law assigned or conferred to them under the Treaties. Therefore, every legislative act must be based on a general or specific treaty provision (the legal basis) empowering the Union, expressly or impliedly, to act. The EU Treaties deal with indirect taxes to some extent,2 but not with direct taxes. There is no explicit legislative base for the harmonisation of direct taxes and Member States are considered to have retained complete competence in this area. Article 115 TFEU and Article 352 TFEU have, so far, been used as general (proxy) legislative bases for the enactment of several corporate tax directives.3 Basically, the Commission proposes legislative instruments on the basis of one of these provisions (most often Art 115 TFEU) emphasising the need for measures to be taken for the establishment or proper functioning of the internal market. Pursuant to both of these legal bases, for the proposals to become EU secondary legislation, all Member States (in Council) have to unanimously agree to these proposals. The European Parliament may only be consulted and its role is largely advisory. The fiscal veto that Member States enjoy as a result of the current arrangement has played a decisive role in the development of EU corporate tax law. The lack of competence combined with the fiscal veto has led to de minimis harmonisation in the area of corporate taxation. Historically, adopting a uniform fiscal policy especially in the area of corporate taxation has proven to be a difficult task.4 Broadly, the design of fiscal policy remains within the powers of Member States. Even though the regulation of Member States’ direct tax affairs and especially the design and implementation of their corporate tax systems is very much left at the discretion of Member States, this discretion must be exercised consistently with EU law.

Art 5 Treaty on European Union (TEU). See Art 28 Treaty on the Functioning of the European Union (TFEU) which provides for a Union based upon a customs union. See Arts 30 and 110 TFEU, which led to the harmonisation of excise duties. 3 For a review of the corporate tax directives, see Christiana HJI Panayi, ‘European Tax Law: Legislation and Soft Law’, in Gore-Browne on EU Company Law (Carsten Gerner-Beuerle ed., LexisNexis) ch 18. Also see Christiana HJI Panayi, European Union Corporate Tax Law (Cambridge University Press, 2021) ch 2. 4 Christiana HJI Panayi, ‘60 Years of Harmonisation Initiatives on Corporate Taxation’ (2021) 12 European Taxation 534–41. 1 2

130

Corporate taxation in the EU  131 Technically, the EU does not receive any yields collected under the corporate tax systems of Member States – at least not directly. The EU’s revenue is derived from its so-called own resources system,5 which includes customs duties on imports from outside the EU and sugar levies,6 a small percentage of the harmonised VAT base of each Member State,7 the plastics own resource,8 as well as other sources of revenue.9 The largest source of own resource is, however, based on gross national income – each Member State transfers a percentage of its gross national income to the EU.10 Member States’ contributions are not fixed and depend on what is needed to finance the balance of total expenditure not covered by the other own resources. Therefore, part of the corporate taxes collected by a Member State go to the EU because they form part of their gross national income. Recently, the Commission proposed three new EU Own Resources which will comprise of revenues from emissions trading (ETS), of resources generated by the proposed EU carbon border adjustment mechanism, and of residual profits from multinationals that will be reallocated to Member States under Pillar One of the Organisation for Economic Co-operation and Development (OECD)/G20 Two-Pillar solution.11 If approved, this will lead to a major change in the EU’s Own Resources. Overall, what could be perceived as the corporate tax system of the European Union is a patchwork of legislative instruments, case law and soft law. This chapter reviews aspects of this system and how it might be expanding as a result of recent developments.

II.

EU CORPORATE TAX LEGISLATION

Notwithstanding the limitations in so far as Union competence is concerned, there have been some ad hoc legislative instruments providing some very basic minimum rules in the area of corporate taxation. The rationale behind these instruments (which justified the legal bases used) was to address some of the distortions caused by the co-existence of different and largely unharmonised corporate tax systems of Member States.

5 See Council Decision (EU, Euratom) 2020/2053 of 14 December 2020 on the system of own resources of the European Union and repealing Decision 2014/335/EU, Euratom, [2020] OJ L 424, pp 1–10. 6 EU governments keep 20 per cent of the amounts as collection cost. See Art 2(1)(a) on traditional own resources and Art 2(3) in Own Resources Decision 2014/335/EU. 7 This is own resources based on value added tax: Art 2(1)(b) of Own Resources Decision 2014/335/ EU. The uniform rate is fixed at 0.30 per cent (Art 2(4)) but the VAT base to be taxed is capped at 50 per cent of the gross national income for each country. This rule is intended to prevent less prosperous countries having to pay a disproportionate amount. 8 Council Decision (EU, Euratom) 2020/2053 of 14 December 2020 on the system of own resources of the European Union and repealing Decision 2014/335/EU, Euratom, [2020] OJ L 424, pp 1–10. 9 Other sources of revenue include tax and other deductions from EU staff remunerations, bank interest, contributions from non-EU countries to certain programmes, interest on late payments and fines. 10 See Art 2(1)(c) in Own Resources Decision 2014/335/EU. Correction mechanisms are designed to correct excessive contribution by certain Member States: see Arts 4–5. 11 Commission Communication, The next generation of own resources for the EU Budget, COM(2021) 566 final (Brussels, 22 December 2021), available on 4 March 2023 at https://​eur​-lex​.europa​ .eu/​legal​-content/​EN/​TXT/​?uri​=​COM:​2021:​566:​FIN.

132  Research handbook on corporate taxation Two of the first directives to be enacted were the Merger Directive and the Parent-Subsidiary Directive. The Merger Directive deals with some of the obstacles arising from certain types of cross-border mergers and reorganisations.12 Under certain strict conditions, the Merger Directive facilitates the tax neutral realisation of mergers, divisions, partial divisions, transfer of assets and exchanges of shares in which companies from two or more Member States are involved. The Parent-Subsidiary Directive13 aims to alleviate double taxation arising from the cross-border payment of profit distributions between group companies, in order to encourage the grouping together of companies from different Member States. Under certain conditions, the Parent-Subsidiary Directive prevents the Member State in which a subsidiary company is resident from imposing a withholding tax on profits distributed to its parent company. Furthermore, the Directive prevents the Member State in which the parent company is resident from taxing such distributed profits. If the Member State of the parent company taxes these profits, then it must allow the parent company to deduct from the amount of tax due the fraction of the corporation tax paid by the subsidiary that relates to those profits. The Parent-Subsidiary Directive was subsequently amended to prevent double non-taxation. The Interest and Royalties Directive14 aims to alleviate double taxation from the cross-border payment of interest and royalty between group companies. Broadly, under the Interest and Royalties Directive, interest or royalty payments arising in a Member State are exempt from tax in that State, provided that the beneficial owner of the interest or royalties is a company in another Member State, or a permanent establishment situated in another Member State of a company of a Member State. There are also directives which facilitate the cooperation between Member States for the recovery of taxes or for exchange of information.15 Under the Mutual Assistance Directive for the Recovery of Taxes, a Member State (through its competent authority) may request assistance from another Member State for the recovery16 of all taxes levied by the first Member State.17 A Member State may also request any information which is foreseeably relevant to Council Directive 2009/133/EC of 19 October 2009 on the common system of taxation applicable to mergers, divisions, partial divisions, transfers of assets and exchanges of shares concerning companies of different Member States and to the transfer of the registered office of an SE or SCE between Member States (codified version), [2009] OJ L 310/34. 13 Council Directive 2011/96/EU of 30 November 2011 on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States, [2011] OJ L 345/8. This has codified previous versions of the Directive: Council Directive 90/435/EEC of 23 July 1990 on the common system of taxation applicable in the case of parent companies and subsidiaries in different Member States, amended by Council Directive 2003/123/EC of 22 December 2003, [1990] OJ L 225. 14 Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States, amended by Council Directive 2004/66/EC of 26 April 2004, Council Directive 2004/76/EC of 29 April 2004 and Council Directive 2006/98/EC of 20 November 2006, [2013] OJ L 141. 15 See Council Directive 2010/24/EU of 16 March 2010 concerning mutual assistance for the recovery of claims relating to taxes, duties and other measures, [2010] OJ L 84/1; the Mutual Assistance Directive for the exchange of information (Council Directive 2011/16/EU of 15 February 2011 on administrative co-operation in the field of taxation, [2011] OJ L 64/1). 16 Mutual Assistance for the Recovery of Claims Directive, Art 10. 17 Ibid, Art 1. This includes a wide range of taxes, penalties, fees, interest and costs relating to claims. There is no recovery for compulsory social security contributions, for duties of a contractual nature such as consideration for public utilities, or criminal penalties imposed on the basis of public prosecution. 12

Corporate taxation in the EU  133 the applicant authority in the recovery of its claims.18 Furthermore, the Directive also allows precautionary measures to be imposed by the other Member State.19 Under the Directive on Administrative Cooperation (DAC),20 there are also provisions for exchange of information between Member States. The 2011 version of the Directive and subsequent amendments have introduced important provisions for automatic exchange of information. Initially, there was only automatic exchange of information for five types of income, namely: income from employment, director’s fees, life insurance products not covered by other directives, pensions, and ownership of and income from immovable property.21 Subsequently, provisions were introduced22 for the automatic exchange of financial account information, similar to the OECD’s Common Reporting Standard,23 as well as the automatic exchange of information on tax rulings and advance pricing agreements,24 under certain conditions.25 Later on, amendments were agreed which introduced the automatic exchange of country-by-country reports26 and the automatic exchange of reportable cross-border tax planning arrangements in order to disclose potentially aggressive arrangements.27 The last amendment to this Directive extended the scope of the automatic exchange of information rules to digital platforms.28 There is now an obligation on digital platform operators to provide information on sellers of goods and providers of personal services, rental of immovable goods/property (including parking spaces) and any mode of transport. The Commission is now considering the next amendment to the DAC, to include crypto-assets and e-money. Depending on the outcome of a public consultation,29 the Commission will consider whether and which assets should be subject to any proposed expansion of the Directive, including how to define crypto-assets and to identify the relevant intermediaries for tax and reporting purposes.

Ibid, Art 5. Ibid, Art 16. 20 See Council Directive 2011/16/EU of 15 February 2011 on administrative cooperation in the field of taxation, [2011] OJ L 64/1. 21 See Art 8. 22 Council Directive 2014/107/EU of 9 December 2014 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation, [2014] OJ L 359/1. 23 See OECD, Standard for Automatic Exchange of Financial Account Information Report (OECD Publishing, 2014). 24 Council Directive (EU) 2015/2376 of 8 December 2015 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation, [2015] OJ L 332/1. 25 See Christiana HJI Panayi, ‘The Europeanisation of Good Tax Governance’ (2018) 36 (1) Yearbook of European Law 442–95, pt III.C.IV. 26 Council Directive (EU) 2016/881 of 25 May 2016 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation, [2016] OJ L 146/8. 27 Council Directive (EU) 2018/822 of 25 May 2018 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross border arrangements, [2018] OJ L 139/1. 28 Council Directive (EU) 2021/514 of 22 March 2021 amending Directive 2011/16/EU on administrative cooperation in the field of taxation, [2021] OJ L 104/1. 29 See Inception impact assessment – Ares(2020)7030524, available at https://​ec​.europa​.eu/​info/​ law/​better​-regulation/​have​-your​-say/​initiatives/​12632​-Tax​-fraud​-​&​-evasion​-strengthening​-rules​-on​ -administrative​-cooperation​-and​-expanding​-the​-exchange​-of​-information​_en. 18 19

134  Research handbook on corporate taxation Another very important piece of legislation is the Anti-Tax Avoidance Directive (ATAD) which sets out some minimum anti-avoidance rules.30 It provides for uniform (but de minimis) interest limitation rules to prevent multinational groups from artificially shifting their debt to jurisdictions with more generous deductibility rules; exit taxation rules to ensure that, where a taxpayer moves assets or its tax residence out of the tax jurisdiction of a State, that State taxes the economic value of any capital gain created in its territory even though that gain has not yet been realised at the time of the exit; a General Anti-Abuse Rule (GAAR) to cover gaps that may exist in a Member State’s specific anti-abuse rules; Controlled Foreign Company (CFC) rules to prevent the shifting of large amounts of profits towards controlled subsidiaries in low-tax jurisdictions; and rules on hybrid mismatches to prevent corporate taxpayers from taking advantage of disparities between national tax systems in order to reduce their overall tax liability. The scope of this latter provision was further broadened to include provisions against hybrid mismatch arrangements with third countries.31 In addition, there is the Tax Dispute Resolution Mechanisms Directive which aims to facilitate the resolution of disputes between Member States.32 The Directive streamlines tax dispute resolution involving two different competent authorities. It also establishes mandatory arbitration.33 The Directive applies, inter alia, to disputes arising from the interpretation and application of tax treaties leading to double taxation. Overall, the Directive broadens the scope of the EU rules on dispute resolution, which hitherto were limited to the Arbitration Convention and its focus on transfer pricing disputes. The above legislative instruments are buttressed by the case law of the Court of Justice, which sets out how the general fundamental freedoms are to be interpreted in various (often complex) corporate tax scenarios.34 Some of this case law is examined next.

III.

THE IMPACT OF CASE LAW ON MEMBER STATE CORPORATE TAX SYSTEMS

By contrast to the rather limited legislative instruments, the case law of the Court of Justice in this area is vast. With the risk of oversimplifying some of this complex litigation, in this section, I will explain the principles derived in certain areas which have affected Member State corporate tax rules.

See the Anti-Tax Avoidance Directive: Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market, [2016] OJ L 193/1. 31 See Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries (ATAD II), [2017] OJ L 144/1. 32 Member States had until 30 June 2019 to transpose the Directive into national laws and regulations. The Directive applies to complaints submitted after that date on questions relating to the tax year starting on or after 1 January 2018. Member States may, however, agree to apply the Directive to complaints related to earlier tax years. 33 Council Directive (EU) 2017/1852 of 10 October 2017 on tax dispute resolution mechanisms in the European Union, [2017] OJ L 265/1. 34 Christiana HJI Panayi, ‘EU Tax Law and Companies: Principles of the Court of Justice’, in Gore-Browne on EU Company Law, ch 19. 30

Corporate taxation in the EU  135 Early case law dealt with how tax rules affected the neutrality of legal form and the freedom of establishment. More specifically, early case law focused on cases where a permanent establishment and a resident company were treated differently by tax law. In the Avoir Fiscal case,35 under French tax law, French branches of foreign insurance companies were not given the same tax credit (the ‘avoir fiscal’) as French companies. The Court of Justice found this treatment to be incompatible with freedom of establishment. A foreign insurance company, through its French branch, was subject to taxation in the same way as a French insurance company. Therefore, they were in a comparable situation and the different treatment of the two entities was discriminatory. Later cases were decided in a similar way. In the Commerzbank case,36 the UK tax legislation only allowed the so-called ‘repayment supplement’ for late tax refunds to UK companies. UK branches of non-resident companies were denied this. The Court of Justice found the refusal to grant the repaying supplement incompatible with freedom of establishment. Interestingly, it was first attempted to deal with this case in the context of the non-discrimination provision of the UK-Germany tax treaty, but no breach of this provision was found.37 In Halliburton,38 it was found that a Dutch rule which exempted from transfer tax only transfers of immovable property between resident companies was in breach of the freedom of establishment. The Court of Justice also found in the Royal Bank of Scotland case39 and the CLT-UFA SA case40 that the taxation of branches at a higher rate than resident companies could violate the freedom of establishment. The Court of Justice has also examined cases on the compatibility of anti-abuse provisions with EU law. In the Cadbury Schweppes case,41 it was found that the UK CFC rules restricted the freedom of establishment, as they only applied to resident companies that had a controlling holding in their non-resident companies. As far as justifications were concerned, it was held that any advantage resulting from the low taxation in the Member State of the subsidiary could not by itself authorise the Member State of the parent company to offset that advantage by less favourable tax treatment of the parent company.42 Also, the need to prevent the reduction of tax revenue was not an acceptable justification.43 The prevention of tax avoidance and evasion was also considered. It was emphasised that the mere fact that a resident company established a secondary establishment such as a subsidiary in another Member State could not justify a general presumption of tax evasion.44 A national measure restricting freedom of establishment could only be justified where it specifically related to wholly artificial arrangements aimed at circumventing the application of the legislation of the Member State concerned.45

Case 270/83 Commission v France (‘Avoir Fiscal’) [1986] ECR 273. Case C-330/91 Commerzbank [1993] ECR I-4017. 37 See R v IRC ex parte Commerzbank AG [1991] STC 271. 38 Case C-1/93 Halliburton Services BV v Staatssecretaris van Financiën [1994] ECR I-1137. 39 Case C-311/97 Royal Bank of Scotland v Elliniko Dimonsio [1999] ECR I-2651. 40 Case C-253/03 CLT-UFA SA v Finanzamt Köln-West [2006] ECR I-01831. 41 Case C-196/04 Cadbury Schweppes and Cadbury Schweppes Overseas [2006] ECR I-7995. 42 Ibid, para 49. 43 Ibid. 44 Ibid, para 50. 45 Ibid, para 51. 35 36

136  Research handbook on corporate taxation Although the UK CFC rules were suitable for the attainment of this objective, they also had to be proportional. More specifically, the CFC rules had to exclude from their scope situations whereby, despite the existence of tax motives, the incorporation of a CFC reflected economic reality. In determining whether economic reality existed, in addition to the subjective element, which consisted of the intention to obtain a tax advantage, objective circumstances had to be taken into account.46 These objective factors, which were ascertainable by third parties, included, in particular, the extent to which the CFC physically existed in terms of premises, staff and equipment.47 However, the fact that the activities that corresponded to the profits of the CFC could just as well have been carried out by a UK company did not lead to the conclusion that this was a wholly artificial arrangement.48 Furthermore, for the UK CFC rules to be proportional, the UK parent had to be given an opportunity to produce evidence that the arrangement was genuine.49 Cadbury Schweppes was a landmark case50 and its ‘wholly artificial arrangements’ test was adopted in other areas of anti-abuse rules, such as for thin cap or interest deductibility rules.51 In a later case,52 the Court of Justice considered the impact of Germany’s former CFC rules on a Swiss subsidiary and reviewed the application of the wholly artificial arrangements test in the context of the free movement of capital. Interestingly, the referring court had asked whether the interpretation of the concept of ‘wholly artificial arrangements’ adopted by the Court of Justice in Cadbury Schweppes could be applied to the situation in the main proceedings, which involved the free movement of capital and not the freedom of establishment. The Court of Justice found that in the context of the free movement of capital, the concept of ‘wholly artificial arrangements’ could not be limited to the indications set out in Cadbury Schweppes as to when the establishment of a company did not reflect economic reality, ‘since the artificial creation of the conditions required in order to escape taxation in a Member State improperly or enjoy a tax advantage in that Member State improperly can take several forms as regards cross-border movements of capital’.53 The Court of Justice conceded that those indications may also amount to evidence of the existence of a wholly artificial arrangement for the purposes of applying the rules on the free movement of capital, ‘in particular when it proves necessary to assess the commercial justification of acquiring shares in a company that does not pursue any economic activities of its own’.54 However, in the context of the free movement of capital, the concept of wholly artificial arrangements was also capable of covering any scheme which has as its primary objective or one of its primary objectives the artificial transfer of the profits made by way of activities carried out in the territory of a Member State to third countries with a low tax rate.55

Ibid, paras 64–5. Ibid, para 67. 48 Ibid, para 69. 49 Ibid, para 100. 50 Christiana HJI Panayi, ‘CFC Rules under EU Tax Law: The Legacy of Cadbury Schweppes’, in John Snape and Dominic de Cogan (eds), Landmark Cases in Revenue Law (Hart Publishing, 2019). 51 Case C-524/04 Test Claimants in Thin Cap Group Litigation Order [2007] ECR I-2107. 52 Case C-135/17 X-GmbH v Finanzamt Stuttgart Körperschaften, ECLI:EU:C:2019:136. 53 Ibid, para 84. 54 Ibid. 55 Ibid. 46 47

Corporate taxation in the EU  137 Arguably, references to ‘one of the primary objectives’ in the X case could be perceived as a loosening of the wholly artificial arrangements test. This seems to be closer to the principal purpose test of the OECD Model Tax Convention,56 as well as the GAAR of the ATAD and of the Parent-Subsidiary Directive. As far as passive investment income is concerned, there has been extensive case law which fills in the gaps from the limited application of the Parent-Subsidiary Directive. Insofar as inbound dividends (i.e. foreign-sourced dividends) are concerned, the general principle is that shareholders (corporate or non-corporate) receiving inbound dividends should be treated the same way as shareholders receiving domestic dividends if they are in an objectively comparable situation, unless different treatment is justified. If the country of residence of the shareholder chooses to provide reliefs for domestic dividends, then it must provide the same relief at least for EU-sourced dividends. Even when the exemption or relief is subject to stricter rules, that could also be discriminatory.57 The seminal cases are Verkooijen,58 Lenz59 and Manninen,60 which dealt with individuals receiving dividends as a result of their shareholdings. Many other cases followed suit, dealing with corporate shareholders61 and those holding interests in investment funds.62 The Court of Justice has clarified in a recent case that the Member State of residence is under no obligation to match the tax base of the tax credit it granted with the tax base used by the source State.63 Case law on the taxation of outbound dividends starts from a similar premise to that of inbound dividends. The source state (i.e. the state of the distributing company) must ensure equal tax treatment of resident and non-resident recipients of dividends, if they are in a comparable situation. From the source state’s perspective, resident and non-resident shareholders are in a comparable situation if they are both subject to source state taxes.64 Therefore, it is possibly discriminatory for a tax charge to be imposed by the source state on outbound dividends only, or for relief from economic double taxation to be available only to resident shareholders, if the non-resident shareholder was also subject to tax on the dividends in the source state. Furthermore, even if the same withholding tax is imposed on domestic and See Art 29, para 9 of the OECD Model Tax Convention (OECD (2017), Model Tax Convention on Income and on Capital: Condensed Version 2017, OECD Publishing, available at http://​0​-dx​-doi​-org​ .catalogue​.libraries​.london​.ac​.uk/​10​.1787/​mtc​_cond​-2017​-en). This was introduced as a result of Action 6 of the BEPS Action Plan, which considered measures to prevent treaty abuse. See also Art 7 of the OECD’s Multilateral Instrument (Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS), available on 14 April 2023 at https://​www​.oecd​.org/​tax/​treaties/​multilateral​-convention​ -to​-implement​-tax​-treaty​-related​-measures​-to​-prevent​-BEPS​.pdf. 57 Case C-685/16 EV v Finanzamt Lippstadt, ECLI:EU:C:2018:743. 58 Case C-35/98 Staatssecretaris van Financiën v BGM Verkooijen [2000] ECR I-4071. 59 Case C-315/02 Anneliese Lenz v Finanzlandesdirektion für Tirol [2004] ECR I-7063. 60 Case C-319/02 Petri Manninen [2004] ECR I-7477. 61 See, e.g. Case C-446/04 FII Group Litigation [2006] ECR I-11753; Case C-101/05 Case A [2007] ECR I-11531; Case C-157/05 Holböck [2007] ECR I-4051; Case C-194/06 Orange European Smallcap Fund [2008] ECR I-3747; Joined Cases C-436/08 Haribo and Case C-437/08 Salinen [2011] ECR I-305; Case C-47/12 Kronos, ECLI:EU:C:2014:2200. 62 Case C-480/19 E v Veronsaajien oikeudenvalvontayksikkö, ECLI:EU:C:2021:334. 63 Case C-403/19 Société Générale SA v Ministre de l’Action et des Comptes publics, ECLI:EU:C:2021:136. 64 See Case C-374/04 ACT Group Litigation; Case C-170/05 Denkavit [2006] ECR I-11949; Case C-521/07 Commission v Netherlands [2009] ECR I-4873; Case C-379/05 Amurta SGPS v Inspecteur van de Belastingdienst [2007] ECR I-9569 etc. 56

138  Research handbook on corporate taxation outbound dividends, if no expenses are allowed for non-resident shareholders but only for resident ones, then this could again be discriminatory.65 Moreover, if a final withholding tax is imposed on dividends paid to non-resident loss-making companies but resident recipient companies would be taxed on the dividends once they become profitable again, this could be discriminatory as it would lead to a non-recoverable expense for non-resident shareholders.66 It has also been held that a Member State cannot exclude from a tax exemption dividends paid to an investment fund in a third country, if there is a mutual administrative assistance agreement between the Member State and the third country.67 The Court of Justice has also found that a restriction may be neutralised by the domestic rules of the source state or a tax treaty between the source state and the state of residence but only if these methods are available to all Member States.68 In addition to the above case, there is also extensive case law in the area of cross-border loss relief. In the infamous Marks & Spencer case,69 it was found that the restriction of group relief only between resident companies or for losses linked to a UK permanent establishment restricted the freedom of establishment. The restriction could be justified on the following grounds, taken together: the preservation of the allocation of taxing rights between Member States, the prevention of double relief of losses and the risk of tax avoidance. Proportionality was also crucial. It had to be questioned whether the non-resident subsidiary had exhausted all possibilities for relief available in its Member State of residence: whether the losses could be used by the foreign subsidiary either by carry-back, current year relief against other local profits, or carry-forward either by the subsidiary or a third party.70 In many cases that followed, the so-called exhaustion of possibilities test was applied (not always consistently) in the context of other group loss relief cases,71 cases dealing with fiscal unities72 and cases dealing with loss relief of foreign permanent establishments.73 The principles set out by the Court of Justice in the area of exit taxation have also been contradictory over time. In the early case law which dealt with individuals, the Court of Justice 65 Joined Cases C-10/14, C-14/14, C-17/14 JBGT Miljoen v Staatssecretaris van Financiën, ECLI:EU:C:2015:608; Case C-252/14 Pensioenfonds Metaal en Techniek v Skatteverket, ECLI:EU:C:2016:402; Case C-18/15 Brisal – Auto Estradas do Litoral SA v Portugal, ECLI:EU:C:2016:549. 66 Case C-575/17 Sofina SA v Ministre de l’Action et des Comptes publics, ECLI:EU:C:2018:943. 67 Case C-190/12 Emerging Markets Series of DFA Investment Trust, ECLI:EU:C:2014:249. 68 Case C-540/07 Commission v Italy [2009] ECR I-10983; Case C-487/08 Commission v Spain, ECLI:EU:C:2010:310. 69 Case C-446/03 Marks & Spencer [2005] ECR I-10837. 70 Ibid, para 55. 71 See, e.g. Case C-123/11 A Oy, ECLI:EU:C:2013:84; Case C-322/11 K case, ECLI:EU:C:2013:716; Case C-607/17 Memira, ECLI:EU:C:2019:510; Case C-608/17 Holmen, ECLI:EU:C:2019:511; Case C-405/18 AURES Holdings, ECLI:EU:C:2020:127; Case C-749/18 B and Others, ECLI:EU:C:2020:370. 72 Case C-418/07 Société Papillon [2008] ECR I-8947; Case C-337/08 X Holding [2010] ECR I-1215; Case C-39/13 SCA Group Holding BV, ECLI:EU:C:2014:1758; Case C-386/14 Groupe Steria SCA, ECLI:EU:C:2015:524; Joined Cases C-398/16 and C-399/16 X BV and X NV v Staatssecretaris van Financiën, ECLI:EU:C:2018:1100. 73 Case C-414/06 Lidl Belgium [2008] ECR I-3601; Case C-157/07 Krankenheim [2008] ECR I-8061; Case C-18/11 Philips Electronics, ECLI:EU:C:2012:532; Case C-48/13 Nordea Bank Danmark A/S v Skatteministeriet, ECLI:EU:C:2014:2087; Case C-388/14 Timo Agro, ECLI:EU:C:2015:829; Case C-650/16 A/S Bevola and Jens W Trock ApS v Skatteministeriet, ECLI:EU:C:2018:424; Case C-28/17 NN A/S, ECLI:EU:C:2018:526.

Corporate taxation in the EU  139 found exit taxes to be restrictive of the freedom of establishment as they subjected a taxpayer transferring their tax residence to disadvantageous treatment in comparison with a person who maintained their residence in a Member State. Even the imposition of administrative burdens for the suspension of the payment or the provision of guarantees was found to be restrictive.74 Later case law almost reversed this position. In the National Grid Indus case,75 the Court of Justice found that levying taxes on unrealised capital gains over the assets of a company when it transfers its place of management to another Member State restricted the freedom of establishment. This restriction could be justified on the basis of ensuring the preservation of the allocation of taxing powers between Member States. However, as far as proportionality was concerned, the Court of Justice distinguished between the establishment of the amount of tax and the recovery of the tax. It was concluded that the immediate recovery of the tax at the time when the company transfers its place of management, without the company being given the possibility of deferred payment of the tax, was disproportionate. By contrast, the definitive establishment of the amount of tax without taking into account decreases in value was not disproportionate. Subsequent case law followed this judgment and the dichotomy between immediately ascertainable exit charge and recovery.76 Building on this precedent, in later case law, the Court of Justice found it permissible for the exit tax to be payable in instalments of ten years77 and five years.78 This has been built into the exit tax provision of the ATAD – Article 5. Under this provision, an exit tax is applicable on specific transfers of assets or the transfer of residence, requiring the Member State of origin to levy tax on the market value less their value for tax purposes.79 For transfers from a Member State to another Member State, tax could be paid in instalments over a five year period or until the disposal of the assets to a third party, if that is earlier.80 Interest can be charged and when there is a demonstrable and actual risk of non-recovery, guarantees can be demanded.81 The receiving Member State has to accept the market value established by the Member State of the taxpayer or the permanent establishment as the starting value of the assets for tax purposes (i.e. there will be a step-up).82 In summary, these are some of the basic principles set out by the Court of Justice in areas affecting Member State corporate tax regimes. In the European Union, at the time of writing, there is no harmonised corporate tax base and no common tax rate. As shown in the previous section, the legislative instruments that deal with corporate taxation are very few and target specific areas. There are, however, ongoing efforts to introduce legislation partially harmonis-

74 Case C-9/02 Hughes de Lasteyrie du Saillant v Ministère de l’Économie, des Finances et de l’Industrie [2004] ECR I-02409; Case C-470/04 N v Inspecteur van de Belastingdienst Oost/Kantoor Almelo [2006] ECR I-7409. 75 Case C-371/10 National Grid Indus [2011] ECR I-12273. 76 Case C-269/09 Commission v Spain, EU:C:2012:439; Case C-38/10 Commission v Portugal, ECLI:EU:C:2012:521; Case E-15/11 Arcade Drilling AS v The Norwegian State [2013] 1 CMLR 416; Case C-301/11 Commission v Netherlands, ECLI:EU:C:2013:47; Case C-64/11 Commission v Spain, ECLI:EU:C:2013:264; Case C-261/11 Commission v Denmark, ECLI:EU:C:2013:480. 77 Case C-164/12 DMC, ECLI:EU:C:2014:20. 78 Case C-657/13 Verder LabTec GmbH & Co KG v Finanzamt Hilden, ECLI:EU:C:2015:331. 79 Art 5(1) of the Directive. 80 Art 5(2) of the Directive. 81 Art 5(3) of the Directive. 82 Art 5(5) of the Directive.

140  Research handbook on corporate taxation ing the corporate tax base and tax rates for multinationals. These initiatives are discussed in the next section.

IV.

CORPORATE TAX BASE AND TAX RATE

For the last 20 years, the Commission has been working on proposals to introduce a common corporate tax base and consolidation for some group companies. Starting from the 2001 Company Tax Study,83 the Commission recommended a single set of rules to calculate the taxable profits of companies in the EU. The focus was on the so-called Common Consolidated Corporate Tax Base (CCCTB). The (first) official proposal for the CCCTB was published in 2011.84 Broadly, the 2011 CCCTB proposal provided companies with establishments in at least two Member States with detailed optional rules to compute their group taxable income according to one set of rules, those of the new consolidated tax base, rather than according to the national tax bases of each Member State. It also provided a comprehensive consolidation of profits and losses on an EU basis.85 There was strong resistance against this proposal by several Member States, in particular the UK and smaller Member States.86 After years of technical discussions in Council, it was clear that some of the provisions of the original CCCTB proposal and especially consolidation were too ambitious to be adopted all at once. Following the completion of the first stage of the Base Erosion and Profit Shifting (BEPS) project, in October 2016, the Commission relaunched the CCCTB but in a bifurcated format. There were two separate Directives, one for a Common Corporate Tax Base (the CCTB)87 and the other, again, for a Common Consolidated Corporate Tax Base (the CCCTB).88 By moving consolidation outside of the initial proposal into a separate one, the Commission tried to gain more support at least for the common tax base. One important difference between the 2016 CCTB/CCCTB proposals and the 2011 CCCTB proposal was that the new rules (i.e. the common tax base and subsequently consolidation) were mandatory for large corporate groups – defined as groups with a consolidated turnover exceeding €750m.89 It was no longer an option for eligible groups to opt in to the new tax base, as it was in the 2011 proposal. Companies falling outside the scope of the proposed Directive90

Company Taxation in the Internal Market, SEC(2001) 1681. Proposal for a Council Directive on a Common Consolidated Corporate Tax Base (CCCTB) COM(2011), 121/4 2011/0058. 85 See Commission press release, IP/11/319, dated 16 March 2011. 86 See ‘Study on the Economic and Budgetary Impact of the Introduction of a Common Consolidated Corporate Tax Base in the European Union’, commissioned by the Irish Department of Finance from EY in 2011. Also see Michael Devereux and Simon Loretz, ‘The Effects of EU Formula Apportionment on Corporate Tax Revenues’, Oxford University Centre for Business Taxation, WP 7/06. 87 Proposal for a Council Directive on a Common Corporate Tax Base, COM(2016)685 final, available on 14 April 2023 at https://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​?uri​=​CELEX​%3A52016PC0685 (CCTB Directive). 88 Proposal for a Council Directive on a Common Consolidated Corporate Tax Base, COM(2016)683 final, available on 14 April 2023 at https://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​?uri​=​CELEX​ %3A52016PC0683 (CCCTB Directive). 89 See proposed Art 2(1)(c) of the draft CCTB Directive. 90 Art 2 of the draft CCTB Directive. 83 84

Corporate taxation in the EU  141 could opt to apply its rules under certain conditions (voluntary opt-in).91 Therefore, the new CCTB/CCCTB proposals were aimed at replacing the Member States’ corporate tax bases for eligible taxpayers rather than providing an additional optional tax base to choose from. Another important difference between the 2016 CCTB/CCCTB proposals and the 2011 CCCTB was that the proposed rules were limited to EU-resident companies (the qualifying subsidiaries)92 and their EU permanent establishments. EU permanent establishments of third-country companies were not covered – their position was to be dealt with in bilateral tax treaties and national law. The common tax base was designed broadly: all revenues would be taxable unless expressly exempted.93 The basic formulation of the tax base was the following: revenues less exempt revenues, deductible expenses and other deductible items.94 There was also a list of non-deductible expenses95 and detailed rules on depreciation.96 The 2016 CCTB proposal introduced a very generous provision for deduction in order to attract high-value R&D activities to the EU: the super-deduction for R&D costs. It was provided that, on top of the amounts already deductible for R&D costs, a deduction of an extra 50 per cent of R&D costs each tax year would be granted for costs up to €20m and 25 per cent for expenditure above this level. An enhanced 100 per cent extra deduction would be available to start-ups for R&D expenditure up to €20m.97 Another addition to the CCTB proposal was the allowance for growth and investment (AGI), which was inserted to neutralise the asymmetry between debt and equity financing.98 The AGI was defined as the difference between the equity of a taxpayer and the tax value of its participation in the capital of associated enterprises.99 Under this rule, taxpayers would be given a deduction in respect of a notional yield on defined increases in their equity (the AGI equity base).100 This would be deductible from their taxable base subject to certain conditions dealing with anti-tax avoidance. In case of an AGI equity base decrease, an amount equal to the notional yield of the AGI equity decrease shall become taxable. The original 2011 CCCTB proposal and the 2016 CCCTB Directive set out the conditions for the formation of a consolidated tax group, as well as the mechanism for formulary apportionment and allocation of the consolidated tax base to the relevant Member States. In addition, there were rules for entering and leaving a group, the treatment of losses, business reorganisations and the intra-group transfer of assets. Under the 2016 proposal, consolidation became mandatory to all groups that fall within the scope of the CCTB proposal – that is, with a consolidated group revenue exceeding €750m. The formula for apportionment was identical

See proposed Art 2(3) of the draft CCTB Directive. A ‘qualifying subsidiary’ is defined as every immediate and lower-tier subsidiary in which the parent company has a right to exercise more than 50 per cent of the voting rights and it has an ownership right amounting to more than 75 per cent of the subsidiary’s capital or profit. See proposed Art 5(1) of the draft CCTB Directive. 93 Preamble, p 9, of the draft CCTB Directive. 94 Ibid, Art 7. 95 Ibid, Art 12. 96 Ibid, Chapter IV, art 30 et seq. 97 Ibid, Art 9(3). 98 Ibid, Art 11. 99 Ibid, Art 11(1). 100 Ibid, Art 11(3). 91 92

142  Research handbook on corporate taxation to the one proposed in the 2011 CCCTB proposal and was based on three equally weighted factors: labour, assets and sales.101 As in the 2011 proposal, intangible assets were excluded from the base of the asset factor and the sales factor was sales by destination.102 The 2016 CCCTB Directive also contained sector-specific formulae for financial institutions,103 insurance,104 oil and gas,105 shipping and air transport.106 In addition, there were detailed administrative provisions for consolidated groups.107 The proposed regime was meant to offer qualifying groups a one-stop-shop approach – the group would deal with one Member State tax administration in the EU, which was usually the Member State where the group’s parent company was tax resident.108 It should be emphasised that neither the initial CCCTB proposal, nor the subsequent ones affected tax rates: the aim was to harmonise the tax base. Corporate tax rates were seen as an area remaining within national sovereignty. In the Communication on Business Taxation from the 21st century,109 the Commission stated that, by 2023, there would be a new proposed framework for business taxation in the EU: the ‘Business in Europe: Framework for Income Taxation’ (or BEFIT).110 The BEFIT is expected to provide a single corporate tax rulebook for the EU, providing for fairer allocation of taxing rights between Member States. The aim will be to reduce administrative burdens, remove tax obstacles and create a more business-friendly environment in the Single Market. As such, BEFIT is expected to replace the CCCTB, which will be withdrawn. Although details of the BEFIT were not set out in the Commission Communication or subsequently, from the general information given so far it would seem that it is quite similar to the CCCTB, as it is based on a common rulebook for the tax base, consolidation and formulary apportionment. It is baffling why the Commission is withdrawing the CCCTB when its replacement is likely to be almost identical, at least as far as the core principles are concerned. As far as uniform tax rates are concerned, so far, there have been three proposals providing for the imposition of a tax and at a certain rate. One is a long-standing proposal for the imposition of a financial transaction tax which is still pending, the other is a proposal for a 3 per cent digital services tax which has now been withdrawn and the third is the recent proposal for a minimum corporate tax rate. The Directive to introduce a common system of Financial Transaction Tax (FTT) was published in 2011.111 The FTT was largely a reactive measure to the financial crisis, engulfing the EU (and the rest of the world) at the time. The FTT was indeed hailed as a levy imposed to ensure that the financial sector contributed to the costs of the financial crisis. The FTT was also meant to discourage excessively risky activities by financial institutions but not to affect

See Chapter VIII of the draft CCCTB Directive. See Arts 37–8 of the CCCTB Directive. 103 Ibid, Art 40. 104 Ibid, Art 41. 105 Ibid, Art 42. 106 Ibid, Art 43. 107 See Chapter IX of the draft CCCTB Directive. 108 See detailed rules in Chapter IX of the proposed CCCTB Directive. 109 Communication on Business Taxation for the 21st century, COM(2021) 251 final. 110 Ibid, pp 11–13. 111 Proposal for a Council Directive on a common system of financial transaction tax and amending Directive 2008/7/EC, COM(201) 594 final, Brussels, 28 September 2011 (2011 FTT Proposal). 101 102

Corporate taxation in the EU  143 citizens and businesses. It would only apply if one of the two parties was a financial institution and if one of the two parties – whether the financial institution or the non-financial institution – was established in a Member State.112 A tax of 0.1 per cent for most financial transactions other than derivatives and 0.01 per cent for derivative contracts was proposed. These were minimum rates and participating Member States were entitled to apply higher rates. It was proposed that each financial institution that was a party to the financial transaction would pay the tax and there would be joint and several liability as regards this charge. The proposed Directive was never approved and met with resistance from several Member States and especially the UK, Sweden, Bulgaria, Czech Republic, Cyprus, Malta and Denmark. By June 2012 at the Economic and Financial Affairs Council (ECOFIN) meeting, it became clear that this proposal could only be adopted through the enhanced cooperation procedure set out under the EU Treaties,113 which requires a minimum of nine Member States to adopt a legislative measure between themselves even if not all Member States agree to this measure. On 14 February 2013, the European Commission published a proposal for a Council directive implementing enhanced cooperation in the area of FTT,114 accompanied by another Impact Assessment.115 The proposal had to be unanimously approved by the participating Member States to be adopted by them. The Commission’s revised proposal was met with strong disapproval by the UK Government which challenged the authorising decision at the Court of Justice,116 arguing that it would have extraterritorial effect and would result in non-participating Member States incurring implementation and collection costs. The Court of Justice rejected the UK’s request on the basis that its arguments were based on the draft Directive, which was not part of the decision to authorise the use of enhanced cooperation.117 Even though this decision effectively gave participating countries the green light to proceed with enhanced cooperation, nevertheless, the FTT proposal was never adopted. It has not been officially withdrawn and seems to feature on the agenda of successive Commission presidencies. However, this proposal (and subsequent versions of it) have never been approved.118 Another proposal which stipulated the actual imposition of a tax was the proposal for a digital services tax.119 This proposal was produced in the context of the Commission’s

112 For an analysis of the proposed rules, see Christiana HJI Panayi, Advanced Issues in International and European Tax Law (Hart Publishing, 2015) ch 8. 113 Art 20 TEU and Arts 326–34 TFEU. 114 Proposal for a Council Directive implementing enhanced cooperation in the area of financial transaction tax, COM(2013) 71 final. 115 Commission Staff Working Document, ‘Impact Assessment accompanying the document Proposal for a Council Directive implementing enhanced cooperation in the area of financial transaction tax: analysis of policy options and impacts’, SWD(2013) 28 final of 14 February 2013. 116 Case C-209/13 United Kingdom v Council, ECLI:EU:C:2014:283. 117 The review of the Court of Justice was limited to the issue of whether that decision was valid as such in light of Art 20 TEU and Arts 326–34 TFEU, which defined the substantive and procedural conditions relating to the granting of such authorisation. As such, the Court of Justice found the challenge to be premature. 118 See, e.g. the 2018 summer reports that the French and German finance ministers have suggested the relaunch of the FTT, and its adoption by all Member States. Tax Analysts, Doc 2018-25787 (22 June 2018). 119 Proposal for a Council Directive on the common system of a digital services tax on revenues resulting from the provision of certain digital services, COM(2018) 148 final.

144  Research handbook on corporate taxation initiative for a ‘Fair and Effective Tax System in the EU for the Digital Single Market’120 and represented a short-term measure. The digital services tax was proposed to apply at the rate of 3 per cent on gross revenues created from activities where users played a major role in value creation such as selling of online advertising space, making available to users of a multi-sided digital interface, transmission of data collected about users and generated from users’ activities on digital interfaces. Only entities with total annual worldwide revenues of €750m and EU taxable revenues of €50m would be subject to this tax, irrespective of whether they were established in a Member State or third country. Again, many Member States were hostile to this proposal, calling for discussions on a global approach at OECD level. Conferring taxing rights based on the location of the digital user was a major deviation and Member States wanted such reform to be agreed at an international level and not by the EU unilaterally. Following the conclusion of the OECD’s Two-Pillar Solution and the subsequent endorsement of it by the G20 and 136 countries, model rules were put in place to implement the global minimum corporate tax rate of 15 per cent (the GloBE rules).121 Soon thereafter, on 22 December 2021, the Commission published its own proposal for an EU directive on global minimum taxation for multinationals,122 which broadly mirrored the OECD model rules. This draft was subsequently revised in compromise texts and was eventually adopted in December 2022.123 Broadly, the Directive ensures that through the Income Inclusion Rule (IIR) and the Undertaxed Profits Rule (UTPR), when a group is subject to an effective tax rate lower than 15 per cent, Member States will collect a ‘top up’ tax.124 In the initial version of this Directive, the UTPR was an Undertaxed Payments Rule,125 as per the initial OECD proposal.126 Its scope was later reconfigured to become an Undertaxed Profits Rule, in the March 2022 compromise draft.127

120 See Communication from the Commission to the European Parliament and the Council, ‘A Fair and Efficient Tax System in the European Union for the Digital Single Market’, COM(2017) 547 final, Brussels. 121 OECD, ‘Tax Challenges Arising from the Digitalisation of the Economy: Global Anti-Base Erosion Model Rules (Pillar Two) – Inclusive Framework on BEPS’, OECD, Paris (2021), available at https://​www​.oecd​.org/​tax/​tax​-challenges​-arising​-from​-the​-digitalisation​-of​-the​-economy​-commentary​ -to​-the​-global​-anti​-base​-erosion​-model​-rules​-pillar​-1e0e9cd8​-en​.htm. 122 Proposal for a Council Directive on ensuring a global minimum level of taxation for multinational groups in the Union, COM(2021) 823 final, available on 14 April 2023 at https://​eur​-lex​.europa​.eu/​legal​ -content/​EN/​TXT/​?uri​=​CELEX​%3A52021PC0823. 123 Council Directive (EU) 2022/2523 of 15 December 2022 on ensuring a global minimum level of taxation for multinational enterprise groups and large-scale domestic groups in the Union, [2023] OJ L 13/9. 124 Art 1 and Chapter II. 125 Proposal for a Council Directive on ensuring a global minimum level of taxation for multinational groups in the Union, COM(2021) 823 final, available at https://​ec​.europa​.eu/​taxation​_customs/​system/​ files/​2021​-12/​COM​_2021​_823​_1​_EN​_ACT​_part1​_v11​.pdf. 126 See fn.121. 127 See Draft Council Directive on ensuring a global minimum level of taxation for multinational groups in the Union – Compromise text, Interinstitutional File: 2021/0433(CNS), Brussels 12 March 2022, available on 14 April 2023 at https://​data​.consilium​.europa​.eu/​doc/​document/​ST​-6975​-2022​-INIT/​ en/​pdf.

Corporate taxation in the EU  145 There is one important difference between the directive and the OECD’s approach: the EU rules and more specifically the IIR will apply to ‘large-scale domestic groups’128 with a threshold of €750m consolidated revenue in at least two of the four preceding years.129 This was to avoid any risk of discrimination between cross-border and domestic situations and to ensure equal treatment. There are transitional rules for multinational groups in the first five years of the initial phase of their international activities, irrespective of whether the ultimate parent entity is located in the EU or outside of the EU.130 The same transitional rule applies to domestic large-scale groups for five years, whether or not they are in the initial phase of their activities.131 Another difference is that the Directive does not specifically provide for the Subject to Tax Rule (STTR) of the OECD Pillar Two proposals, the STTR being seen as naturally suited to be addressed in the context of bilateral tax treaties.132 The UTPR functions as a backstop rule, in addition to the IIR. It applies in situations where a group is based in a non-EU country and that country does not impose the minimum rate. In such circumstances, all the constituent entities of the Ultimate Parent Entity (UPE) in jurisdictions with an appropriate UTPR framework will be subject to the UTPR.133 The constituent entities of such a multinational group that are located in a Member State will be apportioned and will have to pay, in their Member State, a share of the top-up tax linked to the low-taxed subsidiaries of the MNE group.134 The calculation and allocation of the UTPR top-up tax in the Directive is based on the same two factors provided for under the OECD rules: number of employees and carrying value of tangible assets.135 Interestingly, the Directive provides the option of a domestic top-up tax.136 The domestic top-up tax allows the jurisdiction in which a low-taxed entity is resident to levy the top-up tax before application of the IIR at the level of the parent company. Where a domestic top-up tax is in place, the parent entity applying the IIR will be required to give credit for the domestic top-up tax when calculating the top-up tax payable for that jurisdiction.137 There are detailed rules on the calculation of qualifying income or loss,138 the computation of adjusted covered taxes139 and the calculation of effective tax rate and the top-up tax.140 There are also special rules for mergers and acquisitions141 as well as distribution regimes.142 The Directive provides for some exceptions. Certain entities will not be in scope, including government entities, international organisations, non-profit organisations, pension funds and 128 This is defined in Art 3(5) as ‘any group of which all entities are located in the same Member State’. 129 See Art 2 and Chapter XI. 130 Art 47(1) and (2). 131 Art 50. 132 See explanatory memorandum, p 1. 133 See Arts 12–13. 134 See Arts 13–14. 135 See Art 14. 136 Art 11. 137 Art 11(2). 138 Chapter III, Arts 15–19. 139 Chapter IV, Arts 20–25. 140 Chapter V, Arts 26–32. 141 Chapter VI, Arts 33–7. 142 Chapter VII, Arts 38–43.

146  Research handbook on corporate taxation investment funds that are the parent entity of a multinational group.143 International shipping income and partly ancillary international shipping income are also excluded from the application of the rules.144 There is also a de minimis income exclusion, in order to reduce the compliance burden.145 Further, there is the substance carve-out, pursuant to which companies will be able to exclude from the top-up tax an amount of income that is at least 5 per cent of the value of tangible assets and 5 per cent of payroll. The policy rationale behind this is to exclude a fixed amount of income relating to substantive activities like buildings and people. For the first ten years, there is a transitional rule where the substance carve-out starts off at 8 per cent of the carrying value of tangible assets and 10 per cent of payroll costs.146 For tangible assets, the rate will decline annually by 0.2 per cent for the first five years and by 0.4 per cent for the remaining period. In the case of payroll, the rate will decline annually by 0.2 per cent for the first five years and 0.8 per cent for the remaining period. The administrative provisions are set out in chapter VIII of this Directive.147 Each constituent entity of an MNE group located in a Member State must file a top-up tax information return, unless the return is filed by the MNE group in another jurisdiction, with which the Member State has an exchange of information agreement. The constituent entity might also designate another entity located in its Member State to file on its behalf. The returns must be filed within 15 months after the end of the fiscal year to which they relate. Member States must introduce penalties for failures to file the information return within the prescribed deadline or for making false declarations.148 These penalties must be ‘effective, proportionate and dissuasive’.149 The original draft Directive stated that an administrative pecuniary penalty of at least 5 per cent of the constituent entity’s turnover should be introduced by the Member State,150 but this has now been dropped. Finally, the Directive sets out the rules under which the legal framework of a third-country jurisdiction shall be considered as equivalent to the EU rules.151 As stated in the preamble to the approved Directive, the effectiveness and fairness of the global minimum tax reform heavily relies on its worldwide implementation. As such, it is vital that all major trading partners apply an equivalent set of rules.152 Initially, the Commission was proposing that the Directive be finalised by mid-2022 and transposed into domestic law of the Member States effective on 1 January 2023. Although the adoption of this Directive was a priority for the French presidency, nevertheless, this had not been possible, due to the objections of some Member States. Two subsequent revised compromise texts153 were rejected at ECOFIN meetings in March and April 2022. Whilst there was not much progress during the Czech Presidency, rather sur-

Art 2(3). Art 17. 145 Art 30. 146 See Art 48. 147 See Arts 44–5. 148 Art 46. 149 Ibid. 150 Art 44(2). 151 See Art 52. 152 Preamble, para 26. 153 Draft Council Directive on ensuring a global minimum level of taxation for multinational groups in the Union – Compromise text, Interinstitutional File: 2021/0433(CNS), Brussels, 28 March 2022, 143 144

Corporate taxation in the EU  147 prisingly, a formal agreement was reached at ECOFIN on 15 December 2022, with all Member States voting in favour and Hungary abstaining. Member States must now adopt the approved Directive by 31 December 2023.154

V. CONCLUSION The Directive on effective minimum corporate tax rate is not the only legislative proposal that the Commission had been working on. In fact, the Commission has been very active in the last few months, proposing two more directives, which were largely foreshadowed in the Commission Communication on Business Taxation in the 21st Century. The Commission has now proposed a Directive on the misuse of shell entities,155 also called the Unshell proposal. The aim of this directive is to establish transparency standards around the use of shell entities, so that their abuse can more easily be detected by tax authorities. The Directive does not define shell entities but introduces a filtering system comprising of several indicators that constitute a type of ‘gateway’. The draft Directive sets out three gateways.156 If an undertaking fulfils the criteria for all three gateways, it will be required to annually report more information to the tax authorities through its tax return (defined as reporting undertakings). Certain undertakings are exempt from reporting as they are considered as commonly used for good commercial reasons.157 Furthermore, an undertaking that would meet the criteria for being considered as a reporting undertaking would still be able to request an exemption from its reporting obligations if its existence does not reduce the tax liability of its beneficial owner(s) or of the group, as a whole, of which the undertaking is a member.158 An entity crossing all three gateways will be required to disclose certain information (substance indicators) in its tax return. If an entity fails at least one of the substance indicators, it will be presumed to be a shell. Where a company is presumed to be a shell entity, it will not be available on 14 April 2023 at https://​data​.consilium​.europa​.eu/​doc/​document/​ST​-6975​-2022​-INIT/​ en/​pdf​?mc​_cid​=​1086d2af3b​&​mc​_eid​=​a768783dd7 and Draft Council Directive on ensuring a global minimum level of taxation for multinational groups in the Union – Presidency compromise text, Interinstitutional File: 2021/0433(CNS), Brussels, 16 June 2022, available on 14 April 2023 at https://​ data​.consilium​.europa​.eu/​doc/​document/​ST​-8779​-2022​-INIT/​en/​pdf. These dealt, inter alia, with the time of transposition, and provisions to delay the application of the IIR and UTPR. 154 Council Directive on ensuring a global minimum level of taxation for multinational enterprise groups and large-scale domestic groups in the Union, available on 14 April 2023 at https://​data​.consilium​ .europa​.eu/​doc/​document/​ST​-8778​-2022​-INIT/​en/​pdf. 155 Proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU, COM(2021) 565 final. 156 Arts 6–10. The first gateway examines the activities of the entities based on the income they receive. This gateway is met if more than 75 per cent of an entity’s overall revenue in the previous two tax years does not derive from the entity’s trading activity or if more than 75 per cent of its assets are real estate property or other private property of particularly high value. The second gateway requires a cross-border element and examines whether the company receives the majority of its relevant income through transactions linked to another jurisdiction or passes this relevant income on to other companies situated abroad. The third gateway focuses on whether corporate management and administration services are performed in-house or are outsourced. 157 Art 6(2). 158 Art 10.

148  Research handbook on corporate taxation able to access tax relief and the benefits of the tax treaty network of its Member State and/or to qualify for the treatment under the Parent-Subsidiary and Interest and Royalties Directives.159 The Member State of residence of such company can deny to issue a tax residence certificate or the certificate will state that the entity is a shell company. In addition, payments to third countries will be subject to withholding tax and will not be seen as passing through the shell for tax purposes. Entities that do not meet all substance indicators will have the opportunity to rebut the presumption of being a shell. They will have to present additional evidence, such as detailed information about the commercial, non-tax reason of their establishment, the profiles of their employees and the fact that decision-making takes place in the Member State of their tax residence.160 Information received on all reporting entities (whether assessed as shell entities or not) would be exchanged automatically between the tax authorities of the EU Member States. Penalties for non-compliance with the reporting requirements of this draft Directive include administrative sanctions of at least 5 per cent of the undertaking’s turnover in the relevant tax year, if the undertaking fails to disclose relevant information or if it makes a false declaration in the tax return.161 More recently, on 11 May 2022, the Commission proposed another directive laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate income tax purposes (DEBRA).162 Again, this was foreshadowed in the Commission’s Communication on Business Taxation in the 21st Century. The proposed rules seek to equalise the tax treatment of debt and equity and alleviate the debt-equity tax bias, as this is considered highly distortive of investment decisions. Under the DEBRA proposal, an allowance on equity is introduced which will be deductible from the taxable base of a taxpayer for corporate income tax purposes for ten consecutive tax periods, up to 30 per cent of the taxpayer’s Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). If the deductible allowance on equity is higher than the taxpayer’s net taxable income in a tax period, Member States must ensure that the taxpayer is able to carry forward, without time limitations, the excess of allowance on equity. In addition, the taxpayer may carry forward, for a maximum of five tax periods, the part of the allowance on equity which exceeds 30 per cent of EBITDA in a tax period. The DEBRA proposal also introduces interest deduction limitations. Member States that already have a notional interest deduction regime will have to abolish it. It remains to be seen whether either of these proposals will achieve unanimity in Council. The Unshell proposal has been heavily criticised for the vagueness of some of the provisions and the heavy burden imposed on companies.163 The more recent DEBRA proposal has also been criticised in that the debt-equity bias problem has been debated at length in the past and the recommendations under BEPS Action 4 seem to have been widely accepted as the way forward. Arts 11–12. Art 9. 161 Art 13. 162 Proposal for a Council Directive on laying down rules on a debt-equity bias reduction allowance and on limiting the deductibility of interest for corporate income tax purposes, COM(2022) 216 final. 163 For criticism, see Pasquale Pistone, João Félix Pinto Nogueira, Alessandro Turina and Ivan Lazarov, ‘Abuse, Shell Entities and Right of Establishment: A Plea for Refocusing Current Proposals and Achieving Deeper Coordination within the Internal Market’ (2022) 14 (2) World Tax Journal 187–236. 159 160

Corporate taxation in the EU  149 Furthermore, the fact that the proposed EU rules, if adopted, will eventually replace national interest deduction regimes raises subsidiarity concerns.164 It also deviates from older directives such as the Parent-Subsidiary Directive and the Merger Directive which enable Member States to provide more extensive reliefs to eligible taxpayers. It is not surprising, therefore, that work on this proposal has been suspended by the Commission in light of the many interlinkages with other corporate tax dossiers.165 In this chapter, a broad overview was given of what could be considered as being encompassed in the European Union’s corporate tax regime. It was shown that through a patchwork of minimum EU rules (enacted through directives) which try to address some of the distortions caused by the co-existence of different and largely unharmonised tax systems of Member States, enriched (but also sometimes contradicted) by the voluminous case law of the Court of Justice, Member State corporate tax regimes are hugely affected by EU law.166 Whether this is satisfactory and conducive to legal certainty is very much debated.167 The Commission’s more recent initiatives seem to be exacerbating the situation. They also seem to be further disrupting the very delicate balance between the development of EU corporate tax law (whether from an internal market perspective or anti-abuse perspective) and the protection of Member States’ tax sovereignty. These initiatives also appear to be an opportunistic reaction to other political developments and to lack coherence. It is no surprise that the proposed directives have been met with strong resistance by some Member States. It is time the Commission applied some long-term strategic thinking in its future proposals on corporate taxation, rather than relying on current political idiosyncrasies to advance its agenda. Much hope is placed on the forthcoming BEFIT proposal, in that it could lead to more comprehensive reform and, eventually, a more transparent and competitive EU corporate tax system.

Art 5 TEU. See Council, Draft ECOFIN, Report to the European Council on tax issues (14905/22) (25 November 2022), available on 14 April 2023 at https://​data​.consilium​.europa​.eu/​doc/​document/​ST​ -14905​-2022​-INIT/​en/​pdf, p.6. 166 Christiana HJI Panayi, ‘EU Tax Law and Companies: Principles of the Court of Justice’, in Gore-Browne on EU Company Law, ch 19. 167 See some of my earlier criticisms in Christiana HJI Panayi, ‘The Peripatetic Nature of EU Corporate Tax Law’ (2019) 24 Deakin Law Review 1–60 and the final chapter in Christiana HJI Panayi, European Union Corporate Tax Law (Cambridge University Press, 2021). 164 165

10. Corporate taxation in the UK Michael McGowan

1. INTRODUCTION The United Kingdom (‘UK’) has long taxed company profits. This process accelerated in the first half of the twentieth century when various measures were introduced to finance two world wars. This summary focusses on the position from 1965 when the UK introduced corporation tax (‘CT’) to replace previous measures and to tax more comprehensively the income and capital gains of companies. Furthermore, under CT, it became much clearer that the UK taxation of companies entailed economic double taxation of company profits: once at entity level and again, in particular, when distributed to shareholders. This summary reflects the law at the end of March 2023. It reflects the pressures on the UK both to provide a modern, competitive corporate tax system while also preserving the UK tax base. It may not be relied on as legal advice.

2.

THE MEANING OF ‘COMPANY’

A complication has been uncertainty surrounding the meaning of a ‘company’ for CT purposes. Particular problems arise when dealing with non-UK entities with a UK tax presence sufficient to expose them to CT, or whose members are subject to UK tax. Are such entities ‘companies’? The main definition is in section 1121 Corporation Tax Act 2010 (‘CTA 2010’). This states that, in particular, a ‘company’ includes a ‘body corporate’ and an ‘unincorporated association’ but does not include a ‘partnership’. Exploring these concepts in depth is beyond the scope of this chapter but several comments can be made. ‘Body corporate’ is not defined in UK tax legislation, so one falls back on UK judicial decisions for clarification. They indicate that an entity is only a ‘body corporate’ if it is both a legal person and there is a sufficiently clear distinction between its activities and those of its members. In other words, there must be an ‘intention to incorporate’, often although not always highlighted by some public process of incorporation, for example, registration of a new body under the UK Companies Acts or the passing of a special Act of Parliament. The existence of legal personality (itself a complex concept) is necessary but not enough by itself to create a ‘body corporate’. Hence in Scotland (one of the UK’s three constituent legal jurisdictions), a partnership is a legal person but is not a ‘body corporate’. Section 4(2) Partnership Act 1890 (‘PA’) makes clear that it is a partnership. It is therefore not a ‘company’ within section 1121 CTA 2010. A ‘body corporate’ need not issue shares to its members. UK company law allows1 the creation of a ‘company limited by guarantee’ which does not issue transferable shares but



1

Sections 3 and 11 Companies Act 2006.

150

Corporate taxation in the UK  151 whose members must make a contribution (usually capped) to company assets in an insolvent liquidation. Companies limited by guarantee are widely used in the charitable sector. They are in principle subject to CT, although likely to benefit from tax exemptions for their charitable activities. A ‘body corporate’ need not offer limited liability to its members. Again UK company law permits2 the creation of an unlimited liability company. This is not a partnership and typically issues shares to its members (of whom there must be at least two). Members have an unlimited liability to make good any asset shortfall of the company in an insolvent liquidation. That liability is owed to the company, not directly to its creditors. A UK ‘limited liability partnership’ or ‘LLP’ is not a partnership at all. It is a special form of ‘body corporate’ created by registration3 and largely subject to UK corporate, accounting and insolvency legislation. Its members typically do not hold share capital. It is deemed to be a partnership in most cases for the purposes of taxing its income and capital gains.4 In short, it is not a taxable entity but is ‘transparent’. Therefore, it should usually not be subject to CT although its members may be subject to CT separately if they are ‘companies’. An ‘unincorporated association’ is a rare beast whose meaning is disputed. The courts have indicated5 that it is an entity which lacks legal personality, which is formed for non-business purposes (so it is not a partnership) and which is based on a contractual relationship between its members. The UK tax authorities (‘HMRC’) regard this definition as too narrow and there is some historical support for their position. However, their approach does not distinguish sufficiently between a ‘partnership’ or a simple joint venture based on co-ownership (neither of which is a ‘company’ for CT) and an ‘unincorporated association’ (which is). ‘Unincorporated associations’ are mainly encountered in relation to members’ clubs, although clubs can also be ‘bodies corporate’. ‘Partnerships’ are not ‘companies’ for CT purposes. UK LLPs have already been discussed. The meaning of a ‘partnership’ is a vexed but key concept for CT purposes. There is a lack of judicial and administrative guidance in this area. Problems arise especially when dealing with non-UK entities which may, or whose members may have enough UK tax presence to be exposed to CT. Briefly, the UK adopts a ‘resemblance’ method when classifying non-UK entities as ‘partnerships’ or not. What UK domestic entity do they most closely resemble? There are many flaws with this method. Two points can be made. The UK domestic law definition of a partnership (not a tax definition)6 is a ‘business in common with a view of profit’. This old definition rests heavily on the English law idea of a partnership as a profit-motivated business arrangement carried on by at least two persons acting as each other’s business agents. Indeed in English law (but not Scottish law), a partnership is not a legal person at all. It is very unclear that this domestic thinking should be applied without modification when defining a ‘partnership’ for CT purposes, and especially when dealing with non-UK entities. The second point flows from the first. A non-UK entity should be capable of being a ‘partnership’ for CT

Section 3(4) Companies Act 2006. See in particular sections 1–3 Limited Liability Partnerships Act 2000. 4 Section 863 Income Tax (Trading and Other Income) Act 2005 (‘ITTOIA’), section 1273 Corporation Tax Act 2009 (‘CTA 2009’) and section 59A Taxation of Chargeable Gains Act 1992 (‘TCGA’). 5 See Lawton LJ in Conservative and Unionist Central Office v Burrell [1982] 2 All ER 1. 6 Section 1 PA. 2 3

152  Research handbook on corporate taxation purposes even if it is a legal person. It would be strange if the only entity with legal personality which the UK regarded as a ‘partnership’ for tax purposes was a Scottish partnership.7 There is no elective entity classification in UK tax law, unlike the United States (‘US’) ‘check-the-box’ system, although a UK LLP is in effect a UK private limited company which is taxed in most cases as a partnership. There are few restrictions on setting up UK LLPs, unlike, say, Subchapter S corporations in the US. Some commentators have suggested that non-UK corporate bodies can effectively be made ‘transparent’ for UK tax purposes by appropriate changes to their local law constitutional documents. This thinking reads too much into certain UK judicial decisions.8 In any case, it would be vigorously resisted in practice by HMRC.

3.

TERRITORIAL LINKS

However defined, a ‘company’ must have the relevant territorial link to the UK if it is to be subject to CT. There are various possible links discussed in outline below. There is also a special UK regime for taxing exploration and exploitation of natural resources on the UK ‘continental shelf’, notably the North Sea. This is not discussed further. UK Residence A UK-resident company is in principle liable to CT on its worldwide income and gain, subject to relevant exemptions.9 With one exception discussed below, a UK-incorporated entity is automatically UK-resident.10 A non-UK-incorporated entity will also be UK-resident if its ‘central management and control’ is located in the UK, even if only in part. This means in practice that a non-UK-incorporated entity wishing to remain non-UK-resident should ensure that its highest level of strategic management (not necessarily its day-to-day management) remains outside the UK. This is a question of fact. If the company is managed by a board of directors taking all its key strategic decisions, those decisions should be properly discussed, made and minuted outside the UK at properly constituted board meetings which do not simply ‘rubber stamp’ decisions taken elsewhere, for example, in the UK by a dominant UK shareholder. It is advisable to have a majority of directors at any meeting who are not UK-resident although what matters most is where key decisions are made in substance. Subsidiary companies controlled from the UK can present particular problems11 in this respect, although with care, it is possible to maintain their non-UK residence. The exception mentioned above applies where12 a UK-incorporated company is also resident in a jurisdiction with which the UK has a tax treaty (e.g., because its ‘effective manage Whose partnership status is clear from PA. UK LLPs are of course legal persons usually taxed in the UK as partnerships but without being partnerships for all purposes. 8 See in particular Anson v HMRC [2015] STC 1777. 9 Section 5(1) CTA 2009 and section 2B TCGA. 10 Section 14 CTA 2009. 11 See the Court of Appeal in HMRC v Development Securities PLC and others [2020] EWCA Civ. 1705. This case is the latest of several regarding subsidiaries involved in tax avoidance schemes, which claimed to be non-UK-resident. 12 Section 18 CTA 2009. 7

Corporate taxation in the UK  153 ment’ is in that other jurisdiction). It can then be treated as non-UK-resident for all UK tax purposes, if the tie-breaker clause in the ‘Residence’ Article of the treaty allocates residence to the UK’s treaty partner. Non-UK residence of a UK-incorporated company has become harder to achieve on this basis now that tie-breaker clauses increasingly allocate exclusive treaty residence to one jurisdiction only if the relevant competent authorities agree. Some UK treaty partners (e.g., the Netherlands) are receptive to such agreements, given time and safeguards. Others (notably, the US) are not. UK ‘Permanent Establishment’ A non-UK-resident company will be liable to CT if and to the extent that13 it carries on a ‘trade’ through a UK ‘permanent establishment’ (a ‘p.e.’). Whether there is a UK p.e. will be defined firstly by reference to any UK treaty with the relevant jurisdiction. If there is no such treaty, the UK has a domestic law definition14 of a p.e. largely based on the OECD Model Treaty. It has been modified to reflect changes to that definition which are inspired by the OECD’s Base Erosion and Profit Shifting (‘BEPS’) programme. Not all businesses are ‘trades’ for UK tax purposes. In particular, for historic reasons, renting real property is typically a ‘business’, but not a ‘trade’. That aside, any active profit-orientated business of providing goods or services is likely to be a ‘trade’ although cases at the margin are fact-sensitive. Hence banking, investment management, retailing, manufacturing or building for resale are typically trades for UK tax purposes. A non-UK-resident company conducting a trade through a UK p.e. will be subject to CT on the income and chargeable gain referable to that p.e. and its activities. The UK does not operate a ‘force of attraction’ principle. Where a non-UK bank conducts a trade through a UK p.e., HMRC will rely on the p.e. definition to attribute ‘free capital’ to it for CT purposes.15 This will reduce the financing deductions available to that p.e. ‘UK Property Dealing or Developing’ A non-UK-resident company which lacks a UK p.e. will still be subject to CT in respect of any trade involving dealing in or developing UK real estate.16 This broadly drafted rule catches various types of speculative UK real estate development activity if the non-UK-resident’s tax presence manages to fall short of a UK p.e. UK Property Rental Business Until recently, a non-UK-resident company which simply leased UK real estate for rent was subject to income tax, not CT. Such non-resident landlords are now only subject to CT on that income, together with income and expense from related financing transactions.17 This makes

Section 5(2)(b) CTA 2009 and sections 2B(3) and 2C TCGA. Sections 1141–3 CTA 2010. 15 See Irish Bank Resolution Corporation Ltd (in liquidation) and others v HMRC [2020] EWCA Civ. 1128. 16 Sections 5(2)(a) and 5B CTA 2009. 17 Section 5(2)(c) and (d), (3A), (3B), (4) and (5) CTA 2009. 13 14

154  Research handbook on corporate taxation them subject to a wider range of restrictions on deducting their costs (especially financing costs). They will also be subject to a higher headline tax rate from April 2023. Tax can be collected by withholding although it is usually possible to disapply withholding, subject to satisfactory compliance by the non-UK-resident company with the CT self-assessment rules discussed in 4. ‘Non-Resident Chargeable Gains’ The UK has now moved into line with international norms by taxing non-UK-residents on chargeable gains from direct or indirect disposals of UK real estate. This applies in particular to offshore real estate holding companies. These will be subject to CT on those gains, in addition to property rental income mentioned above. The new rules are complex. Special rules apply where UK real estate is directly or indirectly owned by non-UK-resident collective investment funds.18 In outline, a taxable indirect disposal of UK real estate can only arise if19 the non-UK-resident company disposes of an interest in a ‘company’ at least 75 per cent of whose gross asset value is attributable to UK real estate. The non-UK-resident company must also have at least a 25 per cent ‘investment’ (ignoring certain loans) in that property holding company. These 75 per cent and 25 per cent thresholds are fairly generous by international standards. Treaties may well permit the UK to apply in future lower thresholds when taxing the UK real estate gains of non-UK-residents. The UK has recently renegotiated its treaty with Luxembourg to protect its taxing rights in respect of direct and indirect disposals of UK real estate. The previous treaty with Luxembourg was generous to Luxembourg investors in UK real estate.

4.

TAX RATES AND PROCEDURE

The UK long pursued a policy of reducing its headline CT rate. This rate is currently 19 per cent (ignoring the special, higher rates that apply to the banking industry and UK exploration and exploitation activity in the North Sea). However, this process is scheduled to end when CT rates rise to 25 per cent with effect from April 2023. This is part of the UK’s fiscal response to the costs of the Covid pandemic. It remains to be seen whether this is a medium-term trend given the fiscal and inflationary challenges confronting the UK. Historically, CT has been a lesser source of revenue compared in particular to VAT, income tax (especially on employment income) and social security contributions (‘National Insurance’). That may be about to change, especially given the worsening economic situation. When the 25 per cent rate takes effect, there will be a lower (19 per cent) rate for smaller companies. The policy of reducing the headline CT rate was largely funded by broadening the CT base, notably by restricting tax depreciation reliefs (‘capital allowances’). CT rates are set by reference to the UK financial year which runs from April 1 to March 31. However, income and gain for CT purposes is computed by reference to ‘accounting periods’. Where these straddle April 1 and CT rates differ pre- and post-April 1 (as expected in 2023), income and gain must be apportioned to the parts of the accounting period falling either side 18 19

See Schedule 5AAA TCGA. Section 2B(4) TCGA and Schedule 1A TCGA.

Corporate taxation in the UK  155 of April 1, before applying the relevant rate to each part-period. The definition of ‘accounting period’ can be complex20 but will often coincide with the period for which the company draws up its commercial accounts. However, a CT accounting period cannot exceed 12 months. The company must prepare a CT return containing its self-assessment and file it no later than 12 months after the end of the relevant accounting period. CT for that period must be paid no later than nine months after the end of that period. Late payments attract interest and, in some cases, penalties. Overpayments attract a lower rate of interest. There is scope for CT payers who are affiliated to net off their overpayments and underpayments when deciding if they are owed, or owe interest. This tends to reduce their overall interest bill on underpayments. For larger companies, CT must be prepaid in four instalments before the nine-month deadline mentioned above.21 Instalments are computed on the basis of what CT the company expects to pay for the relevant accounting period. If reality and those expectations diverge, instalment levels must be adjusted up or down subsequently. This may entail catch-up payments or, conversely, reduced instalments, together with interest payments from or to the taxpayer, depending on whether it has underpaid or overpaid earlier in the instalment cycle. The CT rate is the same for both income and capital gains. This differs from the UK tax treatment of individuals. From 1982 until 2017, companies could index their cost base in capital assets by reference to the UK Retail Prices Index of inflation. Indexation could only be used to reduce a gain, not to create a loss. No further indexation accruals have been permitted since 2017. However, accrued and unused indexation for the pre-2018 period, in respect of assets acquired before 2018 and still held, is not lost. Despite the UK now experiencing serious inflation, there are no current plans to revive indexation.

5.

INCOME VERSUS CAPITAL GAIN?

For historical reasons, the UK has never had a comprehensive definition of ‘income’. Therefore, it differs from, say, the US which does. Although the legislation regarding CT was largely rewritten in 2009 and 2010, this did not lead to income being defined comprehensively for CT purposes. Instead, CT is payable on a number of broad categories of profit regarded as income (notably trading income, income from real property, interest, dividends and ‘miscellaneous income’). It is also payable on chargeable (‘capital’) gains which are not income at all for UK tax purposes, but a distinct category of taxable profit arising from ‘disposals’ of ‘assets’ (but not of ‘liabilities’).22 However, there have been moves since the 1990s to modernise the categories of profit on which CT is chargeable. These changes were partly designed to align tax accounting better with normal commercial accounting, for example, allowing tax deductions for commercial expenditure (such as certain foreign exchange costs) which otherwise risked being non-deductible. The changes also tended to move items otherwise treated as capital gain or loss into the ‘income’ category for CT purposes. This has been true in particular of profits

Sections 9–12 CTA 2009. Corporation Tax (Instalment Payments) Regulations 1998: SI 1998/3175 (as amended). There are in fact two instalment payment regimes: one for ‘large’ and another, accelerated regime for ‘very large’ companies. 22 TCGA defines chargeable gains separately. 20 21

156  Research handbook on corporate taxation and losses from many financial assets and liabilities (‘loan relationships’ and ‘derivative contracts’) and from intangible assets (defined according to generally accepted UK accounting standards or ‘GAAP’) which are used on an ongoing basis in a CT payer’s business. These changes have also introduced extensive ‘regime-specific’ anti-avoidance rules.23 These changes only apply for CT. They do not affect the tax base of those business organisations (e.g., large professional partnerships of individuals) which fall outside CT. These still pay income tax and capital gains tax on their profits, even though in economic terms, they resemble large private companies.

6.

CORPORATION TAX INCENTIVES, ESPECIALLY FOR INTANGIBLES ACTIVITY AND R&D COSTS

Business entities subject to CT benefit, for reasons that are not easy to justify, from a wider range of incentives and reliefs, especially relief for expenditure on research and development (‘R&D’) and in relation to taxing intangibles. While intangibles are a key feature of the modern business environment, the UK capital allowances code24 only gives limited relief for intangibles expenditure. For CT payers only, this is alleviated by the rules mentioned in 5. regarding ‘intangible fixed assets’. These permit tax depreciation on such intangibles either according to what is permitted by GAAP or, by election, on a 4 per cent per annum ‘straightline’ basis.25 The UK offers a preferential CT rate (effectively 10 per cent) for certain income from patents, including patent sales.26 The so-called ‘patent box’ is the UK equivalent of (often more generous) innovation regimes in other jurisdictions (notably, the Netherlands). The UK regime was modified to allay concerns that, in its original form, it favoured the purely passive holding of patents. It contains complex conditions limiting the preferential CT rate to income derived from the innovative features of patents, and not, in particular, from related marketing activities. It also applies only to patents whose status is established by an official registration process of the kind that is standard in Europe. It will not apply to patents whose status is instead established purely by litigation. Increasing overall levels of research and development expenditure has been a goal of successive UK governments. Tax relief has an important role to play although, again, the main available reliefs are limited to CT payers. For ‘small and medium-sized enterprises’, there is a ‘super-deduction’ of 86 per cent, from April 2023, for non-capital27 expenditure on research and development. In certain cases, if the super-deduction produces a tax loss, this can be ‘sur-

See Parts 5 and 6 CTA 2009 (‘loan relationships’), Part 7 CTA 2009 (‘derivative contracts’) and Part 8 CTA 2009 (‘intangible fixed assets’). 24 See Capital Allowances Act 2001 (‘CAA’). 25 Sections 729–31 CTA 2009. 26 Part 8A, Chapter 2A CTA 2010. The preferential rate may affect whether the UK-resident company meets the minimum tax requirements under the OECD’s Pillar II 15 per cent minimum effective tax rate proposals (‘Pillar II’). The UK has committed to implement Pillar II, while enacting its own 15 per cent ‘qualified domestic minimum top-up tax’. Capital allowances may also be available for patent expenditure: see Part 8 CAA. 27 For capital expenditure on research and development, there may be 100 per cent capital allowances, but no ‘superallowance’, under Part 6 CAA. 23

Corporate taxation in the UK  157 rendered’ to HMRC for a cash payment. There are overall cash limits on the relief which can be claimed under this super-deduction scheme. Also available to CT payers, of whatever size, is the less generous research and development expenditure credit.28 This is an ‘above the line’ credit of 20 per cent29, from April 2023, for qualifying expenditure on research and development. It has proved the more important incentive and, relatively speaking, less expensive in overall tax terms. The credit is taxable income for CT purposes. A normal deduction in computing income for CT should also be available for the expenditure which triggers the credit. For these purposes, the UK defines ‘research and development’ expenditure more restrictively than some jurisdictions. In particular, the expenditure must relate to advancing the frontiers of knowledge. It is not enough that it relates simply to enhancing the efficiency or knowledge of the relevant business.30 The research and development tax relief regime is under review. This is partly to curb abusive claims and also to limit reliefs in most cases to UK-based research and development. Unlike some other jurisdictions, the UK gave reliefs for activities taking place entirely outside the UK. In some respects, the regime has been made more generous, for example, extending relief to certain ‘cloud-computing’, pure mathematics and dataset costs. There is ongoing discussion about whether to replace the two existing schemes for relieving R&D expenditure with a single scheme. The increase in the CT rate from April 2023 has already been mentioned. To sweeten the pill, a transitional regime of ‘super’ capital allowances has been introduced for CT payers only. These allowances of between 50 per cent and 130 per cent apply to pre-April 2023 expenditure on new, not second-hand assets.31

7.

THE TAXATION OF SHAREHOLDERS AND OTHER ECONOMIC STAKEHOLDERS

The discussion of CT so far has focussed entirely on the taxation of the company itself. This is only half the story. It was recognised in 1965 that CT would entail economic double taxation of corporate profit, at entity level and in particular on distribution to shareholders. The post-1965 history of taxing shareholders of UK companies has been complex. In brief, the situation is now as follows. Unusually by international standards, and with rare exceptions (notably, UK ‘real estate investment trusts’), there is no withholding tax on UK-source dividends. UK-taxpaying corporate shareholders of a company (whether it pays CT or not) are likely to benefit from the UK ‘dividend exemption’, discussed in 10. UK-taxpaying individual shareholders of a company (whether it pays CT or not) no longer get significant relief for tax paid at

Sections 104A–Y CTA 2009. Consequently, the UK considers that this credit is not a tax reduction for the purposes of Pillar II. 30 Section 437 CAA, section 1006 Income Tax Act 2007 (‘ITA’) and related regulations. 31 Technically, relief is limited to assets which are ‘plant and machinery’ for UK tax purposes. In practice this category is quite broad, although see the recent decision in Cheshire Cavity Storage 1 Ltd and another v HMRC [2022] STC 622. In March 2023, plans were announced to, in effect, extend such allowances beyond March 2023. 28 29

158  Research handbook on corporate taxation entity level, although there is a limited reduction in marginal UK tax rates on dividend income, compared to other income sources. Hence for individual shareholders, the UK has largely reverted to a ‘classical’ system of dividend taxation, although for many UK retail investors, an exemption from tax on dividends may apply if their shares are held in a so-called ‘Individual Savings Account’. From 1973 to 1998, the UK operated a ‘partial imputation’ system of dividend taxation. This effectively allowed UK shareholders (including some tax-exempts) and shareholders in favoured treaty jurisdictions (notably, the US and the Netherlands) a refundable ‘tax credit’ for some of the CT payable at entity level. Other European jurisdictions (e.g., France) operated similar systems. Australia still operates a ‘franking credit’ system in respect of Australian-source dividends payable to Australian taxpayers. The UK ‘partial imputation’ system was dismantled from the late 1990s, largely because of inconsistencies with EU rules on freedom of establishment and the free movement of capital. Although the UK has now left the EU, there is no suggestion that ‘partial imputation’ will be reinstated. Unlike the US, the UK has fairly formalistic rules (the ‘distribution’ rules) for defining items which should be taxed in the same way as dividends, especially if received by UK-taxpaying shareholders. Space does not permit a comprehensive review of this list.32 However, ‘distributions’ include a ‘dividend’, in the company law sense of a formal distribution of profit to members. They also include payments on a direct share buyback to the extent that the amount repaid exceeds capital subscribed for the relevant share. Certain returns on debts will be treated as ‘distributions’ too. If so, they will be non-deductible. In practice, the two most important examples are payments (other than a return of principal) on unlisted convertible debt and on so-called ‘results-dependent’ debt.33 While convertible debt can be readily ‘listed’ on one of the many international stock exchanges ‘recognised’ by the UK34 to avoid the first issue, the second issue is more complex. Debt will be ‘results-dependent’ if the ‘consideration’ given for it is ‘to any extent dependent on the results of the business’ of the debtor company.35 This will clearly catch an interest rate which is wholly or partly tied to a particular level of profit or turnover. An exception36 preserves the deductibility of interest on project-finance loans where the interest margin moves up or down depending, respectively, on whether the project is performing badly or well. However, the UK tax authorities consider that all ‘limited-recourse’ debt is ‘results-dependent’. This overlooks the genuinely commercial purpose of most limited-recourse debt. Subordinated debt typically does not raise equivalent issues, especially if widely held, even though its economic function may often be similar to limited-recourse debt. There is an expanded definition of ‘distribution’ for a wide range of benefits and facilities provided by UK-resident ‘close’ companies to any of their economic stakeholders (‘participators’) as well as to certain connected persons.37 ‘Participators’ include, but are not limited to, shareholders.38 While the definition of ‘close’ company39 is mainly limited to companies ‘con 34 35 36 37 38 39 32 33

See Part 23 CTA 2010. Section 1000(1)F together with section 1015(3) and (4) CTA 2010. Section 1137 CTA 2010 and related HMRC guidance. Section 1015(4) CTA 2010. Section 1017(1) CTA 2010. Sections 1064–9 CTA 2010. Section 454 CTA 2010. Section 439 CTA 2010.

Corporate taxation in the UK  159 trolled’ by five or fewer such ‘participators’ or by any number of ‘participators’ who are also ‘directors’, many UK-resident companies fall into the ‘close company’ net, not least because ‘control’40 is broadly defined for these purposes. Having listed shares is not an automatic escape route from ‘close’ company status. Much will depend41 on how widespread ownership is and the level of share dealing activity. By contrast with the US, the UK has no tax concept of ‘earnings and profits’ (‘E&P’) when deciding whether value extracted from a company is a ‘distribution’. Hence even if a company is awash with profit in a commercial sense, a direct buyback of its shares (see above) will generally not be a ‘distribution’ to the extent the amount repaid represents the amount subscribed for the relevant shares. In some situations, the US treats a sale of shares to a third party as a dividend to the extent of underlying E&P in the issuing company. This is only possible in the UK where a share sale is caught by the anti-avoidance regime targeting certain ‘transactions in securities’.42 Unlike the US, the UK also lacks an economics-based approach to defining equity versus debt. The contrasting UK and US approaches have in the past spawned hybrid debt structures designed to capitalise on this difference. Very deeply subordinated, long-dated or undated debt will be recognised as ‘debt’ for UK tax purposes if it can in principle be redeemed on a future event (e.g., a liquidation of the debtor). It does not matter that the creditor cannot trigger an event of default or a debt acceleration. Nor does it matter that it may receive little or nothing on redemption because it is deeply subordinated. Many billions of such ‘perpetual’ debt have been raised by UK banks in the form of listed bonds, with the added benefit that such debt can count towards a bank’s regulatory capital base. However, despite this formalistic UK definition of debt, there are now many restrictions for CT purposes on deducting interest expense. The most important are: (a) (b)

The UK ‘thin capitalisation’ rules.43 The ‘main purpose’ anti-avoidance rules in the regimes dealing with ‘loan relationships’ and ‘derivative contracts’.44 (c) The anti-‘hybrid mismatch’ rules enacted in the wake of the 2015 BEPS Action 2 conclusions.45 (d) The ‘corporate interest restriction’ enacted following BEPS.46 Where (a), (b) and (c) bite, they typically deny a deduction outright. Where (d) bites, a deduction may be merely delayed. The rules in (b) have been quite extensively litigated with outcomes largely unfavourable to CT payers.47 There has been little or no litigation to date on (a), (c) and (d). The UK was an early adopter following BEPS of anti-‘hybrid mismatch’ and ‘corporate interest restriction’ rules. However, the EU Anti-Tax Avoidance Directive 2016 (as

42 43 44 45 46 47 40 41

Sections 450–51 CTA 2010. Sections 446–7 CTA 2010. Part 13 Chapter 1 ITA and Part 15 CTA 2010. Part 4 Taxation (International and Other Provisions) Act 2010 (‘TIOPA’). Sections 441–2, 455B–D, 690–92 and 698B–D CTA 2009. Part 6A TIOPA. Part 10 TIOPA. For a recent example, see BlackRock Holdco 5 v HMRC [2022] STC 1490 and cases cited therein.

160  Research handbook on corporate taxation amended in 2017) (‘ATAD’)48 has meant that similar rules have been, or are being, adopted by competitor jurisdictions in the EU.

8.

THE UK AS A HOLDING COMPANY JURISDICTION: INTRODUCTION

The last point links to the wider topic of whether the CT regime means that the UK is a favourable jurisdiction for locating an international holding company. Interest deductibility may be important in this respect. Hence it is relevant that competitor jurisdictions such as Ireland and Luxembourg have been required by ATAD to enact anti-‘hybrid mismatch’ and ‘corporate interest restriction’ rules, which are broadly similar to the UK’s. Another factor in the UK’s favour is the general lack of a domestic withholding tax on dividends. It is relatively easy to avoid UK interest withholding tax by ‘listing’ relevant debt instruments on one of the many international stock exchanges ‘recognised’ by the UK . ‘Listing’ for these purposes need not entail active dealing in the debt. The fact that the debt is privately placed or held intra-group is not problematic. This contrasts with the US ‘portfolio interest’ exemption. More problematic is the UK restriction (mentioned above) on deducting the return on ‘limited recourse’ debt. Headline CT rates are also set to rise significantly from historic lows. However, since 2000, the UK has introduced two important exemptions for CT payers, which are of particular relevance to a holding company. These are the ‘substantial shareholdings exemption’ (‘SSE’) on chargeable gains and the worldwide dividend exemption. The UK has also made changes to its ‘controlled foreign company’ rules which have made life easier for UK holding companies.

9.

THE UK AS A HOLDING COMPANY JURISDICTION: THE SSE

The SSE49 is the UK equivalent of a ‘participation exemption’ for chargeable gains and has been expanded significantly since first introduced. It is in most cases a full exemption from CT on chargeable gains on share disposals. In one situation, it may provide a partial exemption. The basic exemption50 typically applies where a ‘substantial’ beneficial holding of ‘ordinary share capital’ is disposed of in whole or part, and has been held continuously by the disposing company for at least 12 months in the six years preceding the disposal. ‘Ordinary share capital’ includes all types of share capital other than shares carrying a purely fixed rate of return. The disposing company can be a passive holding company. The company whose shares are disposed of need not be a UK company nor a UK taxpayer. However, it must either primarily carry on a ‘trade’ by UK standards or be the holding company of a ‘group’ or ‘subgroup’ whose activities, viewed on a consolidated basis, primar-

Council Directive 2016/1164 (as amended by Council Directive 2017/952). Schedule 7AC TCGA. 50 Paragraph 1 Schedule 7AC TCGA. 48 49

Corporate taxation in the UK  161 ily consist of ‘trading’.51 The concept of a ‘trade’ has already been discussed. In particular, a real estate holding company will not be ‘trading’ for these purposes. A group holding company with subsidiaries may qualify so long as the group or subgroup to which it belongs is mainly (in practice at least 80 per cent) ‘trading’ when viewed on a consolidated basis.52 Affiliated companies can form a ‘group’ or ‘subgroup’ for these purposes if there is a genuine economic affiliation between them of at least 50+ per cent.53 Certain activities preparatory to trading count as ‘trading’ for these purposes. It is also possible to ‘look through’ to the underlying activities of some joint venture companies to decide whether a company which is a joint venturer is ‘trading’ or belongs to a trading group or subgroup.54 The ‘trading’ criterion can throw up hard cases at the margin, especially if a company, group or subgroup carries on both trading and non-trading activities over time. For a shareholding to be ‘substantial’, it must usually comprise at least 10 per cent of the ‘ordinary share capital’ of the investee company. This is not just measured formalistically by reference to percentage ‘beneficial’ ownership of issued share capital. There are additional economic tests to determine that the investor is entitled to at least 10 per cent of the distributable profits of the investee company, and at least 10 per cent of assets available to its ‘equity holders’ (including certain hybrid debt holders) on a hypothetical liquidation.55 If the basic exemption conditions are met,56 a disposal of any shares in the investee company (including fixed-rate shares) will be exempt. The basic exemption is supplemented by further complex exemptions, widening the SSE’s scope. There is an exemption for disposals of certain derivative rights over shares, such as options or convertible debt.57 More importantly, there is an exemption for disposals of shares where the conditions for claiming the basic exemption have been met in the prior two years but are no longer met. This further exemption ensures in particular that the SSE is available when a ‘substantial shareholding’ is disposed of in stages over a period of time.58 The most important additional exemption59 is the most recent. This enables certain tax-exempts60 (notably, sovereign investors such as sovereign wealth funds, charities and pensions funds) to use a UK-resident holding company as an intermediate investment vehicle without incurring CT on chargeable gains from share disposals by that holding company. Where this exemption applies, it does not matter whether the UK-resident company is invested in a company, group or subgroup whose activities are mainly ‘trading’. Hence this exemption could apply to a disposal of shares in a company holding UK real property. This further exemption will also apply to share investments by a UK-resident company of at least £20,000,000, even if they represent less than a 10 per cent shareholding in the investee compa-

53 54 55 56 57 58 59 60 51 52

Paragraph 19(2) Schedule 7AC TCGA. Paragraphs 20–22 Schedule 7AC TCGA. Paragraph 26 Schedule 7AC TCGA. Paragraphs 23–4 Schedule 7AC TCGA. Paragraph 8 Schedule 7AC TCGA. I.e., a ‘substantial shareholding’ in the right kind of company for the relevant 12-month period. Paragraph 2 Schedule 7AC TCGA. Paragraph 3 Schedule 7AC TCGA. Paragraph 3A Schedule 7AC TCGA. ‘Qualifying institutional investors’, as defined in paragraph 30A Schedule 7AC TCGA.

162  Research handbook on corporate taxation ny.61 Lastly, this exemption can still apply in part where between 25 per cent and 80 per cent of the UK-resident holding company is itself held by relevant tax-exempts.62 The tax exemptions which the UK grants to sovereign entities are quite generous by international standards. It has recently been decided not to limit them nor to limit relief under this particular limb of the SSE.

10.

THE UK AS A HOLDING COMPANY JURISDICTION: THE DIVIDEND EXEMPTION

This was introduced in 2009, not least to address concerns that the pre-existing UK rules for taxing non-UK dividends contravened EU rules on the freedom of establishment and free movement of capital. The dividend exemption63 has not been altered since the UK left the EU. It is the UK equivalent of a ‘participation exemption’ for dividends, but with important differences. It is elective, unlike the SSE. A CT payer can opt out of the exemption64 and instead claim a UK foreign tax credit in respect of a non-UK dividend. For shareholdings of at least 10 per cent, the UK will usually give credit for non-UK tax (‘underlying tax’) on the profits from which the dividend is paid. Opting out of the exemption may be beneficial if the dividend is paid from a jurisdiction whose treaty with the UK only grants relief from non-UK withholding tax if the dividend is ‘subject to tax’ in the UK. Only a few UK treaties contain such language. There is a separate dividend exemption for ‘small’ companies.65 This is not considered further. The dividend exemption applies in the same way to both UK and non-UK dividends and other ‘distributions’. ‘Distributions’ are defined as mentioned earlier, but do not include any amount regarded as a return on debt.66 Indeed, to avoid the exemption being exploited in hybrid mismatch structures, it does not apply if the distribution is deductible outside the UK.67 While the exemption is available in respect of larger shareholdings,68 it can also apply to smaller ‘portfolio’ shareholdings,69 to other holdings of non-redeemable ordinary shares70 or, indeed, to any distribution which is not part of ‘arrangements’ with a ‘main purpose’ of reducing UK tax.71 Hence the dividend exemption is more generous than both the SSE and equivalent exemptions in jurisdictions such as Luxembourg and the Netherlands. Ireland does not have a dividend exemption at all and its SSE equivalent is narrower.

Paragraph 8A Schedule 7AC TCGA. Paragraph 3A(4) Schedule 7AC TCGA. There is a full exemption if the percentage held is 80 per cent or more. 63 Part 9A CTA 2009. 64 Section 931R CTA 2009. 65 Sections 931B–CA CTA 2009. 66 Section 931D(b) CTA 2009. 67 Section 931D(c) CTA 2009. 68 Section 931E CTA 2009. 69 Section 931G CTA 2009, meaning holdings of less than 10 per cent of the relevant share class. 70 Section 931F CTA 2009. 71 Section 931H CTA 2009. 61 62

Corporate taxation in the UK  163 Unlike the SSE, the dividend exemption requires no minimum holding period in respect of the relevant shares. The activities of the distributing company need not amount to ‘trading’ nor do they need to be taxable. However, several quite broad anti-avoidance rules must be kept in mind. In particular, the limb of the exemption applying to larger controlling shareholdings, or to significant shareholdings in some joint venture companies, can be disapplied where the distribution is paid out of profits arising before the controlling, etc. shareholding was acquired.72 It may still be possible to rely on other limbs of the dividend exemption in this situation. A basic principle is that the dividend exemption does not apply if the distribution would be a ‘trading’ receipt of the payee,73 for example, where a bank receives a dividend on shares held by it for financial trading purposes (‘inventory’), but not dividends on shares in its subsidiary. Another anti-avoidance rule74 ensures that this principle is not circumvented by, for example, routing dividends through an investment company subsidiary of the bank. A further anti-avoidance rule denies the dividend exemption to the extent that the distribution generates some form of deduction elsewhere.75 This rule is targeted at mismatch schemes and supplements the basic rule that the dividend exemption does not apply to distributions deductible outside the UK.

11.

THE UK AS A HOLDING COMPANY JURISDICTION: QAHCS

Since 2000, the UK has therefore created tax reliefs which enable it to compete credibly as a suitable jurisdiction for an international holding company, although there are extra factors to take into account, for example, the impact of UK accounting standards and the UK tax treatment of senior executives. The most recent development in this area is the Qualifying Asset Holding Company or ‘QAHC’ regime. The elective QAHC regime76 took effect from April 2022 and offers the UK investment fund industry a tax-efficient domestic investment holding company roughly equivalent to entities already available in Luxembourg and Ireland. A QAHC’s primary investors77 will typically be onshore and offshore institutional investors, for example, widely-held-and-marketed onshore and offshore collective investment schemes (which are often ‘tax transparent’), as well as other QAHCs. The QAHC, while technically liable to CT as a UK-resident, is in practice likely to be subject to very little UK tax, provided that it does not carry on significant ‘trading’ activity and is not a direct or indirect investor in UK real estate. It can claim the SSE and the dividend exemption. It enjoys additional reliefs from CT on income and gains in respect of sharehold-

Section 931J CTA 2009. Section 931W(1) CTA 2009. 74 Section 931Q CTA 2009. 75 Section 931N CTA 2009. 76 Schedule 2 Finance Act 2022 (‘FA 2022’). 77 So-called ‘Category A investors’, defined in paragraphs 8–11 Schedule 2 FA 2022. The QAHC is obliged to check that such investors predominate. 72 73

164  Research handbook on corporate taxation ings, gains in respect of non-UK real property78 plus an exemption79 from CT on income from non-UK real estate which has been taxed outside the UK. It does not enjoy a CT exemption in respect of debt instruments and derivatives. However, it may end up paying little CT in respect of such instruments to the extent that they are debt-funded. The UK rule denying deductions for the return on ‘results-dependent’ debt has been relaxed,80 as for UK ‘securitisation’ companies. QAHCs also enjoy a special exemption from UK withholding tax on interest.81 Subject to safeguards, they can redeem or repurchase their own shares without triggering a CT distribution and without incurring UK stamp duty.82 This is a very high-level summary of the QAHC regime which is still bedding in. The ownership pre-conditions for QAHCs are complex but are intended to ensure that the regime is targeted at institutional investors. It is not meant to facilitate use of the UK as a conduit jurisdiction for purely private investment. The requirement that QAHCs should not conduct significant ‘trading’ activity raises questions about their suitability for credit funds, especially those originating new loans. Lastly, there is the key question of treaty relief. While UK-resident and liable to CT, QAHCs are subject to a special elective tax regime designed in practice to minimise their UK tax liabilities. It remains to be seen how this is viewed by UK treaty partners, especially if a treaty contains a ‘principal purpose’ test along the lines of the 2017 OECD Model Treaty and the OECD Multilateral Instrument. It will be necessary to show that the QAHC has UK ‘substance’ (e.g., business premises and suitably qualified personnel) although this should be achievable given the scale of the UK investment fund industry. A lesser issue will be whether the QAHC ‘beneficially owns’ its income for treaty purposes, especially if it is heavily debt-funded (e.g., a QAHC controlled by a credit fund). The EU published in December 2021 a draft Directive restricting tax benefits to ‘shell’ companies lacking ‘substance’. While not directly relevant to QAHCs because of the UK’s departure from the EU, there is talk of a parallel EU initiative aimed at third-country entities. This could affect QAHCs, which cannot anyway claim the benefits of the EU Parent-Subsidiary and Interest and Royalties Directives.

12.

THE UK AS A HOLDING COMPANY JURISDICTION: ‘CONTROLLED FOREIGN COMPANY’ RULES

‘Controlled foreign company’ (‘CFC’) rules directly affect a jurisdiction’s viability as a holding company jurisdiction. The UK first adopted such rules in 1984, although they were greatly overhauled in 2012–13. The changes were intended to make the rules less invasive while protecting the CT base from ‘artificial erosion’. They were partly prompted by developments at EU level regarding the freedom of establishment. The UK’s departure from the EU has not led to the CFC rules becoming more restrictive.83 Paragraph 53 Schedule 2 FA 2022. Paragraph 52 Schedule 2 FA 2022. 80 Paragraph 44 Schedule 2 FA 2022. 81 Under a new section 888DA ITA. 82 Paragraphs 47 and 54 Schedule 2 FA 2022. 83 However, Pillar II may require UK-resident parent companies to operate the equivalent of a CFC rule (the ‘Income Inclusion Rule’) in relation to controlled entities which do not meet the minimum effective taxation requirements of Pillar II. 78 79

Corporate taxation in the UK  165 At EU level, ATAD requires some jurisdictions which did not have comprehensive CFC rules (notably, Ireland, Luxembourg and the Netherlands) to introduce such rules. This reduces any competitive advantage they may have enjoyed by not having such rules. The UK CFC rules still remain complex. A summary follows. A broad definition of ‘control’ applies.84 This will extend to situations not typically regarded as entailing ‘control’, for example, a significant (at least 40 per cent) stake in some non-UK-resident joint venture companies.85 The CFC rules only impose a charge on UK-resident companies with an economic stake of at least 25 per cent in the relevant CFC,86 although the entitlements of connected persons can be aggregated when deciding if this threshold is met. The CFC rules do not tax CFC profits which the UK would regard as chargeable gains.87 These can be taxed instead under a more narrowly targeted regime88 aimed at the chargeable gains of non-UK-resident ‘close’ companies. That regime too has been modified to reflect concerns about its compatibility with EU rules on the freedom of establishment and free movement of capital. Profits of a non-UK-resident company are only subject to a CFC charge if, applying UK CT standards, that company is paying an effective tax rate which is less than 75 per cent of what it would pay if UK-resident.89 This less-than-75-per cent threshold is relatively high. For example, the ATAD equivalent is just over 50 per cent. The non-UK ‘permanent establishment’ of a UK-resident company can elect to be exempt from CT. If it does so, a variant of the CFC rules applies to that ‘permanent establishment’ if it is taxed outside the UK at a low effective rate by UK standards.90 The CFC rules do not always apply to income from non-UK real estate.91 There is an exemption, with safeguards, for non-UK-resident companies with low profits or, in some cases, which earn a low profit margin.92 Unlike the previous UK CFC rules, there is no ‘motive’ exemption as such. The rules also contain a fairly long list of lowish-risk ‘excluded’ jurisdictions.93 A company solely tax-resident in one of these potentially falls outside the CFC rules. However, there are significant additional preconditions (notably regarding passive income) for this exclusion to apply. This is especially true of companies resident in those tax havens (e.g., Panama) on the list, which mainly comprises jurisdictions imposing significant levels of corporate income taxation. Ireland and Singapore are not on the list at all. Luxembourg is, with specific safeguards. Leaving these exemptions aside, the CFC rules are mainly targeted at profits where the existence of those profits in the alleged CFC is attributable to ‘significant people functions’

Sections 371RA–RG TIOPA. Section 371RC TIOPA. 86 Section 371BD TIOPA. 87 Section 371SA(3)(b) TIOPA. 88 Sections 3–3G TCGA. While narrower overall, this regime can also attribute gains to UK taxpayers who are not CT payers. 89 Section 371NB TIOPA. 90 Part 2 Chapter 3A CTA 2009. 91 Sections 371CA and 371VI TIOPA. 92 Part 9A Chapters 12 and 13 TIOPA. 93 Sections 371KA–KG TIOPA, coupled with the Controlled Foreign Companies (Excluded Territories) Regulations, SI 2012/3024. 84 85

166  Research handbook on corporate taxation in the UK which do not take the form of a taxable UK ‘permanent establishment’. This is a fact-sensitive assessment and largely depends on whether the non-UK-resident company has the facilities, resources and qualified personnel to operate on a ‘standalone’ basis. The ‘significant people function’ yardstick is largely derived from OECD thinking on attributing profits to a ‘permanent establishment’ when applying the OECD Model Treaty. The CFC rules exempt non-trading finance profits from ‘qualifying loan relationships’ (‘QLRs’) of certain group finance companies.94 QLRs are basically intra-group loans. Sometimes this exemption covers 100 per cent of those profits although more usually only 75 per cent.95 There are significant anti-avoidance restrictions. For obvious reasons, the exemption does not cover intra-group loans by the CFC to UK-taxpaying companies. Furthermore, the exemption has been narrowed, in line with ATAD, to prevent it applying where the relevant profits would otherwise relate to ‘significant people functions’ (e.g., credit appraisal) in the UK. There is ongoing EU litigation about whether this exemption contravenes EU rules outlawing unlawful ‘state aid’. This is only relevant to years before the UK left the EU and before the ATAD-inspired changes were made to the exemption. The UK has lost the first round of this litigation.96

13.

CORPORATION TAX ‘GROUPING’

Outside the area of VAT, the UK does not have a concept of consolidated tax filing. Each company is a separate taxpayer for CT purposes and must file its own self-assessment return, although there is procedural scope for a group to make and receive CT payments and repayments on an aggregate basis.97 However, the CT rules contain ‘grouping’ rules largely designed to replicate the effects of consolidated filing. These rules (unlike the VAT consolidation rules) apply automatically if the relevant conditions (notably, regarding affiliation) are met. The CT rules on ‘grouping’ contain two broad categories. The first are those relating to ‘group relief’. This enables98 affiliated UK-taxpaying companies to share losses and other reliefs, other than capital losses. Since 2017, there is scope for sharing some historic, as well as current-year losses. For two companies to form a group for ‘group relief’, one company must ‘beneficially’ own, directly or indirectly, at least 75 per cent of the ‘ordinary share capital’ of the other company.99 It must also meet economic tests to ensure that it is entitled to at least 75 per cent of the distributable profits and liquidation surplus which the other company could distribute to its shareholders and holders of certain hybrid (e.g., convertible) debt. Group relief may be restricted if, in particular, there are ‘arrangements’ under which ‘control’ of one of two otherwise-

Part 9A Chapter 9 TIOPA. Section 371ID TIOPA. 96 United Kingdom v European Commission, ITV plc v European Commission Joined cases T-363/19 and T-456/19 [2022] STC 1038. 97 Section 59F Taxes Management Act 1970: ‘group payment arrangements’. 98 Parts 5 and 5A CTA 2010. 99 Sections 151–2 CTA 2010. 94 95

Corporate taxation in the UK  167 grouped companies could shift, even if only in the future.100 The latter restrictions do not apply to certain commercial joint venture and share mortgage arrangements.101 The grouping tests will also be met for ‘group relief’ if two companies are each directly or indirectly owned by a third company which meets the above-mentioned share and economic ownership tests in relation to each of the first two companies. In other words, sister companies can be ‘grouped’. Furthermore, none of these companies need be UK-resident or UK-incorporated. However, reliefs can only be shared between those group members which have a UK tax presence. So a UK-resident group member can ‘surrender’ losses to another UK-resident group member. A non-UK-resident company which is subject to CT (e.g., because it trades via a UK ‘permanent establishment’) can ‘surrender’ its UK losses to another UK-taxpaying group member. However, this is denied where those losses are allowable against any person’s tax liability in another jurisdiction (e.g., in the company’s head office jurisdiction).102 The rules defining a CT group in relation to chargeable gains and losses are similar but less strict than for ‘group relief’. The economic ownership tests in particular only require 50+ per cent economic entitlement to distributable profits and liquidation surplus.103 The stability rules regarding ‘arrangements’ are inapplicable. Where UK-taxpaying companies are ‘grouped’ for chargeable gains purposes, assets can be moved between them on a tax-neutral basis.104 They can also share chargeable losses.105 There is scope for clawing back deferred chargeable gains on intra-group asset transfers where the transferee leaves the group within six years of the relevant intra-group transfer.106 However, there is an important override of that clawback107 if the SSE could apply on a disposal of shares in that transferee company when it leaves the group. The rules for grouping in relation to chargeable gains are largely mirrored in the special CT regimes for ‘loan relationships’, ’derivative contracts’ and ‘intangible fixed assets’.

Sections 154 and 156 CTA 2010. Sections 155A and 155B CTA 2010. 102 Section 107 CTA 2010. The limited rules allowing cross-border loss transfers from EU affiliates with no UK tax presence have been abolished with effect from October 2021. 103 Section 170 TCGA. 104 Section 171 TCGA. 105 Sections 171A–B TCGA. 106 Section 179 TCGA. 107 Section 179(3A)–(3H) TCGA. 100 101

11. Corporate taxation in Germany Joachim Englisch

I.

HISTORICAL ROOTS OF THE CONTEMPORARY CORPORATION TAX

As in many other European regions, the emergence of a corporation tax in Germany was a corollary to industrialization.1 Due to its political fragmentation at the beginning of the 19th century, Germany initially lagged behind the economic development in other European countries, but then increasingly caught up by the middle of the century, especially in the course of railroad construction. The required large investments were facilitated by the foundation of (or reorganization of existing businesses into) stock corporations. However, the income tax systems that had been introduced in the German territories in the wake of the Napoleonic Wars in the early 19th century initially did not tax the income of corporations as such, because only individuals qualified as taxpayers. Nor were corporate profits directly attributed to their shareholders as soon as they arose. Due to the principle that income was taxable only when the taxpayer could freely dispose of it, corporate profits were instead only taxable as dividend income upon their distribution. Even this proved difficult when investors did not reside within the territory where the corporation was established and operated its business. The personal income tax system was thus increasingly regarded as unfit for taxing income generated by and through corporations. Notwithstanding their exclusion from the taxation of income strictu sensu, corporations were liable to pay the more traditional ‘objective’ taxes on presumed income, that is, trade tax and property tax. These taxes did not have a personal scope of application and thus did not presuppose a special taxable person status; instead, they were levied in function of the presumed profitability associated with the use of certain factors of production in different sectors of the economy. However, the traditional factor-based taxes relied on the relative homogeneity of business models and profits in strictly regulated crafts. With economic liberalization and industrialization, they became outdated, because they did not adequately reflect the economic cycles and potential of the burgeoning large corporations. Moreover, these modern businesses routinely kept financial accounts and thus offered a more accurate basis for determining their profitability, so that it would have been feasible to tax them on the basis of actual rather than estimated profits. Against this background, Prussia was in 1857 the first German state to comprehensively accord taxpayer status to corporate entities, albeit only in the context of the trade tax and only for a short period. Stock corporations and similar companies were no longer taxed on the basis For a detailed analysis of the history of German corporation tax, see Rasenack, Die Theorie der Körperschaftsteuer, 1974, pp. 19 et seq.; Martini, Der persönliche Körperschaftsteuertatbestand, 2016, pp. 83 et seq.; Martini, Germany, in Gutmann (ed.), Corporate Income Tax Subjects, 2016, p. 279 (pp. 281 et seq.); Seer, Die Entwicklung der GmbH-Besteuerung, 2005, pp. 3 et seq.; Desens, Einführung zum KStG, in Herrmann/Heuer/Raupach, EStG/KStG (2/2020), paras. 2 et seq. 1

168

Corporate taxation in Germany  169 of outdated factor profitability estimates for trade tax purposes, but instead the taxable amount was more closely aligned with the actual ‘return of (shareholder) investment’. It was determined as the sum of balance sheet profits that were distributed to shareholders and interest payments made to them. No tax had to be paid for retained earnings. When the German Empire was founded in 1871, the competence for raising income taxes remained with the newly federated states. In 1878, the Kingdom of Saxony was the first state to integrate the corporation tax into the general – and progressive – income tax. Prussia followed in 1885, when corporations and other legal persons became separate income taxpayers; at the time, income tax was still a municipal tax in Prussia. When income tax was reformed in 1891 and became a state tax in Prussia, this approach was maintained but modified. The tax base was limited to distributed profits and certain other payouts to shareholders and thus effectively operated like a withholding tax on shareholder income. A notional interest deduction was introduced as an early attempt to mitigate economic double taxation. In 1906, a special regime for the new legal form of limited liability companies was added, so as to better reflect their predominant use by small entrepreneurs who were in control of the company. To this effect, LLCs were taxed on their entire accounting profits, irrespective of their distribution or retention, whereas the dividend income was typically tax-free. The Prussian approach of designating corporations as a special category of taxpayers in the (progressive) personal income tax eventually became a model for other states, albeit with significant variation regarding the personal scope, the tax base, and the corporate-shareholder integration. After World War I, the competence for the taxation of income was transferred to the federal level. In 1920, the federal corporation tax also became the first tax on corporate income that was enacted by way of a separate statute and no longer formed part of the personal income tax. It taxed the profits of corporations and similar entities comprehensively at a flat rate, and the legislator deliberately refrained from providing any relief for economic double taxation. This development also further cemented the dual nature of the German system of business taxation, where the tax treatment of pass-through businesses – mainly partnerships – as fiscally transparent entities essentially aligns with the taxation of sole traders, whereas corporations, other legal persons and similar entities are treated as separate taxpayers. In 1925 and 1934, the Corporation Tax Act saw some reforms which were primarily concerned with the qualification and the calculation of taxable income; the relevant changes are still manifest in the structure of the present-day corporation tax. In 1977 and 2001, the corporation tax system underwent fundamental changes regarding the corporate-shareholder integration, which are analyzed more in detail below at V.2.

II.

JUSTIFICATIONS OF THE CORPORATION TAX

When the federal corporation tax was enacted in 1920, and a classical system of unmitigated economic double taxation of corporate profits was established, the legislator relied on the benefit principle to justify the levy of an additional tax at the level of the corporation. In its view, the corporation tax effectively operated as a fee for the conferral of legal personality and the ensuing possibility of investors to avail themselves of several associated advantages. The

170  Research handbook on corporate taxation latter were specified as, inter alia, limited liability, perpetual existence, access to the capital market, and a delegated and professional management.2 This early attempt to justify a separate corporation tax has long been disputed, however, in academic discourse. It has meanwhile been overcome;3 the last influential German scholar who still defended the levy of corporation tax on grounds of the benefit principle was the late Klaus Tipke.4 Indeed, this justification is no longer invoked even by the very legislator itself. There are good reasons for its rejection. First, some of the advantages that were mentioned in 1920 are not (or not any more) reserved to corporations, such as the legal capacity to own assets.5 Others are of no significance for the majority of corporations, such as access to the capital market in case of limited liability companies as the nowadays most widespread category of corporation. Second, it is also questionable to what extent these advantages can be regarded as benefits that are ‘conferred’ upon corporations by the state. This applies all the more in the case of corporations that were established under the laws of a foreign country, which can also come within the ambit of corporation tax under the regimes for both resident and non-resident taxpayers (see below at IV.2). In any event, corporate profits can hardly be regarded, if at all, as an adequate reflection (only) of the benefits derived from a particular legal form. Finally, to the extent that the aforementioned advantages of the corporate form and legal personhood do materialize in higher profits, they would already give rise to a ‘compensating’ higher income tax burden even without the collection of a separate and additional tax. Instead of invoking the benefit principle, a more recent opinion argues that profitable corporations and similar entities have original, independent ability-to-pay due to their legal personhood.6 More specifically, the supporters of this position refer to the ability of legal persons to enter into contracts in their own name, to own property, and to sue and be sued in their own name. According to this ‘legalistic’ view, the commercial law treatment of corporations and other bodies corporate as entities with a separate sphere of property rights should be mirrored by a separate corporation tax system. This argument is therefore also relied on to justify a classical or semi-classical system. See Drucks, Der deutschen Nationalversammlung Band 341, Anlagen zu den stenographischen Berichten, 1920, p. 14; Hüttemann, Besteuerung von Unternehmen – Entwicklungen und Ausdifferenzierung, Steuer und Wirtschaft 2014, p. 58 (p. 63). 3 See Hennrichs, Dualismus der Unternehmensbesteuerung aus gesellschaftsrechtlicher und steuersystematischer Sicht, Steuer und Wirtschaft 2002, p. 201 (pp. 209 et seq.); Schön, Die Funktion des Unternehmenssteuerrechts im Einkommensteuerrecht, DStJG 37 (2014), p. 217 (p. 230); Desens, Einführung zum KStG, in Herrmann/Heuer/Raupach, EStG/KStG (2/2020), para. 34. 4 Tipke, Die Steuerrechtsordnung, vol. 2, 1st ed. 1993, pp.  1030 et seq.; Tipke, Die Steuerrechtsordnung, vol. 2, 2nd ed. 2003, p. 1195. 5 See, e.g., Schön, Die Funktion des Unternehmenssteuerrechts im Einkommensteuerrecht, DStJG 37 (2014), p. 217 (p. 230); Jachmann, Besteuerung von Unternehmen als Gleichheitsproblem, DStJG 23 (2000), p. 9 (pp. 16 et seq.). 6 See, in particular, Hennrichs, Dualismus der Unternehmensbesteuerung aus gesellschaftsrechtlicher und steuersystematischer Sicht, Steuer und Wirtschaft 2002, p. 201 (p. 205), with further references; Hennrichs, Besteuerung von Personengesellschaften – Transparenz- oder Trennungsprinzip?, Finanz-Rundschau 2010, p. 721 (p. 726); Birk, Das Leistungsfähigkeitsprinzip in der Unternehmenssteuerreform, Steuer und Wirtschaft 2000, p. 328 (p. 333); Gosch, Körperschaftsteuer, in Kube et al. (eds), Leitgedanken des Rechts, vol. II, 2013, § 178 paras. 1 et seq. With certain qualifications, see also Lang, Prinzipien und Systeme der Besteuerung von Einkommen, DStJG 24 (2001), p. 49 (pp. 58 et seq. and pp. 98 et seq.). For an extensive overview of the debate in the past century, see Hey, Harmonisierung der Unternehmensbesteuerung in Europa, 1997, pp. 245 et seq. 2

Corporate taxation in Germany  171 However, even though this view has a prominent supporter in the Federal Constitutional Court,7 it is hardly convincing.8 Both the historical development of the ability-to-pay principle and its foundation in constitutional principles characterize it as a principle that is inspired by the ideals of social equalization and social redistribution. All persons with sufficiently close ties (‘nexus’) to a particular jurisdiction should make a solidary contribution to its public finances in function of their personal economic capacity. However, solidarity can only be requested from fellow humans, not from legal constructs. As an expression of the requirement of social justice, the principle of solidarity is directed at a community of natural persons who form the relevant social fabric. Therefore, the ability-to-pay principle, too, can only be applied with respect to the differentiation of tax burdens between individual taxpayers. This corresponds with the public finance insight that tax burdens are ultimately always borne by households and not by firms, because only the former will experience a reduction in their utility and consumption as a consequence of taxation. Apart from these fundamental objections, the justification of a separate corporation tax with the existence of a separate sphere of property rights is also inconsistent with a view towards the duality in the German system of business taxation. Partnerships are treated as fiscally transparent pass-through entities that are not, in themselves, subject to income taxation, even though they, too, can own property, enter into contracts, and litigate, all in their own name. Their equivalent capacity in this regard is expressly stipulated in statutory law for commercial partnerships, and it has long been acknowledged in case law for civil law partnerships (the latter will formally be accorded this status in statutory law as of 2024). Unfortunately, this inconsistency has been entirely ignored by the Federal Constitutional Court in its reasoning in favor of a separate corporation tax. Another argument that is sometimes advanced in German literature in defense of a separate corporation tax points to the limitation of personal liability of the shareholders as justification for the levy of a separate corporation tax.9 However, this position has also been convincingly rejected by most scholars. While limited liability indeed justifies to deny the offsetting of company losses against positive personal income of shareholders, it offers no viable explanation for the establishment of a separate layer of taxation for corporate profits.10 By contrast, a growing group of legal scholars now adhere to the view that has become the predominant opinion in public finance already long ago, according to which the existence of a corporation tax is still – if at all – justified precisely on grounds of the pragmatic reasons that motivated its introduction into the German tax system more than 100 years ago.11 It primarily fulfills a complementary function to the personal income tax, which due to the realization principle cannot capture retained earnings that are not distributed to the shareholders. Moreover, at

See Bundesverfassungsgericht 21 June 2006, case 2 BvL 2/99, BVerfGE 116, 164–202. Likewise Palm, Juristische Person und Leistungsfähigkeitsprinzip, JuristenZeitung 2012, p. 297 (p. 302); Palm, Person im Ertragsteuerrecht, 2013, pp. 485 et seq. 9 See, e.g., Drüen, Rechtsformneutralität der Unternehmensbesteuerung als verfassungsrechtlicher Imperativ?, GmbHRundschau 2008, p. 393 (p. 398); Hüttemann, Die Besteuerung der Personenunternehmen und ihr Einfluss auf die Rechtsformwahl, DStJG 25 (2002), p. 123 (p. 140). 10 See P. Kirchhof, Die Gleichheit der Steuerschuldner vor dem Einkommensteuergesetz, in P. Kirchhof/Nieskens (eds), Festschrift für Wolfram Reiss, 2008, p. 359 (p. 372). 11 See, e.g., Seer, Die Entwicklung der GmbH-Besteuerung, 2005, pp. 40 et seq.; Schön, Die Personengesellschaft im Steuerrechtsvergleich, in Dötsch et al. (eds), Die Personengesellschaft im Steuerrecht, 2011, p. 139 (pp. 141 et seq.). 7 8

172  Research handbook on corporate taxation least in the case of large, listed corporations with constantly fluctuating ownership, the direct attribution of corporate profits to shareholders for taxation purposes would present formidable administrative challenges. From this perspective, the corporation tax does thus not derive its legitimacy from the idea of taxing an original ability-to-pay of the corporation itself. Instead, it should indirectly ensure that the individual (ultimate) shareholders make a timely and solidary contribution to the public finances also with respect to those company profits that are not yet at their personal disposal, because the profits have not – yet – been distributed as dividend income or realized indirectly as a capital gain. This timely taxation is furthermore necessary to establish a level playing field, that is, competitive neutrality, with other legal forms of market participation where profits are directly attributable to the entrepreneurial investor and therefore taxed immediately upon their accrual.12 In addition, in the modern globalized economy the treatment of corporations as taxpayers who create a ‘personal’ nexus for taxation rights does not only serve to tax profits at the right time but also in the right place, in the sense of a broadly understood source state principle. The domicile of the company is used pragmatically as a connecting factor for the taxation of corporate profits; it is therefore possible for the jurisdiction where the corporation has its place of management to also tax those proportions of corporate profits that will eventually accrue to non-resident investors. If one adheres to the pragmatic and indeed more convincing justification for the existence of a corporate income tax besides the personal income tax, economic double taxation of corporate profits is consequently to be regarded as a problematic element of the tax system, which should, in principle, be avoided through corporate-shareholder tax integration.

III.

CONSTITUTIONAL FRAMEWORK OF THE CORPORATION TAX

1.

Fiscal Federalism

Germany is a federally constituted state. Consequently, the constitution establishes a system of fiscal federalism with respect to the three dimensions of taxation powers: the competence to legislate on tax matters, the entitlement to the tax revenue, and the administrative powers with respect to the tax collection. Regarding corporation tax in particular, the revenue is equally divided between the federation (‘Bund’), on the one hand, and the 16 federated states (‘Länder’), on the other hand. The share of the states is distributed among them based on where the tax was collected. Subsequently, the corporation tax revenue is then included in a mechanism of so-called horizontal and vertical fiscal equalization, which aims primarily at reducing the gap between poorer and richer states. The power to enact corporation tax legislation falls under the rules of shared competences. This means that, theoretically, the states can legislate in the field of corporation tax as long as, and to the extent that, Federal Parliament (the ‘Bundestag’) has not made use of its preemptory legislative powers. However, in the reality of German fiscal federalism, the federal level

See Hey, in Tipke/Lang, Steuerrecht, 2021, para. 11.1.

12

Corporate taxation in Germany  173 makes extensive use of its legislative powers in the area of taxation, and this also applies to corporation income tax. The Federal Corporation Tax Act (CTA) constitutes an exhaustive statutory regime of corporation tax. This notwithstanding, the states are still involved in the process of legislation. Since the tax revenue is shared between them and the federation, the constitution prescribes their participation with veto powers through the Federal Council (‘Bundesrat’). This entity constitutes an assembly in which the governments of the 16 states are represented, with graduated and regressive weighting of their votes according to their respective population. An approval of the Federal Council reached by majority vote is necessary for any amendment of the CTA. In practice, this usually implies the need for a political ‘super-coalition’ for any corporation tax reform, because the federal government itself relies on a governing coalition in parliament since decades, and in addition at least some of the opposition parties typically form part of some state governments. This tends to favor small ‘repairs’ of the corporation tax system over its radical reform and explains why the latter kind of reforms have been rare in post-war history. By contrast, the administrative powers are predominantly allocated to the states. The corporation tax is assessed, collected and audited by tax offices as part of the state tax administration. The constitution grants the federal ministry of finance the right to intervene in individual cases, but in practice, it will do so only exceptionally. It is constitutionally disputed whether the federal ministry is also authorized to issue general guidance and tax circulars with binding effect for state tax authorities. In 1970, a pragmatic compromise was found, whereby the federal and the state finance ministries cooperate in the process of drafting federal decrees and circulars. They are issued only if endorsed by a majority of states, and will then be observed by all the state tax administrations. Moreover, certain centralized tasks such as, for example, the reduction or reimbursement of withholding taxes with respect to the income of non-resident corporations, will exceptionally be handled by a federal agency, the so-called Federal Central Tax Office (‘Bundeszentralamt für Steuern’). 2.

Fundamental Rights

The German Federal Constitutional Court is among the most active in Europe with respect to the protection of fundamental rights. In particular, its case law on the tax law implications of the equality principle, the protection of property, and other fundamental rights13 clearly stands out internationally and differs from the more restrained approach of constitutional courts in other jurisdictions such as the US Supreme Court. Specifically with respect to differentiations in the income tax burden, the German Constitutional Court used to routinely practice an intermediate or even strict standard of review for several decades since the 1980s.14 Admittedly, it has relaxed its scrutiny in some recent decisions and it now more often resorts to a mere rational basis review. Nevertheless, the substantiation of the criteria for its ‘sliding scale’ of

For an overview, see Englisch/Kube, Constitutional Requirements for Substantive Tax Law in the Federal Republic of Germany, 2 Review of International and European Economic Law (2023), accessible online at https://​www​.rieel​.com/​index​.php/​rieel/​issue/​view/​5 (last accessed on 30 March 2023); and regarding the case law of the 21st century, see also Waldhoff, Steuerrecht und Verfassungsrecht, Die Verwaltung 2008, p. 259, and Die Verwaltung 2015, p. 85. 14 See Eichberger, Der Gleichheitssatz im Steuerrecht, in Drüen/Hey/Mellinghoff (eds), 100 Jahre Steuerrechtsprechung in Deutschland, Festschrift für den Bundesfinanzhof, Band I, p. 501. 13

174  Research handbook on corporate taxation review is still an ongoing process, and they currently allow for a significant degree of flexibility and discretion of which the Court makes ample use in its jurisprudence on tax measures. Upon a closer look, however, the impact of this judicial activism is not felt alike in all areas of direct taxation. So far, less than 50 cases on corporation tax were heard and decided by the Constitutional Court since its inauguration, and only around ten of those decisions were considered to be of sufficient importance to be published in the official bulletin of the Court. This contrasts sharply with approximately 700 decisions concerning personal income taxation, well over 100 of which were published in the bulletin. Moreover, the Court has shown a clear tendency in the past to exercise a more lenient standard of review in the field of business taxation in general, including corporation tax. As a consequence, the Court has only very rarely held a provision of the CTA to be unconstitutional. There exists thus a certain divide between the Court’s actual judicial practice, on the one hand, and the relatively strong interest of German tax law scholars in the fundamental rights aspects of – and infringements of fundamental rights by – the corporation tax, on the other hand. The two most contentious aspects of the corporation tax from a fundamental rights perspective, which have received considerable attention in academic debate for many years, are the neutrality of taxation with respect to legal forms in the context of a dualistic system of business taxation, and corporate-shareholder tax integration. In German tax law academia, these topics are not merely dealt with from a tax policy perspective, but they are overwhelmingly considered to also have a constitutional law dimension, especially in the light of the equality principle. Fundamental rights concerns have also frequently been raised with regard to limitations in loss offsetting and the deduction of interest payments. The same applies to rules that govern the transition to a new system after one of the – relatively rare – fundamental corporation tax reforms, in particular with a view towards alleged retroactive effects of new legislation. It is worth mentioning that the German corporation tax system is to a certain extent also shaped and influenced by Union ‘constitutional’ law. The case law of the European Court of Justice (CJEU) on the implications of the free movement rights and the prohibition of state aid in the field of taxation, in particular, have left their marks on German corporation tax. However, these aspects will be dealt with more in-depth in a dedicated chapter of this book, and will therefore only occasionally be referred to in the following analysis of the German system.

IV.

OVERVIEW OF THE CONTEMPORARY CORPORATION TAX

1.

Role in the Tax System and Interaction with Other Taxes

The revenue from corporation tax is relatively volatile. Since 2008, when the rate was reduced to 15 percent, corporation tax revenue usually oscillates between 2.5 percent and 5 percent15 of total tax revenue.16 Even at peak times, this is one of the lowest figures among countries with 15 The only exception was the year 2009 in the aftermath of the financial crisis, when corporation tax revenues made up less than 2 percent of overall tax revenues. 16 The total tax revenue excludes social security contributions, which do not form part of the general budget.

Corporate taxation in Germany  175 a corporation tax system globally.17 Nevertheless, the corporation tax regularly still ranks fifth, occasionally fourth, in the German tax revenue hierarchy; behind the dominating personal income tax and value added tax, the municipal trade tax and usually also the energy tax. However, an isolated analysis only of corporation tax revenues would be inadequate, because it would ignore the municipal trade tax (‘Gewerbesteuer’) on the income of corporations. The trade tax is imposed on the income from trade or business generated by a fixed establishment in Germany, regardless of the legal form of the entrepreneur. The starting point for determining its taxable base are the taxable profits as assessed for income tax purposes. These profits are then subject to adjustments that broaden the base in certain regards, especially by partially reversing the deductibility of interest payments, and narrow it in others, especially in order to ensure strict territoriality of taxation. While the municipal trade tax is in great part or even fully creditable against the personal income tax of sole traders or pass-through partners since 2001, no such credit is available for incorporated businesses that are subject to corporation tax. Moreover, when the corporation tax rate was lowered to 15 percent in 2008, the possibility to deduct municipal trade tax liabilities as a business expense was also abolished. As a consequence, the municipal trade tax has effectively mutated into a second tax on (modified) corporate income. Its exact rate is set by the municipality where the business establishment is located. The minimum rate of 7 percent is rarely applied, and the unweighted average rate was 14 percent in 2021. For incorporated businesses, the municipal trade tax therefore normally amounts to roughly half of their total taxes on income, with a cumulated nominal tax burden of approximately 29 percent. The municipal trade tax is one of the root causes of the complexity of the German system of business taxation, even more so for partnerships than for corporations. Numerous initiatives have been launched politically to replace it by some other revenue source for municipalities, and several proposals have been developed to this effect by academics and think-tanks.18 However, to date, all attempts at reform have ultimately failed due to the resistance of municipal interest groups. Since 1995, the corporation tax liability is moreover increased by a so-called solidarity surcharge (‘Solidaritätszuschlag’). This special tax was officially introduced to finance infrastructure projects and transfers to the new East German states after reunification. Its taxable amount consists in the corporation tax liability, upon which a surcharge of 5.5 percent is applied. De facto, the corporation tax rate is thereby increased to 15.825 percent. However, the surcharge is levied as a separate tax, because its revenues accrue exclusively to the federal government and need not be shared with the 16 states. While originally also imposed on individuals as a surcharge to their personal income tax liability, it was partially abolished in this context as of 2021. However, the surcharge is still applied unchanged to incorporated 17 For a comparison, see OECD, Corporate Tax Statistics: Third Edition 2021 (accessible at https://​ www​.oecd​.org/​tax/​tax​-policy/​corporate​-tax​-statistics​-third​-edition​.pdf; last accessed 4 October 2022). 18 See Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung, Jahresgutachten 2000/01, paras. 374 et seq.; Lang et al., Kölner Entwurf eines Einkommensteuergesetzes, 2005, p. 45; Stiftung Marktwirtschaft, Bericht der Arbeitsgruppe Kommunalfinanzen, 2006, pp. 10 et seq.; Jachmann, Eine neue Qualität der kommunalen Steuerfinanzierung: Das Vier-Säulen-Modell der Kommission Steuergesetzbuch, Steuer und Wirtschaft 2006, p. 115; Knirsch/Niemann, Die Abschaffung der österreichischen Gewerbesteuer als Vorbild für eine Reform der kommunalen Steuern in Deutschland?, Steuer und Wirtschaft 2006, p. 278; P. Kirchhof, Das Bundessteuergesetzbuch in der Diskussion, 2013, p. 148.

176  Research handbook on corporate taxation businesses. Its continued collection raises serious constitutional concerns. The main reason for this is that a surcharge is constitutionally conceived as a tax to meet a defined and temporary increase in the financial needs of the federal government, and German reunification has by now occurred more than 30 years ago. Most scholars therefore assume that the surcharge has by now become unconstitutional.19 There is a case pending before the Constitutional Court20 and two more will soon be dealt with by the Federal Tax Court.21 Altogether, the accumulation of corporation income tax, solidarity surcharge and municipal trade tax implies a total nominal tax burden on corporate income of, on average, roughly 30 percent. This is meanwhile one of the highest rates globally, especially for an economy of the developed world.22 This notwithstanding, the share of taxes on corporate income in the overall tax revenue is still slightly below the OECD average. Since the corporation tax base is relatively broad, the most plausible explanation for this situation is that the majority of small and medium-sized enterprises (SMEs) in Germany are organized as fiscally transparent partnerships and their profits are thus not subject to corporation tax. The prevalence of family-owned businesses that constitute the German ‘Mittelstand’ also explains why discussions about the neutrality of legal form, and thus also the interaction between the personal income tax and the corporation tax, are the primary focus of scholarly contributions on fundamental issues of business taxation in Germany.23 2.

Personal Scope

The German CTA does not rely on an exhaustive enumeration of legal forms or organizations for the delimitation of its personal scope. Instead, Sec. 1 (1) CTA combines a non-exclusive list of legal forms with some more general descriptions of qualifying entities in order to determine those that will be subject to corporation tax. In general, organizations, which qualify as legal persons or bodies corporate under private, commercial or public law, will be covered. Other entities that do not fall within the ambit of Sec. 1 (1) CTA usually constitute pass-through partnerships or other fiscally transparent entities whose income is attributed directly to the persons who have an interest in them and who are subject to either personal or corporate income tax. First and foremost, Sec. 1 (1) CTA lists corporations as entities that are within the personal scope of the corporation tax, and explicitly mentions the most relevant German and European legal forms that fall in this category (inter alia, the Societas Europaea, companies limited by shares [‘Aktiengesellschaften’], and limited liability companies [‘Gesellschaften mit beschränkter Haftung’]). In addition, ‘other entities with legal person status under civil law’ are also subject to corporation tax, with special mention of registered cooperatives, mutual insur-

See, e.g., Hey, Steuerrecht zwischen Umverteilung und Standortpolitik, Deutsche Steuer-Zeitung 2017, p. 632 (p. 635); G. Kirchhof, Der geltende SolZ verletzt das GG, Der Betrieb 2021, p. 1039; Kube, Verfassungsrechtliche Problematik der fortgesetzten Erhebung des Solidaritätszuschlags, Deutsches Steuerrecht 2017, p. 1792 (pp. 1799 et seq.); Papier, Solidaritätszuschlag und Finanzverfassung, in Ismer et al. (eds), Territorialität und Personalität, 2019, p. 511 (pp. 513 et seq.). See also Kube, Typus, Widmung und Grenzen der Ergänzungsabgabe, Steuer und Wirtschaft 2022, p. 3. 20 Bundesverfassungsgericht, case 2 BvR 1505/20. 21 Bundesfinanzhof, cases IX R 15/20 and IX R 9/22. 22 Cf. OECD, Corporate Tax Statistics (supra note 17), p. 10. 23 For an extensive overview and references, see Hey, in Tipke/Lang, Steuerrecht, 2021, paras. 13.157 et seq. 19

Corporate taxation in Germany  177 ance companies and registered mutual pension funds. Moreover, Sec. 1 (1) CTA also features a fallback clause whereby any private law associations, foundations, trusts, statutory bodies and other special purpose asset groupings are also included in the personal scope of corporation tax to the extent that they are not treated as fiscally transparent, even if they have not been awarded legal person status. Notably, this also covers investment funds, which benefit from certain exemptions pursuant to the Investment Tax Act, however. Finally, any enterprise of a commercial nature that is operated by a public law entity with legal personhood also qualifies as corporation tax subject, so as to avoid distortions of competition between private and public law agents in the market. By contrast, general or limited commercial partnerships or civil law partnerships that do not have full legal person status are treated as pass-through entities. This applies regardless of whether the partners are individuals or bodies corporate, and also in cases where the partnership interests are publicly held by a multitude of investors. Scholars and practitioners have long argued that ‘public partnerships’ – usually set up as vehicles for closed-end funds – should be regarded as equivalent to ‘corporations’ and thus be subject to corporation tax. However, the Federal Tax Court has rejected this based on a narrow and literal interpretation of Sec. 1 (1) CTA.24 Since then, the focus of the academic debate has shifted to suggesting a legislative amendment to this effect.25 In practice, SMEs are often organized as limited partnerships where only one or more corporations assume the role of general partner, so as to combine the benefits of being treated as a pass-through entity for taxation purposes with a limitation in personal liability. This mix of legal forms results in the application of both tax regimes: fiscal transparency for the limited partners and application of the corporation tax at the level of the general partner(s). Moreover, as discussed below at VII, partnerships can opt to be treated as corporations for corporation tax purposes under certain conditions (‘check-the-box’). The above concepts of bodies corporate or other forms of entities that are subject to corporation tax do not distinguish between domestic, foreign and supra-national (European) legal forms. The latter, too, can therefore be classified as entities that are subject to German corporation tax provided that a taxable nexus exists (see below at IV.3). This is also evidenced by the explicit mention of the Societas Europaea. However, the classification of foreign entities can be less straightforward than in the case of the legal forms of German commercial or civil law, because Sec. 1 (1) CTA explicitly mentions the most common German legal forms that fall under the personal scope of the corporation tax. By contrast, foreign entities must be classified as ‘corporations’ or other legal persons or equivalent asset groupings based on the general characteristics of such entities, which are, however, not elaborated upon any further in the statutory provisions. To this effect, the jurisprudence of the pre-war Supreme Tax Court (‘Reichsfinanzhof’) developed a refined corporate resemblance method (so-called ‘Typenvergleich’) in 1930,26 See Bundesfinanzhof 25 June 1984, case GrS 4/82, BStBl. II 1984, 751. See Schulze-Osterloh, Der Beschluß des Großen Senats des Bundesfinanzhofs GrS 4/82 vom 25. Juni 1984, Jahrbuch der Fachanwälte für Steuerrecht 1985/1986, p.  231; Hey, Unternehmenssteuerreform: Integration von Personenunternehmen in die niedrige Besteuerung thesaurierter Gewinne, in P. Kirchhof et al. (eds), Festschrift für Arndt Raupach, 2006, p. 479 (pp. 492 et seq.); Hennrichs, Besteuerung von Personengesellschaften – Transparenz- oder Trennungsprinzip, Finanz-Rundschau 2010, p. 721 (p. 729). 26 Reichsfinanzhof 12 February 1930, case VI A 899/27, ‘Venezuela’, RFHE 27, 73. 24 25

178  Research handbook on corporate taxation which was subsequently endorsed by German scholarship and is applied until the present day. Under this approach, key characteristics of the foreign entity are assessed based on its civil or commercial law configuration. The main criteria are management structure, investor rights, liability regime, minimum capital or capital maintenance rules, profit distribution rules, registration requirements, transferability of shares, and (un-)limited existence.27 Based on a holistic analysis, it is then decided whether this legal form has more in common with a German corporation or other body corporate, or more with a partnership that is treated as fiscally transparent under German income tax legislation. The entity is then classified accordingly for the purpose of German income taxation. This outcome need not be symmetrical to the classification of the entity under its home state tax law. As a consequence, eventual options that have been exercised under foreign check-the-box rules, as they may exist in, for example, United States income tax law are also irrelevant for the analysis. If the company statutes are dispositive under the relevant foreign company law, the assessment must be based on the concrete choices made in the articles of association of the individual company.28 Moreover, the foreign company law rules that confer a corporation status have no longer any bearing on the assessment if the relevant entity transfers its place of management to Germany and thereby loses the status and qualities of a body corporate, either due to foreign company law or under the ‘real seat theory’ that Germany still applies vis-à-vis third countries that are not EU Member States. In this case, the company will be treated as a partnership also for income tax purposes. Finally, several details of the corporate resemblance method are still disputed.29 3.

Territorial Scope

Regarding the territorial scope of the corporation tax, Sec. 1 (2) CTA establishes an ‘unlimited’, that is, worldwide, tax system for entities that have either their statutory seat or their place of management in Germany. The notion of ‘place of management’ is further defined in the General Tax Code (‘Abgabenordnung’). Aside from minor deviations, the domestic law concept is aligned with the corresponding international tax law concept laid down in Article 4 (1) of the OECD Model Convention.30 The concept of worldwide taxation implies that not only domestic-source income, but also any foreign-earned income is included in the domestic tax base. This stands in marked difference to the municipal trade tax, which adheres to a strict concept of territoriality. For most categories of foreign-source income, an (ordinary) foreign tax credit with per-country limitation is unilaterally granted. However, the principle of worldwide taxation is significantly reduced in scope through Germany’s wide network of approximately 90 double taxation conventions. Germany’s tax treaty policy is characterized by a preference for the exemption method with respect to profits that are attributable to a foreign permanent establishment. Moreover, since Germany does See Bundesfinanzhof 20 August 2008, case I R 34/08, BStBl. II 2009, 263, paras. 20 et seq. See, e.g., Bundesfinanzhof 18 May 2021, case I R 12/18, BStBl. II 2021, 875, para. 13; Schnittker, Steuersubjektqualifikation ausländischer hybrider Rechtsgebilde, Steuer und Wirtschaft 2004, p. 39 (pp. 41–2). 29 For a comprehensive analysis, see Martini, Der persönliche Körperschaftsteuertatbestand, 2016, pp. 130 et seq. 30 For a detailed analysis, see Englisch, German Corporate Residence, in Maisto (ed.), Residence of Companies under Tax Treaties and EC Law, 2009, pp. 461 et seq. 27 28

Corporate taxation in Germany  179 not operate a system of unitary taxation, the profits of foreign subsidiaries will only become subject to German corporation tax once they are distributed to a resident corporation (and they are then usually exempt from tax, see below at V.2.b). An exception applies where the foreign subsidiaries come within the scope of the German controlled foreign company (CFC) regime. Pursuant to Sec. 2 CTA, non-resident corporations and other organizations that fall under the personal scope of Sec. 1 (1) CTA are subject to taxation with respect to any domestic income that they might have. The nexus required for profits to qualify as domestic-sourced income is aligned with the corresponding provisions of the Personal Income Tax Act. The relevant connecting factors broadly correspond to the nexus criteria of the OECD Model Convention, but they also go beyond it in a few aspects. 4.

Taxable Income and Loss Treatment

The tax base of the corporation tax is the taxable income earned by the taxpayer in the taxable period, that is, in the relevant calendar year. The key determinants of taxable income are not specified any further in the CTA. Instead, Sec. 8 (1) CTA refers to the rules on income determination laid down in the Personal Income Tax Act. For resident taxpayers, Sec. 8 (2) CTA furthermore stipulates that all their income is treated as income from trade or business. In their case, as well as in case of all non-resident taxpayers with actual business income, taxable income is therefore determined on an accrual basis. The relevant tax accounting standards are laid down in the Personal Income Tax Act and refer to the financial accounting standards as the starting point for the computation of the taxable profit or loss (‘Maßgeblichkeitsprinzip’). However, several adjustments for taxation purposes are then required. Profit distributions do not reduce taxable income, as specified in Sec. 8 (3) CTA. In line with the above-mentioned general approach, the treatment of losses is also laid down in the Personal Income Tax Act. If the taxpayer has suffered a loss in the taxable period, a loss carry back that allows the taxpayer to claim a refundable tax offset is available. Traditionally, the carry back was limited to EUR 1 million and to the immediately preceding taxable period. In the course of the Covid-19 pandemic, more generous rules have gradually been introduced to improve business cash flow. The legislator has first increased the amount of the loss carry back to EUR 10 million, and it has then expanded the time limit so as to permit loss offsetting with any profits earned in the two preceding taxable periods. As of 2024, the amount of loss carry back will be reduced again to EUR 1 million, but the two-year period will be maintained. Any losses that cannot be (fully) offset by the loss carry back will be carried forward to use in a later income year; the same applies to the extent that the taxpayer opts out of the loss carry back. The loss carry forward is unlimited in time. However, a minimum taxation regime applies, whereby full loss offsetting is only possible against profits of up to EUR 1 million. Beyond that, only 60 percent of current year profits will be reduced by losses from past taxable periods. This is particularly problematic in sectors of the economy with long and volatile business cycles (e.g. the shipyard industry), for special purpose vehicles that will be wound down after the finalization of the respective project (e.g. in the construction sector) or for corporations which are in a process of reorganization after a crisis. It is highly disputed whether the aforementioned minimum tax regime is compatible with constitutional requirements, or whether it constitutes an infringement of the equality principle and other fundamental rights. Opinions are divided on whether the minimum tax rules are

180  Research handbook on corporate taxation constitutional where they ‘merely’ result in a prolongation of the loss offsetting period.31 By contrast, where the limitation in the amount of losses implies that losses that could otherwise have been offset will be definitely forfeited, the overwhelming majority of scholars consider this effect unconstitutional and argue that an exception should be included in the legislation.32 This view is also shared by the Federal Tax Court, which has asked the Constitutional Court to declare the minimum tax regime inapplicable in those situations.33 The latter case is still pending before the Constitutional Court.34 Against this background, but also to enhance economic growth, proposals have been made to phase out the minimum tax limitations of the loss carry forward.35 It has also been suggested to instead address the issue of a build-up of huge loss carry forwards by a time limit for the loss carry forward period.36 However, so far none of those proposals has won political approval. The German CTA used to feature a special anti-avoidance rule that targeted corporate shell purchases since 1990, after the Federal Tax Court had backtracked from its earlier jurisprudence on this matter.37 Under the former Sec. 8 (4) CTA, unused losses and loss carry forwards could no longer offset if the corporation changed its ‘economic identity’ due to a change of shareholders. This was assumed to be the case if more than 50 percent (initially 75 percent) of the shares in the company changed ownership and if the company subsequently continued or resumed its business operations with predominantly new operating assets. Under certain conditions, an exception applied to reorganizations. With effect from 2008, this regime was replaced by the currently still applicable rule of Sec. 8c CTA. Pursuant to this provision, unused losses or loss carry forwards are excluded from offsetting with future profits if shares that represent more than 50 percent of the company’s capital or voting rights are transferred In favor of constitutionality are, e.g., Wendt, Prinzipien der Verlustberücksichtigung, DStJG 28 (2005), p. 41 (p. 75); Seiler, Prinzipien der Einkünfteermittlung – Objektives Nettoprinzip, DStJG 34 (2011), p. 61 (p. 82); Desens, Der Verlust von Verlustvorträgen nach der Mindestbesteuerung, Finanz-Rundschau 2011, p. 745 (pp. 748 et seq.); Drüen, Verfassungsrechtliche Positionen zur Mindestbesteuerung, Finanz-Rundschau 2013, p. 393 (pp. 398 et seq.); Heuermann, System- und Prinzipienfragen beim Verlustabzug, Finanz-Rundschau 2012, p. 435. Unconstitutionality is assumed by, e.g., Lang/Englisch, Zur Verfassungswidrigkeit der neuen Mindestbesteuerung, Steuer und Wirtschaft 2005, p. 3; Bareis, Ist die Mindestbesteuerung verfassungsgemäß?, Der Betrieb 2013, p. 144; Hey, Perspektiven der Unternehmensbesteuerung, Steuer und Wirtschaft 2011, p. 131 (pp. 140 et seq.); Röder, Zur Verfassungswidrigkeit der Mindestbesteuerung (§ 10d Abs. 2 EStG) und der Beschränkung des Verlustabzugs nach § 8c KStG, Steuer und Wirtschaft 2012, p. 18 (pp. 21 et seq.). 32 See, e.g., Raupach, Mindestbesteuerung im Einkommen- und Körperschaftsteuerrecht, in Lehner (ed.), Verluste im nationalen und internationalen Steuerrecht, 2004, p. 53 (p. 61); Weber-Grellet, Mindestbesteuerung/Verlustverrechnung, Die Steuerberatung 2004, p. 75 (p. 82); Lang/Englisch, Zur Verfassungswidrigkeit der neuen Mindestbesteuerung, Steuer und Wirtschaft 2005, p. 3 (pp. 5 et seq. and p. 24); Watrin/Wittkowski/Ullmann, Deutsche Mindestbesteuerung und ihre Belastungswirkung im europäischen Vergleich, Steuer und Wirtschaft 2008, p. 238 (pp. 239 et seq.); Wendt, Prinzipien der Verlustberücksichtigung, DStJG 28 (2005), p. 41 (pp. 76 et seq.). 33 See Bundesfinanzhof 26 February 2014, case I R 59/12, BStBl. II 2014, 1016. 34 See Bundesverfassungsgericht, case 2 BvL 19/14. 35 See, e.g., Dorenkamp, Für einen haushaltsverträglichen Einstieg in den Ausstieg aus der Mindestbesteuerung und gegen eine ‘Verfristung’ von Verlustvorträgen, Finanz-Rundschau 2011, p. 733 (pp. 737 et seq.). 36 See, e.g., Möhlenbrock, Perspektiven der Verlustnutzung bei Körperschaften und deren Anteilseignern, Die Unternehmensbesteuerung 2010, p. 256. 37 See Gosch, Körperschaftsteuer, in Kube et al. (eds), Leitgedanken des Rechts, vol. II, 2013, § 178 para. 11. 31

Corporate taxation in Germany  181 to a single acquirer within a five-year period. The same applies in case of multiple transferees if they are related persons or a group of acquirers with converging interests. Originally, the rule also prescribed a partial discontinuation of loss carry forward in case of a share transfer between 25 percent and 50 percent, but this additional provision was struck down by the Constitutional Court.38 While initially no exceptions were foreseen in Sec. 8c CTA, they have successively been introduced by the legislator after the rule was widely criticized for an overreach that could not be sufficiently justified by tax avoidance concerns. Exceptions apply, in particular, in case of certain reorganizations within group structures characterized by an absence of minority shareholders, and reorganizations with the objective to overcome a crisis if certain preconditions are met. Moreover, losses will not be affected by the rule to the extent that they are matched by ‘hidden reserves’, that is, unrealized gains, at the level of the corporation. Finally, a corporation can claim the continued offsetting of the loss carry forward if it has carried on essentially the same business operations in the three calendar years prior to the transfer of the shares and ever since. Nevertheless, many scholars assume that the provision is still unconstitutional.39 Certainly, at least from a tax policy perspective, it should be reformed and reduced to a sufficiently targeted anti-avoidance provision.

V.

CORPORATE/SHAREHOLDER RELATIONSHIP

1.

Separate Entity Principle

A fundamental difference between pass-through entities and entities that are subject to corporation tax is that only the latter category of entities are treated as separate taxpayers, meaning that different layers of taxation apply to them and to their shareholders. This separate entity principle has several important implications.40 First, it constitutes a guiding principle of corporation tax that informs the constitutional equality principle with its requirement to implement fundamental tax principles consistently. In a similar vein, it determines whether a tax benefit constitutes an advantageous ‘derogation’ from the general tax system and therefore potentially constitutes state aid that is, in principle, prohibited by Union law.41 Second, civil law transactions between shareholders and the corporation will, in general, be recognized also for tax purposes. If the shareholder lends capital or assets to the corporation for consideration, the corresponding expenses will reduce the taxable profits of the corporation. Conversely, the shareholder earns income that is classified according to general princi See Bundesverfassungsgericht 29 March 2017, case 2 BvL 6/11, BVerfGE 145, 106. See, e.g., Drüen, Systemfortschritte im Unternehmenssteuerrecht durch das Wachstumsbeschleunigungsgesetz?, Die Unternehmensbesteuerung 2010, p. 543 (pp. 548 et seq.); Hey, Besteuerung von Unternehmen und Individualsteuerprinzip, in Schön/Osterloh-Konrad (eds), Kernfragen des Unternehmenssteuerrechts, 2010, p. 1 (pp. 17 et seq.). 40 For a comprehensive analysis, see Dorenkamp, Bedeutung des Trennungsprinzips bei der Auslegung des KStG, in Drüen/Hey/Mellinghoff (eds), 100 Jahre Steuerrechtsprechung in Deutschland, Festschrift für den Bundesfinanzhof, Band II, 2018, pp. 1349 et seq. See also Böhmer, Das Trennungsprinzip im Körperschaftsteuerrecht – Grundsatz ohne Zukunft?, Steuer und Wirtschaft 2012, 33. 41 See, in the latter regard, CJEU 28 June 2018, case C-203/16 P, Andres, ECLI:EU:C:2018:505. 38 39

182  Research handbook on corporate taxation ples, for example, as capital income or rental income in the case of individual shareholders. Likewise, employment contracts as managing director, as well as trade transactions between the corporate entity and its shareholders, are also recognized for tax purposes. This means the relevant amounts will generally not be subject to municipal trade tax, neither at entity nor at shareholder level. Moreover, any assets leased out by the shareholder to the corporation remain private assets unless they form part of a business or trade of the shareholder himself. This matters not only for trade tax purposes, but also entails a more favorable tax treatment of capital gains. By contrast, in the case of pass-through entities, all income of the partners derived from transactions with the partnership is classified according to the income classification that applies to the partnership profits (typically, income from trade or business that will be added back to the partnership’s profits for trade tax purposes), any eventual cash-flow effects ensuing from a divergence in the realization of the partnership expenses and the income of the partners (e.g. in case of pension plans for managing partners) are neutralized, and all assets used by a partner in the interest of the partnership become business assets. As a corollary to the beneficial effects of the general recognition of transactions between the corporation and its shareholders for income tax purposes, there is a need for arm’s length control of those transactions. This will be discussed more in-depth below at V.3. Third, profits earned by a corporation or by other entities subject to corporation tax are normally taxable only at entity level as long as they constitute retained earnings. They become taxable at shareholder level only upon distribution as dividends, or indirectly if the shareholder sells shares and realizes a capital gain. Conversely, any eventual losses that have been incurred by a body corporate cannot be offset against positive income of the shareholders. They might only reduce the income of shareholders indirectly, if they materialize as a capital loss when shares are sold, or if they give rise to a partial write-down or even write-off of the shares. However, under the current corporation tax system even these loss realization possibilities have been significantly curtailed, as explained in the next section. Once more, the tax treatment is thus in stark contrast to the tax regime applicable to fiscally transparent partnerships with its direct profit and loss attribution. Furthermore, the existence of two separate layers of taxation for corporate profits raises the perennial issue of all corporation tax systems, that is, whether – and if so how – to integrate the taxation of distributed company profits at entity and shareholder level. The German system has varied between several different approaches since the inception of the corporation tax more than 100 years ago; they are discussed in the next section. 2.

Corporate-Shareholder Tax Integration

a) Historical developments When the federal corporation income tax was introduced in 1920, it followed the ‘classical’ concept of economic double taxation of distributed profits in case of individual shareholders. This was deemed acceptable due to the relatively low level of 10 percent corporation tax, and in view of the presumed economic benefits of incorporation.42 However, already then a participation exemption applied for strategic corporate shareholders (with shareholdings of – initially – at least 20 percent) to avoid cascading of corporation tax in multi-tiered group structures. By

42

See Seer, Die Entwicklung der GmbH-Besteuerung, 2005, p. 44. See also above at II.

Corporate taxation in Germany  183 1925, the corporation tax rate had risen to 20 percent, and the legislator created an exception for low-income shareholders of limited liability companies through a special regime of partial shareholder relief for dividend income. Moreover, small LLCs benefitted from taper relief in their corporation tax burden. The measure was defended on grounds of the economic proximity of these companies to small partnerships and sole traders.43 When the Nazi government rose to power, it agitated against ‘anonymous capital,’ and since 1934 it successively increased the corporation tax rate to 55 percent, without any corresponding shareholder relief for individuals and portfolio investors.44 After the war, the Allied Control Council imposed a graduated corporation tax tariff with a top rate of 65 percent, still with unabated economic double taxation of dividend income apart from the participation exemption for inter-company dividends. The first German post-war government initially maintained this classical corporation tax system and merely replaced the graduated tariff with a uniform rate of first 50 percent, then 60 percent. However, in 1953, the government acknowledged that this system was detrimental to the development of capital markets, and introduced a split corporation tax rate. Henceforth, the 60 percent rate applied only to retained earnings, whereas distributed profits benefitted from a lower rate of 30 percent.45 This system was continued until 1977, with only some variations in the applicable rates. The latter were eventually dropped to 45 percent and 15 percent, respectively, for capital market oriented companies, whereas special and – at least in case of profit distributions – higher rates applied to small and closely held corporations. The year 1977 saw a fundamental reform of the corporation tax system. The classical system with split rate relief was replaced by an imputation system, although the split rate concept was maintained. The corporation tax rate for retained earnings was aligned with the top rate of personal income tax, at the time 56 percent. A complex system of accounts and adjustments ensured that all dividends – including those paid from foreign-sourced profits that had not been subject to the German 56 percent rate – and all other capital distributions to shareholders were subject to a corporation tax burden of 36 percent. This was the prerequisite for the corresponding income tax credit or refund that was granted to all categories of resident shareholders upon the receipt of such distributions. At the same time, the taxable dividend income of the shareholder was increased by the amount of the credit, so as to guarantee the single taxation of the full amount of distributed profits at the applicable rate of the individual shareholder. This imputation system applied also to corporate shareholders; consequently, the participation exemption was discontinued. International tax competition eventually forced the legislator to sever the link of the corporation tax rate on retained earnings to the top income tax rate. By 1999, this rate was successively reduced to 40 percent, whereas the rate applicable to profit distributions was decreased only moderately to 30 percent. De facto, small and closely held corporations could further reduce the corporation tax on reinvested profits if the individual shareholders had lower (average) personal income tax rates, by distributing profits under the condition that they were returned to the company as equity or debt capital; the tax authorities accepted this kind of tax planning.

For a detailed analysis, see Schmidt, Die GmbH in der Steuerpolitik, 1934, pp. 33 et seq. See Rasenack, Die Theorie der Körperschaftsteuer, 1974, p. 127. 45 See Rasenack, Die Theorie der Körperschaftsteuer, 1974, pp. 168 et seq.

43 44

184  Research handbook on corporate taxation The main motivation for the reform of 1977 had been to improve the neutrality of taxation.46 Moreover, the legislator sought to end a perceived preferential treatment of non-resident shareholders, who were typically subject only to moderate final withholding taxes on their dividend income rather than a full additional layer of personal income taxation. The tax treaty limitations on the taxation of dividend income received by non-resident shareholders were also the reason why they were excluded from the aforementioned tax integration system. This, in turn, explains the continuation of the reduced rate for profit distributions, which offered a certain, albeit limited, degree of relief from economic double taxation for this shareholder category. In practice, however, some non-resident shareholders, and institutional investors in particular, could circumvent the limitations in the personal scope of the tax integration regime through elaborate dividend stripping schemes. After it had been in operation for almost 25 years, the imputation system was abandoned in the year 2001 in favor of the current system, which features a less accurate dividend relief. The main, even though not the only, reason for this change was the emerging jurisprudence of the European Court of Justice (CJEU) on supposedly discriminatory features of integration systems such as the German one.47 First and foremost, it could be inferred from some judgments of the Court – and it was indeed subsequently confirmed by what is now settled case law48 – that the CJEU interpreted the free movement rights enshrined in the European Treaties as requiring to treat foreign tax as equivalent to domestic tax for the purposes of the corporation tax credit that could be claimed by resident shareholders.49 This misguided jurisprudence has indeed led to the demise of integration systems within the entire EU,50 because no Member State was willing to fully credit or even refund foreign corporation tax. Second, it had equally transpired from CJEU case law that the free movement rights were also infringed by the exclusion of non-resident shareholders from the personal scope of the integration system. Besides the EU law issues, the German government also felt that the operation of the integration system was too complicated in practice, and that dividend stripping had become too much of a problem. b) The current shareholder relief system The current shareholder relief system was originally a legal transplant from Austria. It combines a uniform low corporation tax rate with a partial exemption of dividends for personal income tax purposes and a participation exemption for corporate shareholders. The corporation tax rate was set at a uniform 25 percent, regardless of whether the profits were retained or distributed. The reduced rate was as much a concession to international tax competition as an integral element of a semi-classical system where the corporation tax burden becomes final and is no longer neutralized for shareholders with a lower personal income tax rate. Instead, 46 See Bundesregierung, Entwurf eines Dritten Steuerreformgesetzes, BT-Drs. 7/1470, pp. 326 et seq., also regarding the following statements. 47 The explanatory memorandum for the reform proposal can be found in BT-Drs. 14/2683, pp. 94 et seq. and pp. 132 et seq. 48 See CJEU, 7 September 2004, case C-319/02, Manninen, ECLI:EU:C:2004:484; 6 March 2007, case C-292/04, Meilicke, ECLI:EU:C:2007:132. 49 For a critical analysis of this development, see Englisch, Dividendenbesteuerung, 2005, pp. 317 et seq. 50 See also Ordower, Tax Neutrality between CIT and Non-CIT Subjects: How to Improve Our Systems?, in Gutmann (ed.), Corporate Income Tax Subjects, 2015, p. 147 (pp. 151–152).

Corporate taxation in Germany  185 the system of shareholder relief initially provided for an exemption of 50 percent of the dividend income in case of shareholders who are subject to personal income taxation. At the same time, only half of the expenditure related to the shareholding (esp. interest and portfolio management expenses) could still be deducted from the tax base. This so-called ‘half-income method’ applied indiscriminately to both domestic and foreign-sourced dividends. It was furthermore extended to the taxation of capital gains and losses. They, too, benefitted from a 50 percent exemption, with a corresponding limitation in the deductibility of the costs of disposal. In 2008/09, the system underwent some changes in the wake of a general reform of the taxation of income from privately held financial assets, especially dividend and interest income. The new regime of dividend taxation now distinguishes between shareholdings that constitute business assets and other shareholdings. Only the former still benefit from a partial exemption of dividend income. Since the corporation tax rate was further lowered to 15 percent in 2008, this exemption has now been limited to 40 percent of the dividend income, however (‘partial income method’). By contrast, dividends on privately held shareholdings are normally subject to a final withholding tax of 25 percent that applies to all ‘income from capital assets’. This income is taxed on a gross basis. Taxpayers can opt for the inclusion of the dividend income in their regular tax base if this leads to a lower overall personal income tax burden, but a deduction of related expenses will still be denied. In principle, this dual system has been extended also to capital gains from the sale or disposal of shares. By way of exception, shareholders with private shareholdings can opt for the ‘partial income method’ of dividend taxation if their percentage of shareholding and/or their entrepreneurial activity meets certain threshold criteria, and the same applies automatically with respect to capital gains taxation for shareholdings of at least 1 percent. It is clear that this ‘semi-classical’ system does not prevent economic double taxation as exactly as the previous integration system. The 15 percent corporation tax burden is neutralized through the ‘partial income’ system only for shareholders with a marginal personal income tax rate of roughly 30 percent; in case of privately held assets, this percentage rises to approximately 36 percent. Shareholders with a higher applicable rate, respectively, benefit from over-compensation, whereas those with a lower personal rate still experience partial economic double taxation. Shareholders who hold their shares as private assets and whose marginal rate is below 25 percent even experience the same economic double taxation as in a classical system without any shareholder relief. Moreover, if one also takes into consideration that corporate profits have typically been subject not only to corporation tax but also to trade tax before distribution, the combined tax burden on dividend income (and, potentially, on capital gains) is always significantly above the personal income tax rate for other categories of income. Admittedly, the previous integration system also ignored the trade tax burden; however, while it was in force, no relief for trade tax was available regardless of the legal form that the business was run in. Since 2001, trade tax has become mostly or even fully creditable for the partners of pass-through entities and for sole traders, so that it now only constitutes an effective additional burden for corporations and similar entities and, indirectly, for their shareholders. Overall, the new system has essentially satisfied the requirements of Union law compatibility of dividend taxation – as established by the case law of the CJEU – but only at the cost of significant distortions. It is less neutral with respect to the tax implications of the choice of legal form, and it increased the pre-existing debt-equity bias of the corporation tax system. Moreover, its concrete design raises several serious constitutional issues. This concerns, in

186  Research handbook on corporate taxation particular, the partial or even full deduction barrier for dividend-related expenditure, the difference in tax treatment between shareholdings held as business assets and those held as private assets, and the severe limitations on loss offsetting under the relevant capital gains regime for privately held shares. The aforementioned features have accordingly been frequently criticized in academic literature.51 Based on its position that the elimination of economic double taxation is at the discretion of the legislator, the Constitutional Court has, however, held most of the constitutionally problematic aspects to be acceptable;52 a case on the limitations of loss offsetting is still pending.53 Regarding corporate shareholdings, the participation exemption that had preceded the abolished integration method has been reinstated in the current system in Sec. 8b CTA for both inter-company dividends and capital gains. It also does not matter in this regard whether the participation is held in a resident or in a non-resident entity. However, de facto only 95 percent of the amount of dividend or capital gain is exempt, because under a deeming provision, 5 percent will be treated as related and non-deductible expenditure. Moreover, as a corollary to the participation exemption, losses from the disposal of shares or write-downs of shares will not reduce the taxable profits of the affected corporation. In 2014, an anti-hybrid provision was added so as to avoid situations of double non-inclusion of distributed profits. Initially, no participation thresholds were foreseen in the context of the corporation tax, and a mere 10 percent threshold for the inter-company dividend exemption applied for the purposes of the municipal trade tax. However, non-resident shareholders receiving inter-company dividends were subject to final withholding taxes and were thus excluded from the scope of the exemptions, unless they came within the ambit of the EU Parent-Subsidiary-Directive or could avail themselves of a tax treaty participation exemption. When the CJEU qualified this detrimental treatment as unjustified discrimination,54 the legislator was not willing to forego the corporation tax revenue on outbound dividend payments. Therefore, a general 10 percent threshold was introduced into the corporation tax exemption regime, that is, corporation tax cascading is not prevented any more in case of portfolio investments. Previously, the trade tax threshold had already been raised to 15 percent for fiscal reasons alone.55 The current regime is thus characterized by inconsistencies in the removal of economic double taxation of inter-company dividends, inconsistencies between corporation tax and trade tax, and also inconsistencies between dividends, on the one hand, and capital gains, where still no thresholds apply for the exemption, on the other. When a corporation is wound up and liquidated, any distributions to the shareholders above the attributable share in capital contributions are treated as a dividend for personal income

51 See, e.g., Englisch, Verfassungsrechtliche und steuersystematische Kritik der Abgeltungsteuer, Steuer und Wirtschaft 2007, p. 221; Weber-Grellet, Die Abgeltungsteuer: Irritiertes Rechtsempfinden oder Zukunftschance?, Neue Juristische Wochenschrift 2008, p. 545; Jochum, Verfassungsrechtliche Grenzen der Pauschalierung und Typisierung am Beispiel der Besteuerung privater Aktiengeschäfte, Deutsche Steuer-Zeitung 2010, p. 309 (pp. 311–15); Jachmann, Ermittlung von Vermögenseinkünften – Abgeltungsteuer, DStJG 34 (2011), p. 251 (pp. 258–65). 52 See, in particular, Bundesverfassungsgericht 12 October 2010, case 1 BvL 12/07, BVerfGE 127, 224, paras. 61 et seq. 53 Bundesverfassungsgericht, pending case 2 BvL 3/21. 54 See CJEU, 20 October 2011, case C-284/09, Commission v Germany, ECLI:EU:C:2011:670, paras. 44 et seq. 55 See Bericht des Finanzausschusses, BT-Drs. 16/5491, p. 23.

Corporate taxation in Germany  187 tax or corporation tax purposes. By contrast, the portion deemed to constitute a mere capital repayment can give rise to a taxable capital gain or loss where it does not correspond with the historical acquisition cost of the shares. 3.

Dealing at Arm’s Length Principle

As mentioned above, business transactions between shareholder and the corporation are also recognized for tax purposes, but only to the extent that the underlying agreement was concluded at arm’s length. If a shareholder receives benefits from the corporation that have not been formally designated as dividend payouts and that also do not meet an arm’s length standard in corporate-shareholder dealings, they will be treated as constructive dividends at both entity and shareholder level. Pursuant to Sec. 8 (3) CTA, corresponding ‘excess’ payments will not reduce the taxable income of the corporation; they are therefore subject to corporation tax and municipal trade tax. In parallel, they are taxed as dividend income of the recipient. In the case of controlling shareholders, the case law of the Federal Tax Court is particularly strict.56 If it cannot be proven that the transaction was agreed upon between the parties in clear and unequivocal terms and in advance of its execution, the informality is regarded as strong indication for a deviation from the arm’s length standard. Conversely, any benefits that accrue to the corporation from transactions with the shareholder will be treated as hidden capital contributions to the extent that the transactions do not meet the arm’s length standard. Consequently, the increase in book income of the corporation that corresponds to the ‘excessive’ benefit will be reversed for taxation purposes. However, an exception applies to benefits that for technical reasons cannot constitute ‘contributions’ (essentially, usages and services that cannot be capitalized, e.g. an interest-free loan from the shareholder to the company). In practice, alleged constructive dividends and hidden capital contributions often give rise to disputes during audits. For SMEs, the main issue are salaries and other benefits received by shareholders who are employed as directors. For large and multinational corporations, the relevant provisions serve as the principal instrument for transfer pricing adjustments. The great practical relevance of the topic is reflected in a large body of corresponding literature. This includes many scholarly contributions, including several doctoral theses and monographs.57 Their primary focus is with the development of adequate criteria for the arm’s length standard and their consistent implementation.

For a detailed analysis and criticism, see Döllerer, Verdeckte Gewinnausschüttungen und verdeckte Einlagen bei Kapitalgesellschaften, 2nd ed. 1990, pp. 102 et seq.; Oppenländer, Verdeckte Gewinnausschüttung, 2004, pp. 110–19. 57 See the references supra note 56; see furthermore, e.g., Pezzer, Die verdeckte Gewinnausschüttung im Körperschaftsteuerrecht, 1986; Bilsdorfer, Der steuerliche Fremdvergleich bei Vereinbarungen unter nahestehenden Personen, 1996; Frotscher, Verdeckte Gewinnausschüttungen, DStJG 20 (1997), p. 205; Bauschatz, Verdeckte Gewinnausschüttung und Fremdvergleich im Steuerrecht der GmbH, 2001; Weber-Grellet, Die verdeckte Gewinnausschüttung als Instrument der Fehlerkorrektur, Betriebs-Berater 2014, p. 2263. 56

188  Research handbook on corporate taxation

VI.

GROUP TAXATION

The separate entity principle that characterizes the German corporation tax implies that different member companies of a group are treated as separate taxpayers rather than as a single taxpayer as they would be in a system of unitary taxation. Consequently, the bases of their tax liability are not consolidated group accounts but rather the individual and unconsolidated profit and loss statements of each corporation that is a group member, after the adjustments required by tax accounting rules. Profits generated by subsidiaries give rise to a tax liability of the latter, not of the parent company, until they are distributed and with the exception of the international CFC regime. However, Sections 14–19 CTA provide for a group taxation regime (the so-called ‘Organschaft’) which is recognized also for the purpose of assessing municipal trade tax. The German group taxation regime has its roots in case law that predates the introduction of the federal corporation tax in 1920.58 Under certain conditions of financial, organizational and economic integration, Prussian courts held a subsidiary to act like an employee of the controlling entity in the context of municipal trade tax.59 While this concept was initially adopted by the Federal Tax Court for corporation tax purposes, too,60 the Court subsequently overruled it. Instead, the Court insisted that the taxable profits of subsidiaries must always be assessed separately, but admitted that they could be attributable to the controlling entity if it had concluded a so-called ‘profit transfer agreement’ (‘Gewinnabführungsvertrag’) with the subsidiary.61 It was only in 1969 that the legislator inserted this jurisprudence into the text of the CTA. On this and later occasions, the legislator made clear that, contrary to certain opinions in literature, it did not regard the group taxation regime as a constitutionally required element of the ability-to-pay principle, but merely endorsed it as an element of good economic policy.62 Due to this historical development, the German group taxation regime is somewhat peculiar in international comparison. First, the participation threshold required for its application is relatively low. It is sufficient that the parent controls, directly or indirectly, the majority of voting rights in the subsidiary. Second, and this is also the explanation therefor, the controlling entity needs to have concluded and practiced a long-term (minimum five years) profit transfer agreement with the dependent corporation, in accordance with the relevant corporate law provisions. Pursuant to such an agreement, the dependent corporation must transfer all of its profits to the controlling entity, and the latter must cover any losses incurred by the subsidiary. Minority shareholders may receive certain forms of compensation, which must, however, not result in a sharing of profits of the dependent entity.63 No further substantive requirements

58 For a more detailed account of historical developments, see Jurkat, Die Organschaft im Körperschaftsteuerrecht, 1975, pp. 87 et seq.; Herzig, Einführung, in Herzig (ed.), Organschaft, 2003, p. 1 (pp. 4 et seq.). 59 See Preußisches Oberverwaltungsgericht 31 May 1902, case VI.G. 38/01, Oberverwaltungsgericht in Staatssteuersachen Band 10, pp. 391 et seq.; 30 January 1909, case V.A. 76/08, Oberverwaltungsgericht in Staatssteuersachen Band 14, pp. 320 et seq. 60 See, e.g., Reichsfinanzhof 11 October 1928, case I A 473/27, RStBl. 1928, p. 360; 13 March 1928, RStBl. 1929, p. 521; 11 June 1929, case I A 531/28, RStBl. 1929, p. 557. 61 See Bundesfinanzhof 24 November 1953, case I 109/53 U, BStBl. 1954 III, p. 21; 14 February 1956, case I 73/55 U, BStBl. 1956 III, p. 151; 5 November 1957, case I 163/56 U, BStBl. 1958 III, p. 24. 62 See, e.g., the explanatory memorandum in BT-Drs. V/3017, pp. 6 et seq. 63 See, e.g., Bundesfinanzhof 10 May 2017, case I R 93/15, BStBl. II 2019, 278, paras. 19 et seq.

Corporate taxation in Germany  189 exist. Third, the group taxation regime is not optional but instead it enters into effect automatically when the criteria that determine its personal, territorial and substantive scope are met. De facto, however, groups can influence the applicability and coverage of the regime, because the conclusion of profit transfer agreements is at their discretion. Regarding the personal scope, only bodies corporate qualify as dependent companies, whereas the controlling entity can have any legal form and can even be an individual taxpayer. The territorial scope is limited to dependent corporations with a domestic place of management and a statutory seat within the EU and EEA. The controlling entity can also be a non-resident taxpayer, provided that the participation in the dependent entity is attributable to a local permanent establishment whose profits can be taxed by Germany according to both domestic and tax treaty law. This is to ensure that the legal consequences of the group taxation regime do not undermine German taxing rights with respect to the subsidiary’s profits. If the conditions for group taxation are met, the entire taxable profits or losses of qualifying dependent corporations will be attributed to the controlling entity for taxation purposes. Consequently, any actual dividend payments are ignored for taxation purposes. However, the attributable profit is still calculated at the level of the subsidiary on the basis of its accounts, and intra-group transactions are therefore not consolidated. The main advantages of the group taxation regime from a taxpayer perspective are therefore the possibility of setting off losses of the subsidiary against profits of the parent and the avoidance of corporation tax and trade tax on 5 percent of dividend payments (see above at V.2.b). In practice, the correct implementation of the profit transfer agreement often causes difficulties, and it is a source of frequent disputes with tax authorities and litigation.64 Moreover, it leads to an unwelcome influence of tax law considerations on commercial law arrangements. The requirement to conclude such an agreement also hampers the inclusion of foreign legal forms into the group taxation regime. The reform proposals that have been developed by scholars and practitioners therefore usually seek to modernize the group taxation regime by substituting the profit transfer agreement.65 Some of those concepts have suggested to raise the participation threshold and to make the election of the regime optional for group members. Others have proposed to establish a ‘group contribution regime’, which would still require actual monetary transfers between group members but no longer a fixed profit transfer agreement. So far, the government has been reluctant to consider those proposals, because it considers the profit transfer agreement to act as a bulwark against a loss importation requirement that could otherwise result from EU non-discrimination standards.

64 See von Wolfersdorff, Die ‘kleine Organschaftsreform’: Erleichterungen bei Abschluss und Durchführung des Gewinnabführungsvertrags, 2012, pp. 26 et seq. 65 See, e.g., Haas et al., Einführung einer modernen Gruppenbesteuerung, Ein Reformvorschlag, ifst-Schrift Nr. 471 (2011); Rödder, Einführung einer neuen Gruppenbesteuerung an Stelle der Organschaft, Die Unternehmensbesteuerung 2011, p. 473; Schön, Die Funktion des Unternehmenssteuerrechts im Einkommensteuerrecht, DStJG 37 (2014), p. 217 (p. 254); Prinz, Steuerliche Grundlagen der ‘Organschaft im Wandel’, in Prinz/Witt (eds), Steuerliche Organschaft, 2nd ed. 2019, p. 1 (pp. 47 et seq.).

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VII. CHECK-THE-BOX 1.

Overview

For 100 years, it has been discussed whether partnerships should be allowed to choose whether they are treated as fiscally transparent pass-through entities or as taxable persons under the corporation tax regime. Proposals to this effect have been part of the debate on how to achieve neutrality of legal form in the German system of business taxation almost immediately after the enactment of a separate corporation tax. The idea was first presented in 1924 by two renowned tax experts.66 In 1951, the legislator warmed up to it and allowed partnerships with a business or trade to opt for the application of the flat corporation tax rate for their retained profits, which then entailed also the application of certain other elements of the corporation tax system. This special regime was abolished two years later, however, due to its complexity and in view of a reduction in the top personal income tax rate. In 1999, the concept was revitalized by the Commission for Business Tax Reform and subsequently included in the draft reform bill that also featured the termination of the imputation system. However, the proposal did not become law due to the resistance of the Federal Council,67 which considered it too administratively burdensome and ineffective in the light of the experiences of the 1950s. Instead, the legislator enacted a special regime for retained partnership profits in 2007. Individual partners can apply for a lower rate on their profit share that is roughly equivalent to the combined corporation tax and trade tax burden on corporate profits. However, when they eventually withdraw the earnings, they must pay a 25 percent top-up tax. This is equivalent to the final withholding tax on dividend income from privately held shares, which typically results in a higher combined burden than the income tax burden that would have arisen under the default pass-through regime. Due to the top-up tax upon withdrawal and several design flaws, the special rate option for retained earnings has been exercised only by a relatively small number of partners.68 It is typically only attractive for partners who have relatively high personal income tax rates and who can postpone a withdrawal of (most of) their profit share for longer periods of time. Moreover, even within its de facto very limited scope of application, the special regime falls significantly short of establishing full neutrality of legal form. This situation has prompted calls to reform the system by either improving the special rate regime or by introducing a check-the-box option for partnerships to be treated as corporation tax subjects.69 The legislator chose the second, more ambitious alternative in 2021 and enacted Sec. 1a CTA, pursuant to which certain partnerships are taxed like a corporation and its partners like shareholders, upon request by the partnership. The new regime has entered into force in 2022 See Becker/Lion, Verhandlungen des 33. Deutschen Juristentag 1925, p. 17. As regards the veto power of the Federal Council, see supra at III.1. 68 See Bundesregierung, Antwort auf die Kleine Anfrage der FDP-Fraktion, BT-Drs. 19/6308, p. 7: in less than 7,000 cases. For a critical appraisal, see Knirsch et al., Aufruf zur Abschaffung der misslungenen Thesaurierungsbegünstigung!, Der Betrieb 2008, p. 1405; Fischer, Thesaurierungsbegünstigung nach § 34a EStG, in Spindler et al. (eds), Festschrift für Harald Schaumburg, 2009, p. 319. 69 See, e.g., Fechner/Bäuml, Fortentwicklung des Rechts der Besteuerung von Personenunternehmen, Finanz-Rundschau 2010, p. 744 (in favor of an improvement of the special rate regime); IDW, Positionspapier zum Einstieg in eine rechtsformneutrale Besteuerung (‘Optionsmodell’), 2019 (in favor of the option for corporation tax). 66 67

Corporate taxation in Germany  191 with the stated intention to significantly enhance the neutrality of the overall system of business taxation.70 In reality, however, it represents only a very small step in this direction. The first major limitation is caused by the asymmetric design of the option, because corporations cannot elect to be treated as pass-through entities, regardless of their size and shareholder composition. Another serious limitation stems from the fact that opting for the corporation tax is only attractive for large and highly profitable companies, and due to certain design flaws of the rules on transition outlined below, even many of these partnerships will not make use of it.71 Their partners can then still make use of the lower rate for retained earnings, since the two (mutually exclusive) special regimes now operate in parallel. 2.

Key Features and Issues

By default, partnerships continue to be treated as fiscally transparent for income tax purposes. Different from the special rate option, the option to corporation tax must be exercised by the partnership and not by individual partners. A request to transition into the corporation tax regime can only be made where all partners have agreed to do so, or if the articles of association so permit, by a qualified majority of at least 75 percent. Both resident and non-resident entities qualify; as a caveat, the latter must be subject to corporation tax in the jurisdiction where they have their place of management, so that the treatment as a corporation in Germany does not give rise to new conflicts of qualification. However, the option is only available for commercial partnerships and registered associations of professionals. General civil law partnerships, in particular, are excluded from its scope. This has rightfully been criticized as inconsistent.72 This limitation will also be difficult to apply in case of non-resident partnerships that have been founded and registered under foreign company law,73 which often does not formally distinguish between commercial and civil law partnerships. By virtue of Sec. 1a (2) CTA, the exercise of the option has the same tax consequences as would arise on the occasion of an actual change of legal form from partnership to corporation. While this might seem like the natural approach, it creates significant obstacles in practice due to the additional tax burdens that a change in legal form can entail. The most relevant – but far from the only – complications are the following: a partner’s share in hidden reserves are realized and the corresponding latent capital gains are taxed not only with respect to assets that exit German tax jurisdiction, but in total if the partner does not transfer ownership of all ‘functionally essential’ assets that he has so far leased to the partnership upon the latter. While an unlimited partner’s share of past losses of the partnership can still be offset against his future positive income through an income tax loss carry forward (but no longer against future company profits), the same is not true for unused losses of limited partners that exceeded their capital contribution. In a similar vein, all trade tax loss carry forwards (and eventual carry forwards of interest deductions resulting from the interest deduction barrier) are lost. Moreover,

See Gesetzentwurf der Bundesregierung, BT-Drs. 19/28656, p. 15. See also the critical assessment by Kahle, Zur Zukunft der Besteuerung der Personengesellschaften, Finanz-Rundschau 2022, p. 377 (pp. 383 et seq.). 72 See Röder, Die Option zur Körperschaftsbesteuerung: Eine erwünschte Rechtsquelle des Personengesellschaftsrechts, Zeitschrift für Gesellschaftsrecht 2021, p. 681 (p. 692). 73 See Dreßler/Kompolsek, Das Optionsmodell zur Besteuerung als Kapitalgesellschaft, Die Unternehmensbesteuerung 2021, p. 301 (p. 302). 70 71

192  Research handbook on corporate taxation partners who have made use of the special rate for retained earnings must immediately pay the 25 percent top-up tax as if they had withdrawn their profit share. This is particularly problematic, because in practice, the profile of partnerships for which the option to corporation tax is attractive overlaps with the categories of partnerships where partners will have found the special rate advantageous. None of these detrimental rules was inevitable; however, the legislator felt that a more neutral treatment would unduly privilege the optional corporation tax regime over an actual change of legal form. Once the corporation taxpayer status has been attained by the partnership, the standard corporation tax regime applies to it and its partners. This implies the application of certain rules that play no role in the tax assessment of a partnership and that can require certain adjustments or even make a use of the option unattractive in the first place. In particular, transactions that are not at arm’s length will now give rise to constructive dividends and thus additional tax burdens, and a partner’s departure abroad can trigger exit taxation. In practice, there is furthermore an important – and inconsistent – exception to the principle of full equivalence: the tax administration does not consider opted-in partnerships to be eligible for group taxation as dependent entities due to a narrow understanding of the required (see above at VI) profit transfer agreement.74 Finally, the option has almost no consequences for taxes other than income tax, corporation tax and trade tax. In particular, certain privileges for partnerships in the context of the inheritance tax and the real estate transfer tax are not or only marginally affected. The partnership can opt out of the corporation tax regime again with effect for any future tax period. However, like the original option, the transition back to the pass-through regime can cause additional tax burdens, too. Loss carry forwards that have been accumulated under the corporation tax regime are lost, also for the purposes of trade tax. All retained earnings are deemed to have been distributed and thus give rise to dividend taxation. If the partnership opts out before seven years have passed, any hidden reserves that could be maintained upon the exercise of the option will be retroactively uncovered and taxed. Again, hardly any of these disadvantages is inherent to the transition back to fiscal transparency; instead, they result from the unreflected application of the – by themselves imperfect – rules on an actual change of legal form. Altogether, the new check-the-box regime is attractive only for relatively few business structures involving partnerships.75 In fact, the number of applications for the first year of the regime’s applicability was reportedly only around 150.76 The main candidates for the option are intermediate holdings in large family-owned firms, where the business law benefits of a partnership (e.g. lower standards regarding accounting, publicity, and employee co-determination) can be combined with the advantages of the corporation tax system (lower rate on retained earnings, participation exemption, recognition of corporate-shareholder dealings). In some cases, international tax planning might be facilitated by the option, too. By

See Bundesministerium der Finanzen, Option zur Körperschaftsbesteuerung (§ 1a KStG), BStBl. I 2021, p. 2212, para. 56; for a different opinion, see Röder (supra note 72), p. 688. 75 For a skeptical appraisal prior to the reform, see also Hey, Und jetzt auch noch eine Körperschaftsteueroption, in Dauner-Lieb et al. (eds), Festschrift für Barbara Grunewald, 2021, p. 361 (pp. 373 et seq.). 76 See Bundesregierung, Antwort auf die Kleine Anfrage der Fraktion DIE LINKE, BT-Drs. 20/1231, p. 6. 74

Corporate taxation in Germany  193 contrast, at the level of operative units the possibility for partnerships to opt for the corporation tax regime should not significantly increase their use, due to their exclusion from group taxation. Certainly, the quest for greater neutrality of legal form in the business tax system has not come to an end due to Sec. 1a CTA.

12. Corporate taxation in France Marilyne Sadowsky

1. INTRODUCTION ‘It is neither politically conceivable nor desirable from the point of view of justice, that no discrimination be made between taxation on capital and labor.’1 This was the justification given for the creation of a capital tax which was presented as one of the three pillars of the 1948 tax reform, in order to restore a differentiation with labor income. The idea was to go beyond the different income categories in order to consider individual situations. The second pillar was the unification of the income tax, through a proportional taxation of all income and a progressive surtax on global income, only payable by individuals. The last one gave birth to the corporate income taxation, with the creation of a proportional tax on the profits made by legal entities. Before 1948, companies and individuals were subject to one of the flat-rate schedular taxes existing, depending on their type of activity. Almost all legal entities were commercial companies which were mainly subject to the tax on industrial and commercial profits. Previously taxation was based on the nature or origin of the income, since 1948 it takes into account the legal status of the taxpayer.2 Why? The main purpose of the reform was to eliminate tax fraud,3 even if other reasons were given: increase fiscal revenues, simplify the system to make it more coherent and complete its modernization in line with the general income tax introduced in 1914 and schedular taxes created in 1917.4 In fact, individuals had a heavier tax burden than corporations, because while they were subject to the same tax as corporations and under the same conditions, only individuals were subject to general income tax. Corporations were mainly subject to the schedular tax on industrial and commercial profits and income tax from movable capital. In addition, companies were exempt from taxation whenever their profits were not distributed. Consequently, the creation of a sui generis corporate taxation was to allow an economic compensation for the advantage of not taxing undistributed profits. The profits of the companies were taxed under a specific proportional tax of 24 percent and the distributed profits to the income tax, leading to the superposition of these two taxes. Finally, an accounting definition of distribution was adopted in order to eliminate the fraudulent distribution of hidden profits and to tax only the effective distributions.5

Ministère de l’Économie et des Finances/Service des Archives Économiques et Financières (MEF/ SAEF), B 28337, ‘Note sur la réforme des impôts directs’, pp. 3–4. 2 R. Plaisant, La réforme fiscale: l’impôt sur le revenu des personnes morales, Dalloz, 1949, p. 150. 3 MEF/SAEF, B 28337, ‘1ère séance du mercredi 24 novembre 1948’, Commission de la réforme fiscale, p. 2. 4 Ibid. pp. 3–4. 5 MEF/SAEF, ‘Impôt sur le revenu des personnes physiques – Annexe relative au mode de détermination des revenus procurés par les actions et parts sociales’, Commission de la réforme fiscale, 5ème séance du jeudi 2 décembre 1948, p. 3 and f. 1

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Corporate taxation in France  195 One can observe that we are facing today the same structural problems as in the past, always seeking to find a satisfactory balance in the tax burden of companies and individuals, depending on the design of the corporation taxation. Every detail counts: the taxable person, the taxable event, the taxable income, the superposition of an income and a corporate taxation, the elimination of double taxation, but also book-tax conformity in the computation of taxable business profits. The task is not easy because it is difficult to anticipate every change in the company’s existence, which also depends on the economic context as shown by the Covid-19 period, which had consequences for corporate income tax in terms of deferral of payment, tax rebates or tax audits. Although this chapter will focus on corporate tax, many other taxes are also due by businesses, including production taxes on wages and labor, added value, turnover or property capital.6 The main elements of the French corporate tax system will be analyzed here with regard to its scope (1), the determination of taxable income (2) and the control of the normality of taxable results (3).

2.

SCOPE OF CORPORATE TAXATION

The scope of corporate taxation is personal (2.1) and territorial (2.2). 2.1

Personal Scope

There are two types of companies: those subject to income tax and those subject to corporate tax. Companies subjected to income tax are divided in two categories. The first category comprises single individual companies (entreprises individuelles), which have no legal personality of their own. They are owned by a natural person through different legal forms and subject to income tax under specific rules mainly applicable to industrial or commercial profits (bénéfices industriels et commerciaux – BIC), comprising activities by nature (Art. 34 of the French Tax Code – FTC) and those by assimilation or determination by law (Art. 35 FTC), or to non-commercial profits (bénéfices non commerciaux – BNC). It is not the nature of the person that is taken into account (natural or legal person), but rather his or her way of acting, professionally or not. In this case, one of the difficulties is to make a distinction between personal and professional assets for tax matters. The entrepreneur will be able to assign certain assets to his professional activity through accountability. He can also choose the unique status of individual entrepreneur (entrepreneur individuel),7 which distinguishes between personal and professional assets, making elements of personal assets unseizable by professional creditors.8 The second category covers partnerships (sociétés de personnes), which have legal personality of their own and unlimited liability. They are covered by article 8 of the FTC, which defines the companies that are subject to income tax and includes different forms of structure (e.g. société en nom collectif or sociétés civiles), with a few exceptions due to the form of the company or the nature of the activity. For tax matters, they are considered as translucent or

D. Gutmann, Droit fiscal des affaires, LGDJ, Lextenso, 12th Edition, 2021, p. 187. The law no. 2022-172 of 14 February 2022 in favor of independent professional activity created this unique status, in order to phase out the former status of individual entrepreneur with limited liability (entrepreneur individuel à responsabilité limitée). 8 Before this law, only the entrepreneur’s principal residence was protected from seizure. 6 7

196  Research handbook on corporate taxation semi-transparent, that is, between tax opacity and tax transparency. The idea is to take into consideration both: the partnership since its results are used to calculate the taxable base, but also its partners since they have to pay the tax on their shares, according to their rights within the partnership. Other companies are subjected to corporate income tax. According to article 206 of the FTC, capital companies (sociétés de capitaux) are subjected to corporate income tax because of their form and whatever their purpose (e.g. public limited companies – société anonyme, partnerships limited by shares – sociétés en commandite par actions, or cooperative companies and their unions – sociétés cooperatives et leurs unions). For tax matters, these companies are considered as opaque and taxed on their own, even if the profits distributed to the partners are taxed in their hands at the time of distribution. The distinction between personal or professional assets does not pose any difficulty here, since the partner’s liability is limited to the capital contributed. However, certain complicating factors exist with the existence of: options in order to soften the delimitation between partnerships and capital companies;9 mixed characteristics of some structures borrowing from partnerships and capital companies leading to a mixed taxation of income and corporation tax (limited partnership or de facto partnership); an activity leading to tax under corporate income tax (e.g. civil companies due to their commercial purpose).10 Certain exemptions are listed in article 207 of the FTC for various reasons, such as the non-profit nature of an activity, the need to promote risky activities or the creation of new or innovative young companies. 2.2

Territorial Scope

The territorial scope of application depends on whether the taxpayer is subject to income tax or corporate tax. If the taxpayer is subjected to income tax, there is distinction to be made. The first situation concerns natural persons. According to article 4 A of the FTC, an individual domiciled in France is liable for income tax on all their income (unlimited tax liability, worldwide basis), whereas the non-resident is liable for income tax only on their French-source income (limited tax liability, territorial basis). In this context, it is essential to determine the place of residence. Concerning the unlimited tax liability, article 4 B §1 of the FTC provides a series of criteria for determining tax residence in France: personal one (home or principal abode in France) or real one (to carry out an activity or to have the center of their economic interests in France). These criteria are alternative, only one needs to be met in order to be considered as a French resident. If a double tax convention (DTC) exists, the situation may change as a result of its application. Generally following the Organisation for Economic Co-operation and Development (OECD) model, the key concept to enter in the French DTC is the residence. In case of residence in both contracting states, some criteria have to be followed by chronological order to determine one residence: permanent home, center of vital interests, habitual residence, nationality and, finally, a mutual agreement procedure. Concerning the limited tax liability, article 164 B of the FTC provides a limitative list of criteria for determining French-source incomes: personal (to locate the debtor of the income in France) or real (to locate the source of income in France). For instance, a partnership may opt for the corporate income tax regime. This option is revocable within 5 years of its exercise. 10 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, p. 158 and f. 9

Corporate taxation in France  197 The second situation concerns partnerships. France has a hybrid conception of partnerships with translucency or semi-transparency, by retaining the existence of the partnership to calculate the profit (distinct entity theory) and also the partners to pay (transparency theory). Consequently, France does not follow the recommendations of the OECD in favor of a principle of tax transparency. This situation can lead to consider partnerships as residents of France for DTC purposes.11 If the taxpayer is subjected to corporate income tax, according to article 209 of the FTC, the profits made by companies exploited in France or where attributable to France under a DTC are taken into account, as well as property incomes.12 In this context, it is essential to determine the place of exploitation. The nationality of the company or the location of the head office do not matter. Three alternative criteria are used to determine this place, derived from a series of case law decisions held in the 1960s: the existence in France of an establishment, of a dependent agent or the realization of a complete commercial cycle. If a DTC is applicable, the result will be different depending on its application, particularly the concept of permanent establishment. A French permanent establishment held by a foreign company must be assimilated to a subsidiary and be recognized as a tax entity, even if it has no legal personality.13 France follows most of the OECD recommendations and considers that the profits attributable to the permanent establishment must be calculated as if it were a separate entity from the head office, and the case law sometimes pushes the tax fiction of the permanent establishment’s autonomy to the extreme.14 The French principle of territoriality has found two historical justifications. For some authors,15 this principle is linked to the French colonial past. Indeed, this rule was an incentive to invest in these territories because of the resulting exemption of income, since at the time capital flows to the outside world were mainly concentrated in the colonies. For others,16 it would be the result of a historical error due to an oversight by the legislator. This principle, originally applicable to industrial and commercial profits within income tax, was mechanically extended to corporate income tax except that in 1976, when the worldwide principle was decided for income tax, the principle of territoriality for corporate tax was left aside. The limits of maintaining such a principle lie in the impossibility to take into account losses realized by the company abroad. In addition, France is applying this principle more and more strictly, having put an end to all the exceptions that existed in the past, through different systems such as the world and consolidated profit (1965–2011), provisions for foreign establishment (1972–2003) and provisions for foreign establishment for small companies (2009–14).

11 M. Sadowsky, ‘France: Taxation of Partnerships – France versus the OECD’ in E. Kemmeren, P. Essers et al. (eds), Tax Treaty Case Law around the Globe 2012, IBFD and Linde Verlag, 2013, p. 80 and f. 12 Incomes from immovable property and capital gains relating to real estate located in France or to shares in companies with a majority of real estate assets have been added by the rectifying finance law for 2009, Law no. 2009-1674 of 30 December 2009 of rectifying finances for 2009, Journal Officiel, no. 303 of 31 December 2009. 13 P. Oudenot, Fiscalité approfondie des sociétés, LexisNexis, 5th Edition, 2020, p. 173 and f. 14 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, p. 526 and f. 15 E. Owens, The Foreign Tax Credit: A Study of the Credit for Foreign Taxes under United States Income Tax Law, Law School of Harvard University, Cambridge, 1961, p. 540 and f. 16 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, pp. 500–501.

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3.

DETERMINATION OF THE TAXABLE INCOME FOR CORPORATE TAXATION

There are similarities between income tax and corporate income tax.17 According to article 221 §1 of the FTC, ‘Corporate income tax is assessed under the same conditions and with the same penalties as income tax (industrial and commercial profits …)’. Thus, the way in which taxable profits are calculated is determined by reference to the rules applicable to industrial and commercial profits. The determination of taxable income leads to the determination of a global income for income tax purposes or a profit for corporate tax purposes (3.1). In addition, there are specific tax rules applying to groups of companies (3.2). 3.1

Determination of a Global Income or a Profit

For income tax, the determination of taxable income is done in two steps. First, the taxpayer’s net income must be determined for the eight categories of income tax: salaries and wages, industrial and commercial profits, agricultural profits, non-commercial profits, income from movable property, capital gains, land incomes and remunerations of company directors. Each of these categories has its own calculation rules. Second, the sum of all these net incomes forms the global gross income, which is the starting point for the calculation of the global net income. Here again, some specific rules apply, whether for the deduction of certain deficits or expenses or for the application of special allowances.18 This can result in a global deficit, which can be carried forward to the global income for 6 years, or in a global income taxable in a progressive way according to five tax brackets.19 For some authors, the global character is not really respected because the structure of the system is frequently modified.20 Thus, some income leaves the ‘common pot’ to be taxed in a specific and separate way, at a proportional rate contrary to the general logic of progressivity. For instance, capital gains realized by individuals on the sale of securities, corporate rights and similar securities were taxed at 19 percent plus 15.5 percent for social security contributions before 2013, and after 2013 were taxed at the progressive income tax scale. In 2018, these capital gains were again taxed proportionally and are now taxed at the flat tax of 12.8 percent plus 17.2 percent for social security contributions. These successive changes make the system difficult to understand for the taxpayer. In addition, labor income is treated differently depending on whether it results from salaried work (wage and salary categories) or not (other possible categories: industrial and commercial profits, non-commercial profits or agricultural profits).21 Finally, the calculation of global income is influenced by the concepts of household (foyer) and family quotient (quotient famil-

17 For a presentation of all the similarities and differences see: C. David, ‘Tax Law’ in Introduction to French Law, G.A. Bermann and E. Picard (eds), Wolters Kluwer, 2012, p. 430 and f. 18 For a detailed analysis of these specific rules, see: G. Gest, ‘France’ in Comparative Income Taxation: A Structural Analysis, H.J. Ault, B.J. Arnold and G.S. Cooper (eds), Wolters Kluwer, 4th Edition, 2020, p. 80 and f. 19 For 2022, the five brackets are the following: (1) up to €10 225 = 0 percent; (2) from €10 226 to €26 070 = 11 percent; (3) from €26 071 to €74 545 = 30 percent; (4) from €74 546 to €160 336 = 41 percent; (5) beyond €160 336 = 45 percent. 20 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, p. 120 and f. 21 Ibid. Eod. Loc.

Corporate taxation in France  199 ial),22 which leads to considering the household as a single economic unit of taxation. Thus, the taxable income is divided into a certain number of shares based on the taxpayer’s situation and family expenses. For corporate income tax, a profit must be determined, revealing the existence of an enrichment. According to article 38 of the FTC, two definitions of net profit coexist. The first paragraph provides for a determination ‘on the basis of the overall results of operations of any kind carried out by the companies’. It is a global approach to the company’s results, which compares the revenues and expenses recorded in the income statement.23 The second paragraph is complementary, as it refers to the balance sheet’s theory allowing to take into account some elements non-registered in the accounting entries. The text aims at ‘the difference between the values of the net assets at the closing and at the opening of the period whose results must be used as a basis for the tax’. Thus, the change in net assets is determined by comparing the balance sheets of 2 successive years, then corrected since the external contributions must be deducted and the withdrawals made by the entrepreneur or partners added. In order to determine the taxable profit, the connection between the accounting result and the tax result needs to be made and leads to some adjustments wherever tax law departs from accounting law.24 If a profit is made, it will be taxed at a proportional rate. In 2022, the gradual reduction decided by the 2017 Finance Act25 is completed to bring the corporate tax rate from 33.33 percent (in force since 1993) to 25 percent,26 at 1 percent of its historical rate in 1948. In 1997, a reduced rate of 15 percent was introduced for small and medium-sized companies and is still applicable to a profit bracket less than or equal to €42,500 from 2023.27 The idea was to promote the equity of these companies, which have more difficulty in accessing bank loans or the financial markets.28 This example confirms the existence in France of some specific Small and Medium Enterprises (SME) carve-outs.29 Certain other reduced rates exist and reflect a political will to

22 It was created after the Second World War by law no. 45-0195 of 31 December 1945 to promote the birth rate. The general idea was to integrate family expenses directly into the tax rate. 23 With respect to non-commercial profits, it is interesting to note that article 93 of the FTC takes a similar approach, namely the difference between revenues and expenses. 24 In practice, there are different tax forms (liasse fiscale) containing some charts to facilitate the transition from one result to the other and declare these elements to the tax authorities. 25 Article 11 of law no. 2016-1917 of 29 December 2016 for the 2017 Finance Act, Journal Officiel, no. 303, 30 December 2016. After 2017, the 2018 Finance Act set different proportional rate per bracket depending of the amount of company’s turnover: article 84 of law no. 2017-1837 of 30 December 2017 for the 2018 Finances Act, Journal Officiel, no. 305, 31 December 2016. 26 According to article 219 of the FTC. It is interesting to mention that the rate progressively reached 50 percent in 1958 and then started to decrease in 1986 to reach 33.33 percent in 1993. 27 In order to benefit from this rate, two conditions must be met: a turnover of less than €10 million and at least 75 percent of the capital must be owned by individuals (or by a company applying this criterion). Before 2023, the threshold was €38,120. 28 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, p. 183 and f. 29 J. Van de Streek, ‘Does Company Size Matter in Defining the Scope of a CIT?’ in Corporate Income Tax Subjects, D. Gutmann (ed.), IBFD, 2015, p. 40 and f.

200  Research handbook on corporate taxation encourage research,30 non-profit organizations31 or the transfer of shares in listed real estate companies.32 In case of deficit, it remains blocked within the company and, unlike income tax, cannot be used by the partners on their personal global income. However, the company has two possibilities. On the one hand, an indefinite carry forward of the deficit exists, capped at €1 million ‘plus 50% of the amount corresponding to the taxable profit of the said year exceeding this first amount’.33 The remaining deficit may continue to be carried forward under the same conditions, until it is fully depleted. On the other hand, the company may opt for a 1-year carry back, within the limit of €1 million.34 In fact, this is a fictitious imputation, which serves to create a claim for restitution of the corporate tax on the state. The company can use it to pay its tax over the next 5 years, after which a refund can be requested for what has not been used. This situation is the result of the Franco-German convergence since the carry forward was limited to 5 years before 2004 and the carry back was limited to 3 years before 2011.35 Then, the profit realized is distributed in the form of dividends to shareholders. Consequently, while the profits have already been taxed at the company level, they will be taxed a second time at the partner level. It is an economic double taxation that disfavors investment in movable property and discourages the distribution of profits.36 To mitigate this double taxation, a tax credit system (avoir fiscal) equal to half of the amounts actually paid by the company was set up in 1965.37 This system was finally withdrawn in 200538 because the treaty extension to non-resident partners was too costly for the French state, and the European Court of Justice case law Verkooijen39 recognized a difference in tax treatment between domestic and foreign dividends. After this withdrawal, the system of taxation of dividends has not stopped changing. Since 2018, dividends for individuals are taxed under the category of movable capital at the flat tax of 12.8 percent plus 17.2 percent for social security contributions. However, the taxpayer may opt for the progressive income tax rate in order to benefit from a 40 percent deduction on the gross amount received.40 In addition, profits made in France by a foreign company through a permanent establishment are deemed to be distributed to the non-resident partners, and are subject to a branch tax payable on the total profits of the permanent establish Since 2019, in order to take into account the ‘nexus’ approach recommended by the OECD and the EU, a new article 238 was enacted to opt, under certain conditions, for a reduced rate of 10 percent applicable to gains and products derived from the transfer, concession or sub-concession of a patent or industrial property rights. 31 According to article 219 bis of the FTC, patrimonial incomes not related to their profit-making activities are taxed at a rate of 24 percent, 15 percent for dividends and 10 percent for certain income related to debt securities. 32 According to article 219 I-a of the FTC, long-term gains on shares in listed companies whose assets consist mainly of immovable property are subjected to a reduced rate of 19 percent. 33 Article 209 §1 of the FTC. 34 Article 220 quinquies of the FTC. This optional mechanism was created in 1985 for a period of 3 years, and then reduced in 2011 to a 1-year period. 35 However, to address the difficulties faced by companies during the Covid-19 period, a 3-year carry back with no limit on the amount was temporarily reintroduced, for 1 year only, by the Amending Finance Law for 2021, Journal Officiel, no. 166, 20 July 2021. 36 P. Beltrame, La fiscalité en France, Hachette, 24th Edition, 2020, p. 42. 37 Law no. 65-566 of 12 July 1965, Journal Officiel, no. 160 of 13 July 1965, article 1. 38 Law no. 2003-1311 of 30 December 2003 for the 2004 Finance Act, Journal Officiel, no. 302, 31 December 2003, article 93. 39 ECJ, 6 June 2000, Case C-35/98, Verkooijen. 40 Article 158 §3 2 of the FTC. 30

Corporate taxation in France  201 ment in the form of a withholding tax, the rate of which is aligned with that of the corporate taxation.41 This principle is mitigated by the application of tax treaties which may limit the rate of withholding, by European law which may lead to a total exemption or by the reversal of the presumption of distribution. If the shareholder is a company, the dividends are subjected to corporate income tax or to a withholding tax if the beneficiary is outside France.42 Practically, this double taxation is set off by a corporate tax rate that is lower than the progressive income tax rate and by the implementation of tax regimes that reduce taxation at the level of the partner, such as the flat tax mechanism or some specific regimes for groups of companies. However, these mechanisms are not specific tax credits that perfectly eliminate economic double taxation. 3.2

Specific Tax Rules for Groups of Companies

The principle of territoriality of corporate tax has become too strict. In this context, the specific French regimes for groups of companies allow for a realistic economic approach to the group, even if they do not go as far as the regimes known in the past, notably that of world and consolidated profit. At the time, this regime was obtained upon approval by the Ministry of the Economy and Finance and allowed French companies to pool the positive or negative results recorded by all their French and foreign operations. In practice, very few companies obtained it. The objective was to facilitate the establishment of groups in foreign markets and to eliminate double taxation within the group. Although the current plans are less ambitious, and waiting for the implementation of a European group scheme, they still provide tax relief. As regards accounting obligations, the general principle is that the smaller the company, the lighter the accounting obligations. Two types of tax measures can be distinguished, the group schemes themselves and the taxation applicable to restructuring operations. Groups of companies can opt for two specific and cumulative tax regimes: the participation-exemption regime (mère-fille) and the tax consolidation regime (intégration). The first participation-exemption regime originated in 1917 with the creation of a tax exemption on industrial and commercial profits for parent companies for their subsidiaries. In 1920, a parent company regime was created, setting up a tax relief system for the shareholders of the parent company when redistributing the income of its subsidiaries. These two different regimes, one offering a tax exemption on industrial and commercial profits and the other a tax relief for the shareholders of the parent company, were merged in 1952.43 The current regime offers two tax advantages. The first one is related to an exemption on dividends in order to ensure tax neutrality within corporate groups so that the circulation of profits takes place at the lowest tax cost. The second one is related to an exemption on capital gains, in order to encourage restructuring and to align the tax treatment of capital gains with that of dividends, because economically a capital gain corresponds to an undistributed dividend. Concerning dividends, conditions are

Article 115 quinquies of the FTC. Article 119 bis of the FTC. 43 On the historical aspects of this regime, see: G. Gest, ‘Histoire et esprit du régime des sociétés mères’, Revue de Droit Fiscal, no. 41, October 2014, comm. 565. 41 42

202  Research handbook on corporate taxation laid down by article 145 of the FTC relating to ownership,44 shareholding and voting rights,45 the time period the shares are held46 and the subsidiaries held.47 Certain exclusions have been made in order to avoid abusive use, location in a non-cooperating state or territory or obtaining a double exemption or double non-taxation. If the conditions are fulfilled, dividends are exempted, apart from a share of the costs and charges equal to 5 percent, tax credits included. It implies to add back to the taxable income of the parent company non-deductible expenses related to holdings that qualify for the dividend exemption. Indeed, it was considered that 5 percent correspond to a fixed cost related to the management of the subsidiary. Since the Group Steria SCA case in 2015,48 dividends paid in the context of tax consolidation are treated in the same way as those paid by non-integrated European subsidiaries that are more than 95 percent owned. Now, a rate of 1 percent applies to dividends in the context of tax consolidation and 5 percent in other cases.49 According to the case law,50 the share of costs and expenses has a hybrid nature since it aims to neutralize the deduction of costs relating to equity investments by reinstating the costs actually incurred in the taxable result, and it is also assimilated to taxation for the difference between the amount of the actual reinstated costs and the lump-sum amount of the share, thus allowing the parent company to set off foreign tax credits against the corporate tax on the taxed fraction of the dividend. This decision is in line with a decision issued a few months earlier concerning the share of costs and expenses applicable to long-term capital gains.51 Concerning capital gains on the sale of substantial investments, it was an alignment on dividends with an exemption, apart from a share of the costs and charges equal to 5 percent of the net result of capital gains. However, since 2013,52 the share of costs and expenses equal to 12 percent of the gross amount (no longer on the net) of the capital gains is taken into account for the determination of the taxable result.53 Therefore, the tax system tends to become stricter and to move away from the treatment reserved for dividends, which may favor ‘pre-sale distributions for essentially tax reasons’.54 The second is the tax consolidation regime. This regime was created in 1988, even though the first draft dates back to 1971.55 The goal was twofold: to consolidate the results of companies that form a group, authorizing the compensation of losses and gains as well as capital 44 A full ownership or a bare ownership by the parent company and the exclusion of usufruct of the shares. 45 The securities must represent at least 5 percent of the capital of the subsidiary, reduced to 2.5 percent of the capital and 5 percent of the voting rights if the parent company is controlled by a non-profit organization. 46 The parent company must have held the securities for at least 2 years. Certain special conditions may exist for the calculation of the period, in particular for restructuring operations. 47 The subsidiaries held must be subject to corporate income tax or an equivalent tax in France or abroad. 48 ECJ, 2 September 2015, Case C-386-14, Groupe Steria SCA. 49 Article 216 of the FTC. 50 CE, 8e/3e ch. réunies, 5 July 2022, no. 463021, SA Axa. 51 CE, 8e/3e ch. réunies, 15 November 2021, no. 454105, Société Air Liquide. However, it appears that the analysis of the share of costs and expenses for capital gains is not identical to that used for dividends in the Axa case. 52 Law no. 2012-1509 of 29 December 2012, Journal Officiel, no. 304, 30 December 2012, article 22. 53 Article 219 I a quinquies of the FTC. 54 D. Gutmann, Droit fiscal des affaires, LGDJ, 12th Edition, 2021, p. 231. 55 J. Guyénot and C.P. d’Evegnée, ‘The French Legal and Tax Aspects of the Formation of Subsidiaries in a European Context’, The International Lawyer, vol. 9, no. 1, January 1975, pp. 101–16.

Corporate taxation in France  203 gains and losses within the group, and to neutralize some inter-group operations in order to avoid double taxation of the same operations within the group. In order to form an integrated group, it is necessary to meet the conditions set out in article 223 A of the FTC relating to the holding of capital,56 submission of all integrated companies to corporate income tax, the agreement of the subsidiary57 and the financial year.58 If the conditions are fulfilled, the parent company becomes solely liable for the corporate income tax due on all the results of the group formed by it and its subsidiaries. Consequently, the fundamental operation will be the consolidation of the results,59 which involves four steps: the determination of each company in the group; the determination of the overall result taking into consideration deficits and profits; the restatement of the overall result in order to tax the group on its real profit; and the taxation of the overall result. The tax will be paid by the head company of the group, even if there is a principle of solidarity in the payment of the tax between all companies of the group. In practice, the tax authorities impose a strong reporting obligation on all group companies in order to have full knowledge of the tax situation of the group.60 One of the difficulties in applying this regime relies on the submission of all integrated companies to corporate income tax in France. This situation explains the development of an important European jurisprudence which led to the evolution of the French system by authorizing two types of horizontal and vertical integration. The Papillon case61 (vertical integration) has led to the recognition for a French parent company of the integration of a French sub-subsidiary, held through a foreign company not subjected to corporate income tax in France but whose registered office is located in the EU. The SCA Group Holding BV case62 (horizontal integration) led to the modification of French law, even if France was not directly concerned, in order to allow the integration of French sister companies, at least 95 percent owned by a parent company established in another member state. Some French integrated groups believe that they can take advantage of EU case law to argue that they can use the losses of their European subsidiaries that are more than 95 percent owned to offset the profits of the French headquarters. The question remains as to whether the territorial limitation of tax consolidation, and in particular whether the restriction of tax consolidation to French subsidiaries only, infringes the freedom of establishment. In the Société Agapes case,63 the French Supreme Court (Conseil d’Etat) definitively condemned any possibility of setting off deficits made by foreign subsidiaries owned at more than 95 percent against the overall result of an integrated group regardless of the nature of the unusable losses.

A quasi-exclusive holding is required since the parent company must hold at least 95 percent of the capital of the group companies, directly or indirectly. 57 In order to be included in the group’s scope of consolidation, all subsidiaries must give their consent individually, by means of a tax consolidation agreement. When leaving the group, certain neutralization measures are called into question. 58 The companies of the group must open and close their fiscal year on the same date. 59 Article 223 B of the FTC. 60 However, the Supreme Court held that the tax burden of the group can be freely allocated among the members of the integrated tax group. See: CE, 8e and 3e sous-sections réunies, 12 March 2010, no. 328424, Sté Wolseley Centers France. 61 ECJ, 27 November 2008, C-418/07, Société Papillon. 62 ECJ, 12 June 2014, C-39/13, SCA Group Holding BV. 63 CE, 9e/10e sous-sections réunies, 15 April 2015, no. 368135, Société Agapes. 56

204  Research handbook on corporate taxation However, the lack of clarity in European jurisprudence continues to give them hope, even if the answer in domestic law remains the same.64 Finally, there are specific rules applicable to corporate restructuring, including operations that modify the share capital through techniques such as capital changes or mergers and similar operations. In the context of a capital increase, there are some techniques related to the taxable event that allow the contributor to avoid immediate taxation, such as tax deferral.65 However, specific favorable tax regimes are more likely to be found in the case of mergers, partial contributions of capital and divisions.66 Indeed, the general idea is to create tax neutrality so as not to slow down economic regroupings or restructuring and to best allow the continuation or distribution of activities under a different legal form. In order to achieve this general objective, a preferential tax regime derogating ordinary law was created in the 1940s67 and is still applicable to the companies participating in these operations and to their partners.68 In this area, the European influence is important, due to the existence of the 1990 Merger Directive69 and is growing as France has to implement a new directive,70 which would improve cross-border transformations by facilitating the transfer of the registered office from one EU member state to another, in order to carry out partial contributions in kind of assets legally placed under the regime of divisions. Thus, it would be possible to transfer entire branches of activity from one EU member state to another. The French tax definitions of mergers and divisions are very broad, as the choice was made to give the same definition to internal and cross-border operations, whereas the notion of a complete branch of activity poses difficulties of interpretation. In fact, the tax regime applicable to mergers also applies to partial contributions of capital and divisions, even if some minor adaptations are due to the structure of the operation and the legal continuity or not of certain companies.71

64 CAA Versailles, 3e ch., 23 juin 2020, no. 19VE01012, Groupe Lucien Barrière, conclusion M. Deroc, note M. Sadowsky, ‘Déduction des pertes définitives européennes: l’importance d’être constant’, Revue de Droit Fiscal, no. 45, 5 novembre 2020, pp. 28–40. 65 Article 150-0 B ter of the FTC (report d’imposition): this technique allows to defer the taxation of the capital gain in order to recognize and fix the taxable event at time of contribution and defer its liability to a later date. 66 Articles 210-0 A, 210 A and 210 B of the FTC. 67 The tax regime for mergers was created by a law of 12 August 1942 and extended to partial contributions of capital by a law of 16 June 1948. 68 Most of the current rules result from the law of 12 July 1965. 69 Council Directive 90/434/EEC of 23 July 1990 on the common system of taxation applicable to mergers, divisions, transfers of assets and exchanges of shares concerning companies of different Member States, Official Journal L 225, 20 August 1990, pp. 1–5. 70 Directive (EU) 2019/2121 of the European Parliament and of the Council of 27 November 2019 amending Directive (EU) 2017/1132 as regards cross-border conversions, mergers and divisions, Official Journal L 321, 12 December 2019, pp. 1–44. 71 For a detailed analysis of the conditions and the different tax techniques, see: P. Oudenot, Fiscalité approfondie des sociétés, LexisNexis, 5th Edition, 2020, p. 659 and f.

Corporate taxation in France  205

4.

CONTROL OF THE NORMALITY OF TAXABLE RESULTS

Under the influence of international and European rules, French law has extended the control tools available to the tax authorities to ensure the normality of the taxable result (4.1), while the means to correct this result remain the same (4.2). 4.1

Extension of Control Tools

The Constitutional Council has enshrined the constitutional value of entrepreneurial freedom.72 In principle, it must limit the interference of the tax authorities in the management of the company, and the entrepreneur must be able to choose the least expensive legal and fiscal solution. However, when the financial interests of the state are compromised by an abnormal management causing the loss of tax revenues, the administration must be able to act. The growing number of European texts relating to the reinforcement of the fight against tax avoidance practices in the context of the Base Erosion and Profit Shifting (BEPS) reform has led to the strengthening of anti-abuse measures. The historical tools are known. On the one hand, some of them are general rules. First, the theory of abuse of law was introduced in article L64 of the Tax Procedure Code (TPC) in 1941 in order to reveal the true legal nature of certain transactions carried out in order to reduce or avoid taxes, allowing the tax authorities to requalify it.73 Initially applicable to registration fees, this general rule was gradually applied to all taxes. This concept refers to a fictitious act with exclusively fiscal purposes, which does not respect the objectives of the authors of the texts. The penalty is heavy, leading to the application of late payment interest and an increase of 80 percent of the evaded duties, reduced to 40 percent if it is not established that the taxpayer is the main beneficiary or has had the main initiative.74 In addition, some specific anti-abuse rules were created for corporate groups in order to exclude them from the favorable group tax regime.75 Second, case law has developed the theory of the abnormal management decision (acte anormal de gestion) in order to neutralize the tax effects of abnormal behavior, with the aim of obtaining a tax saving. It is the act ‘by which a company decides to impoverish itself for purposes that are not in its interest’.76 In this case, the tax authorities may deny the deduction of expenses and tax the company that initiated the act and its beneficiary. On the other hand, other tools were also created to control the normality of taxable results derived specifically from international transactions or some cross-borders flows. With regards to transfer pricing,77 the administration may recharacterize part of the transaction in order to adjust the author of the abnormal transfer and its beneficiary. Two conditions are required: dependencies between related companies – unless the foreign company is located in a preferential tax 72 Constitutional Council, Decision no. 81-132 DC of 16 January 1982, Loi de nationalization, Journal Officiel, 17 January 1982, p. 299. 73 The tax authorities already used the civil law theory of abuse of law during the 19th century. About a circumvention of the registration fees by the taxpayer: Cour de Cassation, Chambre civile, 20 August 1867. 74 Article 1729 of the FTC. 75 Since 2018, in the case of mergers, split operations or partial contributions of assets with tax fraud or evasion as their main objective or as one of their main objectives: article 210-0 A III of the FTC. 76 CE, 3e, 8e, 9e, 10e, Ch. Réunies, 21 December 2018, Société Croë Suisse, §2. 77 Article 57 of the FTC.

206  Research handbook on corporate taxation state78 or an uncooperative state or territory79 – and an indirect transfer of profits. Outside a group, some rules also exist to sanction transfers of assets made by a company to a person or organization outside France.80 With regards to controlled foreign company (CFC) rules, France implemented in the 1980s a rule to fight against the relocation of profits in preferential tax states. According to article 209 B of the FTC,81 the results of foreign companies subject to a preferential tax regime, controlled at more than 50 percent82 by a French company subject to corporate income tax, are subject to corporate income tax in France. However, some safeguard clauses exist if the CFC is located in the EU or in third countries. It was at the same time that France adopted a system to fight against ‘rent a star company’ schemes.83 This historical arsenal has been enriched by other tools derived from the current international context, leading to a proliferation of anti-abuse measures. Indeed, the implementation of Anti-Tax Avoidance Directive (ATAD) 184 involves a new general anti-abuse rule applicable to corporate income tax85 and the creation of a ‘mini abuse of law’ (mini abus de droit)86 beyond corporate income tax. In each of these cases, and without a specific sanction, the concept of abuse of law is extended to a principally fiscal ‘motive’ (Article L 64 A of the TPC) or ‘objective’ (Article 205 A of the FTC), reminiscent of the international Principal purpose test clause (PPT). For the time being, it is still unclear how these rules fit with the historical tools, especially in terms of sanctions. The implementation of ATAD 287 also involves three very technical articles totally dedicated to anti-hybrid instruments.88 Finally, and for the first time, the Supreme Court has recognized the notion of abuse of tax treaties89 in stating that domestic rules may apply (article L 64 of the TPC) only if the treaty ‘does not explicitly provide for the hypothesis of fraudulent evasion of the law (fraude à la loi)’. This question is likely to become less relevant because, with BEPS reform, lot of tax treaties include specific anti-abuse rules allowing tax authorities to set aside the international text in case of abuse.

78 Definition is given by article 238 A of the FTC: ‘not taxable in France or if they are subject to taxes on profits or income that are 40% or more lower than the tax on profits or income for which they would have been liable under ordinary law in France.’ 79 Article 238-0 A provides for the definition and refers to an annual list of these countries. 80 Article 238 bis-0 I of the FTC. 81 A similar provision exists for individuals under the article 123 bis of the FTC. 82 The threshold is reduced to 5 percent when more than 50 percent is held by shareholders established in France who act in concert or by companies that are in a situation of control or dependence within the meaning of article 57 of the FTC. 83 Article 155 A of the FTC. 84 Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market, Official Journal, L 193/1, 19 July 2016. 85 Article 205 A of the FTC. 86 Article L 64 A of the TPC. 87 Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries, Official Journal, L 144/1, 7 June 2017. 88 Article 205 B, C and D of the FTC. 89 CE, 3e, 8e, 9e, 10e, Ch. Réunies, no. 396954, 25 October 2017, Consorts Verdannet. M. Sadowsky, ‘Tax Treaty Abuse as Fraus Legis’, in Tax Treaty Case Law around the Globe 2018, IBFD, 2019, p. 9 and f.

Corporate taxation in France  207 4.2

Correction of the Income or Profit

The conditions of the correction depend on two situations. The first is when a taxpayer makes an accounting error. In this case, the correction is limited. Indeed, a fundamental distinction is made between accounting errors and management decisions. If the accounting error is voluntary, that is, the taxpayer has acted with full knowledge of the facts, correction is impossible. In contrast, correction is possible if the error is involuntary, that is, the taxpayer did not act with full knowledge of the facts. The taxpayer can then request a correction of the result, which is subject to the same rules as a contentious claim, within a period of 2 years.90 As regards management decisions, the correction is impossible, because it results from a choice made by the taxpayer, on the basis of a possibility given by the tax rules, for example the renunciation of a preferential regime. If the error is claimed by the tax authorities, the time limit is longer: 3 years, possibly extended to 10 years in case of hidden activity.91 The main effect of the correction will be to reintegrate the disputed part into the company’s income or taxable profit, and to tax the unduly received benefit in the hands of its beneficiary with the possibility of applying late interest92 and additional penalties.93 On the one hand, the situation is easy to correct when the accounting entry is only in the income statement and corresponds to a single fiscal year. On the other hand, the situation is different when the accounting entry to correct is in the balance sheet, which involves a symmetrical correction to correct all the balances where the error appears. Indeed, the accounting rules require that the opening balance sheet of a fiscal year must correspond to the closing balance sheet of the previous fiscal year.94 Consequently, a time limit has been set up in order to take into account prescription rules of 3 years, in principle, known as the principle of intangibility of the opening balance sheet of the first non-prescribed fiscal year.95

5. CONCLUSION The current French system is not so far from the past. One could even say that the corporate tax is returning to its historical roots, reproducing in recent years the main characteristics of its creation: an almost similar corporate tax rate, a mix of progressivity and proportionality with income tax, a superposition of taxes leading to an economic double taxation of dividends without a specific system to eliminate it. In an international context, the French system highlights its particularities relating to the principle of territoriality of corporate income tax, the tax treatment of partnerships or the conception of income tax through domestic concepts such as the tax household or the family quotient. Finally, it can be seen that despite the successive reforms aimed at simplifying and clarifying the company taxation system, it remains complex and that the main purpose to eliminate tax fraud, which motivated the introduction of a specific tax for legal entities in 1948, is still relevant.

92 93 94 95 90 91

Article R 196-1 of the TPC. Article L 169 of the TPC. Article 1727 of the FTC. Article 1729 of the FTC. Article L123-19 of the Commercial Code. Article 38 4 bis of the FTC.

13. Corporate taxation in Italy Carlo Garbarino

This chapter is part of a Research Handbook and therefore, rather than just providing a synchronic snapshot of the current state of the Italian corporate tax system, critically adopts a diachronic approach that looks at the evolution of the system over time, assessing which changes are ‘exogenous’ and which ‘endogenous’. ‘Exogenous’ changes are those that are the result of tax transplants and policy transfers and are identified on the basis of the conjecture that domestic corporate tax systems develop over time and are interconnected. This expectation relies on the functionalist paradigm according to which rules are means to address problems, so that transplants can be inspired by the functions of corporate tax measures of different national systems. By contrast, ‘endogenous’ changes are those that are the outcome of a domestic mechanism of generation of corporate tax rules. This expectation relies on the premise of ‘differentiation of legal cultures’ according to which the task of research primarily consists of penetrating, understanding and describing legal culture the way it is experienced locally. Therefore the analysis of an individual corporate tax system (Italy) becomes explicative under the condition of being ‘evolutionary’, that is, when it attempts to find which tax solutions have developed domestically in Italy and which have not, where they have originated, why and how they have been imported. We therefore surmise that there are ‘genealogies’ of domestic tax solutions currently adopted in Italy which are traceable to the global dynamic mapping of clusters of countries with respect to corporate tax policy issues. We identify a set of structural policy solutions as the core of the Italian corporate tax system as follows: the design of taxable corporate income (section 1); limitations of interest deductions (section 2); tax treatment of profit distributions (section 3); group consolidation (section 4); and taxation of foreign controlled companies (section 5). We then draw conclusions about a taxonomy of exogenous and endogenous changes of the Italian corporate tax system (sections 6 and 7).

1.

THE DESIGN OF TAXABLE CORPORATE INCOME

The corporate income tax (Imposta sul reddito delle società, ‘IRES’) was introduced in 1974 and thoroughly reorganized as a tax code by Testo unico delle imposte sui redditi (‘TUIR’), which was enacted by Presidential Decree (‘D.P.R.’) 917/1986. TUIR became effective on 1 January 1988 and has been amended several times, in particular by Legislative Decree (‘D. Lgs.’) 344/2003, which enacted the corporate tax reform, lowering the corporate income tax rate from 34 percent to 33 percent; subsequently this rate has reached the current 24 percent. The regional tax on productive activities (Imposta regionale sulle attività produttive, ‘IRAP’) was introduced in 1997 by D.Lgs. 446/1997 and is levied on companies and partnerships that carry on an autonomously organized activity aimed at the manufacturing/trading of goods or the supplying of services. IRAP taxable base is the net value of production derived 208

Corporate taxation in Italy  209 in each Italian region and the standard rate is 3.9 percent but higher rates apply to specific industries. IRAP is partially deductible from IRES. Resident companies and non-resident entities are IRES taxable persons (article 73, TUIR). Resident companies are taxed on their worldwide income but may elect to exempt income derived through foreign permanent establishments. Resident partnerships are fiscally transparent and are not liable to IRES (article 5, TUIR), while the partners are taxed on their share of the partnership’s profits. Non-resident entities of every kind, with or without legal personality (including foreign partnerships), are liable to IRES only with respect to income derived from Italy. All income derived by companies is considered business income and is subject to IRES (article 81, TUIR). IRES income can be profits or losses. Profits are subject to the 24 percent rate. Losses may be carried forward to reduce profits in subsequent fiscal years, up to 80 percent of such profits. The losses realized in the first three fiscal years may be carried forward without such limitation. IRES taxable base is computed by starting from the profit and loss account of the relevant fiscal year on the basis of accounting criteria and then making upward and downward ‘tax adjustments’ in the tax return to determine taxable income reported. So taxable income reported in the tax return does not necessarily coincide with accounting income reported in the financial statement (so-called ‘double track system’). Detailed rules apply for computing adopters’ taxable income on the basis of International Financial Reporting Standards (IFRS). Tax adjustments are very detailed and change continuously, but it is possible to assess five main typologies imposed by TUIR to safeguard the taxable base. First, corporate business income is determined according to a specific tax accrual method that limits the shifting across fiscal years of positive and negative items of income (article 109(1), TUIR), and in addition there are certain exceptions based on perception and other criteria. Second, costs may be tax-deductible in the tax return only if they are incurred for the production of income, with some exceptions (i.e. interest subject to special rules, certain taxes, social security contributions and directors’ fees). Third, costs to be tax-deductible in the tax return must be booked in the financial statement of the relevant fiscal year (article 109(3–4), TUIR), but this is not required for positive items of income which can be directly included in the tax return. Fourth, costs may be tax-deductible in the tax return in a given fiscal year (for example 2022) even if they were booked in the financial statement of a previous fiscal year (for example 2020) if that deduction was postponed (for example in 2020) in compliance with tax laws; this timing disalignment is balanced through special tax adjustments (article 109, TUIR). Finally, costs cannot be tax-deductible in the tax return if, and to the extent that, they relate to business activities or assets that generate exempt income; if costs pertain to activities and assets that generate both taxable and exempt income, a pro rata computation applies (article 109(5), TUIR). Complex legislation has introduced a wide array of tax incentives that modify downward the amount of taxable corporate profits. In addition to the existing favorable tax depreciations, other types of accelerated depreciations and investment deductions – usually in the form of tax credits – were introduced. A host of incentives is based on tax credits related to (i) research and development, (ii) investments in new business assets, in small and medium-sized companies, and in innovative start-up companies. An elective patent box regime has also been introduced

210  Research handbook on corporate taxation that is based on an enhanced (notional) deduction linked to qualified expenses to develop, maintain, protect and exploit qualified intellectual property.

2.

LIMITATION OF INTEREST DEDUCTIONS

In Italy there is a structural bias in favor of debt versus equity in the financing of companies. Debt is preferred to equity because interest expenses are tax-deductible, whereas dividends are not. Furthermore dividends may be partially subject to double taxation, while interest is not subject to double taxation because it is deductible by the payor (unless certain limitations apply). In addition debt financing is not subject to wealth taxes, net worth taxes and other capital duties imposed in Italy on equity contributions and allows the repatriation of invested capital as loan repayments without tax consequences. From a corporate law perspective in Italy debt can also be easily convertible to equity, but not the reverse, while the withholding taxes on interest imposed by tax treaties concluded by Italy are often lower than those on dividends. All these tax advantages have traditionally encouraged taxpayers to prefer debt to equity and thus the problem of tax deduction of interest in the Italian tax system is multifaceted and is addressed by different sets of rules that are described here below. The erosion of the corporate tax base pursued by leveraging closely-held corporations is addressed by a case-by-case test of connection of interest with business activity that prevents the deduction of interest that is not incurred for the production of income. Within closely-held corporations there are also other forms of erosion of the corporate tax base: companies deduct amounts paid to shareholders qualifying them as fees for services, while the amounts paid are effectively return on equity investments. To address this problem administrative guidelines and case law have developed a hidden profit distributions doctrine that bars the tax deduction of these amounts. Another tax rate arbitrage that is pursued by closely-held companies is when these companies are financed by their shareholders through loans: in these cases shareholders receive interest that is deductible from the company tax base subject to the 24 percent tax rate but is taxable for the recipient at a lower rate. To address this problem administrative guidelines and case law have developed a recharacterization doctrine under which interest is deemed to be non-deductible dividends on the basis of indicia such as fixed provision for repayment, interest payment triggered by the accrual of profits in the hands of the payor, the fact that a loan is easily convertible into equity, and so on. At the level of large corporations other manifestations of the problem of tax deduction of interest have emerged in Italy which are different from those of closely-held companies. The first problem is the erosion of the corporate tax base that is pursued through intragroup cross-border financing with interest exceeding market value. This problem is traditionally addressed by transfer price rules based on the arm’s length approach that looks at the amount of interest which would have been paid to a third party. This problem, however, is often compounded by another form of erosion of corporate tax base that is pursued through intragroup cross-border financing with amount of loans exceeding the credit capacity of borrower. This problem was initially addressed in 2004 by the introduction of a debt/equity ratio – the so-called ‘thin cap rules’ – effective in fiscal years 2005–08.

Corporate taxation in Italy  211 Thin cap rules applied to all types of companies including those that exercised an activity of buying and selling securities, but did not apply to banks and small firms. Under thin cap rules the remuneration of the excess loans, directly or indirectly granted or guaranteed by a ‘qualified shareholder’ or by its ‘related party’, was not deductible from taxable income if, at any time during the fiscal year, the ratio between the average amount of the loans and the net book value of shareholders’ equity held by the shareholder or its related parties, increased by the capital contributions of the shareholder or its related parties, was higher than 4:1 (four to one). The amount of the loans exceeding on average this ratio was considered an excess loan that triggered deemed non-deductible dividends. For the purposes of the thin cap rules the shareholder was ‘qualified’ when it directly or indirectly controlled the debtor or held 25 percent or more of the share capital of the debtor, taking also into account participations held by its ‘related parties’, that is, companies controlled by the qualified shareholder pursuant to article 2359 of the Italian Civil Code, and in the case of individuals, family members. The thin cap rules did not apply when the borrower gave proof that the amount of the loans was justified by its own exclusive credit capacity, and that consequently, the loans would have been granted even by independent third parties with the sole guarantee of the company’s assets. In the ratio equity was the net book value of shareholders calculated starting from the financial statements of the preceding fiscal year, including any undistributed income of such year and making several adjustments downward. In the computation of debt, loans granted or guaranteed de jure or de facto by the qualified shareholder or its related parties, including loans arising from mortgages, cash deposits or any other relationship of a financial nature, had to be taken into account. Companies had to track the group outstanding debt on a day-by-day basis. In conclusion the computation of relevant equity and debt for the purposes of thin cap rules implied the complex identification of qualified shareholders and related parties, was technically complex and generated high transaction costs. Another relevant problem in this area was the artificial creation of losses that were matched within the group by specific units carrying ad hoc tax capacity. This goal was achieved by creating special purpose vehicles that, in the context of the leveraged buyout of a target company, matched the deductible interest created by debt created for the acquisition with exempt income in the form of dividends paid by the target company after the acquisition. This problem was initially addressed in 2004 by the introduction of a specific ratio denominated pro rata regulated by article 97, TUIR. The thin cap rules and the pro rata ratio were replaced in 2009 by the adoption of an EBITDA (Earning Before Interest Tax and Amortization) ratio aimed at addressing with a single legislative formula all the different facets of the problem of tax deduction of interest. New article 96, TUIR provided that interest expenses were deductible up to an amount equal to interest income accrued in the same fiscal year and that any excess over that amount was deductible up to 30 percent of the ‘gross operating income’, that is, profits before interest, taxes, depreciation and amortization (i.e. EBITDA). Interest that was not deductible under the EBITDA rule was not recharacterized as a dividend distribution. This accounting EBITDA was calculated as the difference between (i) the value of production (item A of the financial statement scheme contained in article 2425 of the Italian Civil Code) and (ii) costs of production (item B of the financial statement scheme contained in article 2425 of the Italian Civil Code), excluding depreciation, amortization and financial

212  Research handbook on corporate taxation leasing installments relating to business assets, as well as capital gains or losses upon transfer of going concerns. IAS/IFRS adopters had to take into account the corresponding items of their IAS/IFRS financial statement. Any non-deductible interest expenses in excess of the above threshold (i.e. 30 percent of EBITDA) could be carried forward without time limitation (‘carried forward interest’) and could be deducted in the following fiscal years to the extent that the net interest expenses (i.e. those exceeding interest income) accrued in each relevant fiscal year were less than 30 percent of EBITDA. If, in a fiscal year, there was an excess of 30 percent of the EBITDA over the net interest expenses, such excess could also be carried forward without limitation and used to increase the relevant threshold in the following fiscal years. If a company was part of a domestic tax consolidation group, any excess interest expenses over 30 percent of EBITDA or any carried forward interest generated after the inclusion in the tax consolidation could be used to offset taxable income of another company within the tax consolidation group, up to 30 percent of such company’s EBITDA that had not been used to deduct its own interest expenses. In 2019 article 96, TUIR was amended to comply with the Anti-Tax Avoidance Directive (2016/1164) (‘ATAD’). The core of the mechanism described above remained unchanged but the following additional changes were made. Starting from 2019 if interest income is greater than interest expenses in a given fiscal year, excess interest income may be carried forward without limitations, the accounting EBITDA is replaced with a tax EBITDA which is computed on the basis of tax-adjusted values, and the excess tax EBITDA of a given fiscal year can be carried forward for five years. Financial intermediaries (banks, certain finance companies and parent companies of banking groups) and financial holding companies are not subject to article 96, TUIR. Insurance companies, parent companies of insurance groups, qualified asset management companies and qualified brokerage companies are also not subject to article 96, TUIR, but they can deduct interest only up to 96 percent of its amount.

3.

TAX TREATMENT OF PROFIT DISTRIBUTIONS

Italy had a full imputation system introduced in 1977, which was replaced on 1 January 2004 by a participation exemption system of taxation of distributions of corporate profits earned through domestic and foreign subsidiaries. On that date the imputation system was abolished and thus since then resident shareholders no longer benefit from an imputation credit on dividend distributions to prevent double taxation, but dividends are (fully or partially) exempt. A 95 percent dividend exemption is the general rule for recipient companies, unless the dividends ultimately originated in a low tax jurisdiction; in such a case the 24 percent corporate tax rate is applied. Therefore the Italian system adopts a participation exemption system for inter-corporate dividends based on full exemption: even if nominally the exemption is 95 percent, all costs are deductible from the remaining 5 percent taxable amount, so in most cases the taxable amount of dividends is minimal or nil. The previous imputation system faced several practical and policy issues. The main issue was to identify which part of taxed corporate income was actually distributed over the years to shareholders, thereby carrying a credit. In particular when corporate income was exempt and

Corporate taxation in Italy  213 then distributed to shareholders, the issue was whether exemption should be passed through to shareholders, and, if so, whether there should be a ‘compensatory tax’. In addition relevant litigation occurred with respect to dividend washing issues when participants in investment funds were formally treated as shareholders for the purposes of imputation, thus receiving a credit that was not deemed to genuinely belong to them. Complex tax planning schemes were also developed in connection to unused dividend tax credits, which were transferred within the group and allocated to units that had tax capacity to use such credits, so that anti-abuse claims were raised by the tax authorities. Another dividend washing issue was created by tax planning techniques in which dividends were paid to shareholders and, at the same time, these shareholders took advantage of deductible tax writedowns of their participations resulting from the distributions. An internal asymmetry of the imputation system was that capital gains on sales of participations were fully taxable, while dividends received on those shares carried a creditable credit: so there was a disparity of tax treatment between similar situations. An additional problem was whether the dividend tax credit was attributable to the shareholders if they, instead of receiving dividends, sold the shares before distribution of profits and realized capital gains constituted by undistributed profits. Major problems of the imputation system were related to the EU system of cross-border dividends under the Parent Subsidiary Directive (1990/435, amended 2011/96) (‘PSD’) which imposed the ban on double taxation on distributed profits. So a problem occurred when a distributing company not resident in Italy paid dividends to Italian shareholders (inbound dividends) as it was doubtful whether these resident shareholders could get the credit of the foreign corporate tax on those dividends as it occurred with domestic dividends. Another problem occurred when the distributing company was resident in Italy (outbound dividends) as it was doubtful whether and how the tax credit of the IRES could be attributed to the non-resident shareholders. These problems had already been solved by leading Court of Justice of the European Union (‘CJEU’) cases that provided guidelines and standards for national legislators. In 2004 Italy introduced the participation exemption to address these problems and to get aligned to EU law. While solving most of those problems, the participation exemption system introduced new technical issues. In the first place it was necessary to differentiate the treatment of individual and corporate recipient shareholders (this problem was not relevant in the imputation system). In case of corporate recipient shareholders the granting of full exemption was not an issue because the rate of the distributing and recipient company are by necessity the same (24 percent): the profits received by resident companies are not deductible for the payor and excluded from the income of the receiving company for 95 percent of their amount. By contrast, in case of individual recipient shareholders who are subject to progressive rates that are not the same as the corporate tax rate, there is either a 26 percent withholding tax (private shareholders) or a partial exemption (business shareholders). The exemption on dividends from shares also triggered the need to define when a so-called ‘hybrid financial instrument’ is deemed to be equity that generates exempt dividends under the participation exemption. Article 44(2), TUIR, provides that (i) financial instruments whose remuneration totally consists in the participation in the company’s economic results are similar to equity participations and (ii) participations in non-resident companies are similar to equity participations if according to Italian law their remuneration is not deductible from income by

214  Research handbook on corporate taxation the non-resident payor. Silent partnership contracts are deemed to trigger dividends if they meet certain requirements. In the participation exemption system the concept of ‘distribution’ remains as relevant as it was in the imputation system. Therefore the same notion of distribution applies in the imputation and in the participation exemption systems. For example, reductions of share capital are exempt dividends if payments received by shareholders are in excess of their relevant paid-in capital. Dividends in kind and hidden profit distributions also enjoy the exemption. By contrast, returns to shareholders of zero rate loans are not dividends and do not benefit from the exemption. The participation exemption system also relies on rules concerning the requirements that a distributing company must meet in order for its shareholders to benefit from the exemption on the received dividends. Differently from other tax systems in Italy the only requirement is that the recipient company is resident in Italy and that the distribution actually involves profits that were subject to Italian corporate tax or to a tax rate comparable to that of Italy, but there are neither minimum thresholds for a participation, nor distinctions between financial assets versus stock-in trade, nor holding period requirements. In contrast to dividends, the exemption of capital gains from the sale of participations, financial instruments similar to equity participations and certain silent partnership contracts are 95 percent exempt from corporate tax in the hands of the realizing company, only if a set of requirements is met. These requirements are: (i) continuous possession from the first day of the twelfth month preceding the month of the actual sale, considering the participations acquired as of the most recent date as the first participations sold; (ii) classification of participations in the category of financial fixed assets in the first financial statement closed during the period of ownership; (iii) fiscal residence of the distributing company in a state or territory other than those with preferred tax treatment; and (iv) the exercise of a trade or business by the distributing company. Requirement (iii) must be met without interruptions since the beginning of possession. Requirement (iv) must be met without interruptions at least from the start of the third fiscal year prior to the realization and does not apply in the case of participations in companies whose securities are negotiated in regulated markets. The exemption always applies to capital gains realized through public sale offers. Capital losses on participations eligible for the capital gains tax exemption are not deductible for corporate income tax purposes. This means that capital losses (either realized or simply accrued) on shareholdings which qualify for the exemption are irrelevant for tax purposes. General operative expenses are deductible.

4.

GROUP CONSOLIDATION

Groups in Italy may elect to be taxed as single taxpayers for corporation tax purposes under certain regimes introduced in 2004: ‘domestic tax consolidation’ includes only resident group companies (articles 117–29, TUIR), while ‘worldwide tax consolidation’ extends to non-resident group companies having a consolidating company resident in Italy (articles 130–42, TUIR). A so-called ‘consortium relief’ (articles 115–16, TUIR) is also available under different requirements and allows a sharing of profits and losses among different companies through fiscal transparency by election.

Corporate taxation in Italy  215 We discuss now domestic tax consolidation and consortium tax relief, while worldwide tax consolidation will be discussed at section 6 in the context of taxation of foreign controlled companies. Domestic Tax Consolidation When certain requirements are met, domestic tax consolidation allows the full sharing of profits and losses within the group recognized as a single economic unit. Under this regime profits and losses of different resident companies belonging to a group and meeting requirements of a qualified participation are added up: consolidated profits are subject to 24 percent IRES rate and consolidated losses can be carried forward at the level of the consolidation. Group accounting consolidation is not a prerequisite for domestic tax consolidation. To access tax consolidation each eligible company must make an election. This election for consolidation may not be made by companies which enjoy a reduction in their corporate tax rate or in the event of bankruptcy and forced administrative liquidation (articles 125–6, TUIR). When a company elects to consolidate, the company is defined as a ‘consolidated company’ and the election cannot be revoked for three years (article 121, TUIR). There is no ‘all-in-all-out rule’, so it is possible to have one or more different consolidation ‘perimeters’ within a group and just to consolidate only selected companies (so-called ‘cherry-picking’). Within each consolidation perimeter there is only one ‘consolidating company’ which cannot be a consolidated company of another perimeter. The requirements for the election for domestic tax consolidation (article 119, TUIR) are the following: (i) all the companies must have the same fiscal year; (ii) the election must be jointly exercised by the consolidating company and each consolidated company; (iii) the joint exercise of the election must be communicated to the tax authorities; and (iv) each consolidated company must elect domicile at the consolidating company. Domestic consolidation involves the calculation by the consolidating company of a so-called ‘overall aggregate income’ (i.e. consolidated profits or consolidated losses) corresponding to the algebraic sum of the net incomes (i.e. profits or losses) of the consolidating company and each consolidated company. Consolidation applies only to companies resident in Italy for tax purposes – that is, joint-stock companies, limited partnerships with share capital and limited-liability companies – and implies compliance duties for the consolidating company and the consolidated companies. – The consolidating company calculates the overall aggregate income of the consolidation by taking the algebraic sum of the incomes (profits or losses) of the consolidated companies, files the consolidated tax return, pays the 24 percent IRES due on the overall aggregate profits or carries forward the overall aggregate losses and other consolidated tax attributes such as tax credits. – Each consolidated company must file an income tax return for the calculation of its own individual income and supply any needed assistance to the consolidating company to allow the latter to fulfill its obligations (article 122, TUIR). Up to 2008 the consolidated companies had an obligation to supply to the consolidated company the data relative to the assets transferred and acquired in accordance with the neutral taxation system for intragroup

216  Research handbook on corporate taxation transfers; this obligation was eliminated in 2008 when this neutral taxation system was abolished. Two requirements concerning qualified participation must be met by a company to make an election to be consolidated. – First, the consolidating company must control, directly or indirectly, more than 50 percent of the share capital of the consolidated company; this participation is determined by taking into account any proportional reduction produced by the corporate chain of control. For example, if A owns 80 percent of B, which in turn owns 80 percent of C, then C can be consolidated by A which indirectly owns 64 percent of C; this is called a ‘multiplier’ and applies in respect of the computation of the qualified participation for the purposes of domestic consolidation. – Second, the consolidating company, on the basis of the above-described qualified participation, must receive, directly or indirectly, more than 50 percent of the profits reported in the financial statement of the consolidated company. This qualified participation must exist as of the beginning of any fiscal year and continue to exist without interruption for that year (article 120, TUIR). If the qualified participation is no longer met in any moment during the consolidation, the relevant company is ‘de-consolidated’, that is, excluded from the domestic consolidation. After the de-consolidation of an individual company the tax losses resulting from its tax return continue to remain exclusively available to the consolidating company. The same mechanism applies to the merger of a consolidated company into another company not included in the consolidation (article 124, TUIR). Consolidated income – defined as overall aggregate income – includes the total net results of the consolidated companies regardless of the percentage of the controlling shareholding. This is called ‘full inclusion’ with respect to the total of profits or losses of each individual consolidated company which are fully included in domestic consolidation (article 117, TUIR). A specific feature of Italian domestic tax consolidation is therefore that the multiplier operates asymmetrically. The multiplier does operate for the purposes of identifying the qualified participation (to decide whether a company can be consolidated), while it does not operate for the purposes of attribution of profits/losses of a consolidated company which are fully included in consolidation irrespective of the percentage of the qualified participation. Post-consolidation losses are those reported by an individual company after entering consolidation, while pre-consolidation losses are those which were reported by an individual company before entering consolidation. Post-consolidation losses are fully admitted, while pre-consolidation losses are not admitted as such to consolidation as they can only be used by the individual consolidating or the consolidated company by resorting to the general rules about individual-company loss carry forward. In other words pre-consolidation losses are not wasted if a company is consolidated, but can be used by such company only if that company individually, after consolidation, reports taxable profits. In the Italian tax consolidation, consolidated loss-companies contribute to the reduction of the overall aggregate income of the group, so they need to be compensated for this benefit that is brought at the level of the group. By contrast, consolidated profit-companies contribute to the increase of the overall aggregate income of the group, so they must provide corresponding funds required by the consolidating company to pay the 24 percent IRES for the whole group.

Corporate taxation in Italy  217 So there is a need of so-called ‘consolidation covenants’ between the consolidating and the consolidated companies to allocate on a rational basis through so-called ‘consolidation fees’ the compensations to loss-companies and the payments by profit-companies. In this respect article 118(4), TUIR provides that the sums received or paid among the consolidated companies as offsetting entries for fiscal benefits provided or received are not included in taxable income. In practice these sums are effectively paid or received but have no tax impact, that is, they are neither tax-deductible when paid, nor taxable when received. Consortium Relief By exercising an election, the taxable income (profits or losses) of a resident company (‘participated company’) is allocated to each corporate shareholder (‘participating company’) in proportion to its participation, regardless of the actual amount received by such shareholder and effectively paid by the participated company (so-called ‘consortium relief’, article 115, TUIR). Tax profits or losses of the participated company relative to periods in which the election is in effect are allocated to the participating companies in proportion to their respective participations and up to the limit of their effective participation in the net assets of the participated company. The allocation of the profits or losses occurs in the fiscal year of the participating companies in effect as of the date of the close of the participated company’s fiscal year. For the election to be effective each participating company must have voting rights and participation in profits of the participated company of no less than 10 percent and no greater than 50 percent. These requirements must be met as from the first day of the fiscal year and without interruption until the end of the election period. Should the requirements for the exercise of the election cease to exist, the effectiveness of the election terminates as from the beginning of the fiscal year in effect. The election cannot be exercised if the participated company has issued financial instruments or has already made the election either for domestic or worldwide tax consolidation. If the participating companies are not resident, the exercise of the election for the consortium relief can be made, provided that there is no withholding tax obligation in Italy on the profits of the participated company that are allocated to the shareholders. The election is irrevocable for three fiscal years of the participated company and must be exercised by all participating companies together with the participated company and communicated to the tax authorities. The effects of the election do not cease in the case of a change in the shareholder base of the participated company, should the new participating companies meet the requirements for the consortium relief. The exercise of the election does not modify the tax treatment in the hands of participating companies of amounts distributed by the participated company using reserves set up with profits of prior years. The cost of the participations in the hands of the participating companies is increased or decreased, respectively, by the income and losses allocated to them, and are likewise reduced, up to the amount of the income allocated, for the profits distributed to them. The participated company is jointly and severally liable with each participating company for the tax, sanctions and interest consequent to the obligation of allocating the income. The consortium relief is also available for closely-held companies (article 116, TUIR): the election may in fact be exercised by certain small firms with an ownership base consisting

218  Research handbook on corporate taxation exclusively of individuals whose number shall not exceed 10 (or 20 in the case of a cooperative company) with the same means and at the same requirements of consortium relief.

5.

THE TAXATION OF FOREIGN CONTROLLED COMPANIES

CFC Rules CFC rules are provided for by article 167, TUIR introduced in 1991 and subsequently amended several times; the last changes were in 2019 to comply with ATAD. Under the CFC rules the profits of a non-resident company (‘CFC’) are deemed to be the profits of an individual or a company resident in Italy (‘Resident Person’), or a permanent establishment in Italy of a non-Resident Person, if: (a) the Resident Person or the permanent establishment in Italy ‘controls’ (pursuant to article 2359 of the Italian Civil Code), directly or indirectly, also through trustee companies or interposed third persons, the non-resident company; and (b) the non-resident company meets the two following conditions: (i.) the actual foreign income taxes are lower than 50 percent of the IRES that would apply to the company if this were resident in Italy; and (ii.) more than one-third of the company’s revenues are ‘tainted’ (‘passive income’), that is, derive from intragroup fees, interest, royalties, dividends, income from the disposal of shares, from financial leasing, insurance, banking and other financial activities. Until 2018 the requirement for CFC rules to apply was that the CFC was resident in a jurisdiction that was deemed to have a low tax regime, initially on the basis of a ‘blacklist’ and thereafter on the basis of effective rate differentials. Under the CFC rules, all income (profits, but not losses) of the CFC (and not just certain classes of ‘tainted’ income) is allocated to the Resident Person in proportion to its participation in the CFC’s profits, even if there is no distribution of dividends or other form of repatriation of profits. The income is imputed to the Resident Person on the last day of the CFC’s fiscal year. The Resident Person must treat the income allocated under the CFC rules as business income and compute it accordingly, with certain exceptions. The income is taxed separately from the other income of the Resident Person and is subject to a tax rate equal to the average tax rate applied on the aggregate income of the Resident Person which may not be lower than the 24 percent ordinary IRES rate. Income taxes paid by the CFC, whether in the foreign jurisdiction in which it is resident or elsewhere, may be credited against IRES. Dividends paid by CFC are fully exempt for the Resident Person. The Resident Person may apply for a tax ruling to be exempted from CFC rules by giving evidence that the CFC carries on a substantive economic activity supported by personnel, equipment, assets and premises.

Corporate taxation in Italy  219 Worldwide Tax Consolidation Consolidation of non-resident controlled companies of Italian controlling companies is allowed under the same principles described with respect to domestic consolidation, with major exceptions as the requirements for worldwide tax consolidation are stricter than those for domestic tax consolidation. The exercise of the election is permitted only for controlling companies that are deemed to be an ‘Ultimate Parent Company’, that is, a company resident in Italy which meets the following requirements: (i) its participations are negotiated in regulated markets; or (ii) is controlled exclusively by the state, by resident individuals who do not control, taking into account the participations held by their related parties, another resident or non-resident company. Consolidated companies include companies and entities of any type, with or without legal personality, non-resident in Italy in which the Ultimate Parent Company directly or indirectly owns more than 50 percent of shares, quotas, voting rights and profits, with such percentage to be determined by taking into account any proportional reduction produced by the corporate chain of control. This is the ‘multiplier’ and applies with respect to the computation of the qualified participation for the purposes of worldwide consolidation. This qualified participation must exist as of the end of the fiscal year of the Ultimate Parent Company (article 133, TUIR). The amount of participation in the profits is determined by reference to the date of the close of the fiscal year of the non-resident consolidated company or, if later, by reference to the date of the approval or audit of the relative financial statements. Upon the exercise of the election, the profits and losses of the non-resident consolidated companies are allocated to the Ultimate Parent Company, regardless of the distribution, in an amount corresponding to the Ultimate Parent Company’s participation in the profits of the non-resident consolidated companies, taking into account the proportional reduction caused by the corporate chain of control. This is the ‘multiplier’ and applies with respect to the amount of profits and losses that are included in worldwide consolidation (article 131, TUIR). The allocation occurs in the fiscal year of the Ultimate Parent Company and of the consolidated companies in effect as of the date of the close of the fiscal year of the non-resident company. The obligation for the payment of taxes is the exclusive responsibility of the Ultimate Parent Company. If the subjective qualification of the Ultimate Parent Company ceases to exist, the effects of the election terminate as from the fiscal year for the Ultimate Parent Company subsequent to that in which the aforementioned subjective qualification ceased to exist. The Ultimate Parent Company may not exercise the election for the domestic consolidation in the capacity of a consolidated company (article 130, TUIR). The election of the Ultimate Parent Company is irrevocable for five years. The renewal is for three years. The requirements for the election are the following: (i) the election must occur in relation to all non-resident companies of the group that are eligible to be consolidated companies (‘all-in-all-out principle’); (ii) all the consolidated companies must have the same fiscal year; (iii) the financial statements of all the companies must be audited and a certification must be released by each non-resident consolidated company; and (iv) the Ultimate Parent Company must obtain a ruling from the tax authorities that positively verifies the existence of the requirements (article 132, TUIR). The income resulting from the audited financial statements of the consolidated companies is recalculated in accordance with IRES rules with the following adjustments: (i) exclusion of

220  Research handbook on corporate taxation the taxable quota (5 percent) of the dividends distributed; (ii) adoption of uniform criteria for the treatment of the revenues, profits, expenses and charges; (iii) continuity of the accounting criteria adopted; and (iv) exclusion of the foreign-exchange gains and losses relative to intragroup loans with a term of more than 18 months. The Ultimate Parent Company, by computing the algebraic sum of its taxable income (profits or losses) and the taxable income (profits or losses) of the foreign consolidated companies determines the aggregate taxable income in relation to which it pays the corresponding 24 percent IRES, which may be reduced by the deductions, withholding and tax credits relative to the Ultimate Parent Company, as well as by the income taxes definitively paid abroad by the consolidated companies (article 136, TUIR). Pre-consolidation losses are not admitted to consolidation (article 134, TUIR). In computing taxable profits in euros the exchange rate is that of the last day of the applicable financial year.

6.

EXOGENOUS CHANGES: TRANSPLANTS AND CONVERGENCE

We can now draw conclusions by presenting a taxonomy of exogenous and endogenous changes of the Italian corporate tax system over the last two decades. Exogenous changes that have been the result of tax transplants and policy transfers are identified by the idea that solutions found in the Italian corporate tax systems have originated from policies of other countries and then maintained a functional similarity with them (‘convergence’). The exogenous changes that occurred in Italy have a common feature of being caused by transplants that intervened at governmental level. The reason is that relevant tax legislation was passed in the form of Presidential Decrees (D.P.R.) and Legislative Decrees (D.Lgs.) which were enacted by government on the basis of delegating statutes approved by Parliament indicating broad policies. So transplants were made in the stage of the policy process called ‘agenda-setting’ in which the adoption of a foreign model directly responded to the domestic recognition of an emerging policy issue. More generally in the domestic debate arguments in favor of the adoption of foreign solutions through transplants, have been based on findings of evolutionary interconnectedness of different national systems. Exogenous changes occurred with respect to limitations of interest deductions based on legislative formulas (section 2); tax treatment of profit distributions (section 3); and group consolidation (section 4). Three causal factors (or a combination thereof) have led to these exogenous changes: (i) competitive constraints, (ii) practical reasons, and (iii) EU compliance. In respect of limitations of interest deductions Italy has transplanted, in 2004 and in 2009, respectively thin cap rules and the EBITDA ratio on the basis of the German models. Therefore Italy through a process of convergence belongs to the predominant cluster of countries which currently adopt the EBITDA ratio as a replacement of thin cap rules. A mix of competitive constraints and practical reasons motivated the transplants, while EU compliance played a role in the final stage. The thin cap rules were replaced in 2009 by the EBITDA ratio because the computation of relevant equity and debt implied a difficult identification of qualified shareholders and related parties, was technically complex and generated high transaction costs; in addition the thin cap rules were not capable of addressing the arti-

Corporate taxation in Italy  221 ficial creation of losses through debt leverage of special vehicles. Eventually EU compliance was relevant because in 2019 article 96, TUIR was amended to comply with ATAD. With respect to the tax treatment of profit distributions in 2004 Italy transplanted a participation exemption system on the basis of the Dutch and similar models, but also the EU model was relevant. Italy belongs through a process of convergence to the predominant cluster of countries which achieve the same result (full exemption of corporate dividends) even though a slightly different method (100 percent with no deduction of costs versus 95 percent exemption with deduction of costs). All three causal factors of transplants were relevant. First, tax competition constraints induced Italy to introduce through the participation exemption a holding tax regime comparable to those found in most EU countries; in addition, differently from other tax systems, in Italy there are no specific requirements for the exemption on dividends so even minimal participations enjoy the full exemption. Second, practical reasons led to the replacement of the imputation system which not only was affected by dividend washing problems but also made it quite difficult to attribute the dividend credit in case of cross-border dividends. Finally, EU compliance was important: the PSD and CJEU cases clearly established under what conditions an imputation system could be applied to cross-border dividends, implicitly opening the way to the adoption of a simpler exemption system. With respect to group consolidation Italy transplanted in 2004 the Dutch fiscal unity model and consortium relief from the United Kingdom. Italy belongs, through a process of convergence, to the predominant cluster of those countries allowing the offsetting of profits and losses within the group without accounting consolidation as a prerequisite, even if this goal is achieved through different methods (domestic tax consolidation/fiscal unity in continental Europe and OECD countries; controlled transfer of profits in Sweden and Finland; controlled transfer of losses in United Kingdom and Ireland). A mix of competitive constraints and practical reasons motivated the transplant, while EU compliance did not play a significant role because, at the current stage, there is no tax consolidation EU model. Practical reasons had a leading role: the domestic consolidation regime was in fact introduced to counteract domestic aggressive tax planning aimed at transferring losses to profitable companies of the group by offering a systemic and transparent sharing of profits and losses. Once the system had been introduced, tax competition constraints were important and evolved along four dimensions making Italy an attractive jurisdiction for tax-optimizing units of multinational groups located there. First, differently from other countries which require qualified participations of up to 80 percent, in Italy a company can be consolidated with a low threshold of participation (50.1 percent) and even if a significant minority (up to 49.9 percent) is against tax consolidation; often minority shareholders are offered compensation to avoid litigation and consolidation agreements address this problem. Second, this low qualified participation (50.1 percent) triggers full transfer to consolidation of profits and losses of the consolidated company, while other countries allow consolidation in proportion to participations. Third, Italy neither requires consolidation adjustments at the level of the consolidating company, nor accounting consolidation as a prerequisite, thereby minimizing administrative costs. Finally, the ‘cherry-picking’ system is quite flexible and optimizes the matching of profit/losses units within the group. In addition Italy has a consortium relief that allows sharing of profits and losses within the group when the 50.1 percent qualified participation domestic tax consolidation requirement is

222  Research handbook on corporate taxation not met by a participating company: this extends the potential ‘consolidation perimeter’ within the group, particularly in case of corporate joint venture structures.

7.

ENDOGENOUS CHANGES: PSEUDO-TRANSPLANTS AND SPONTANEOUS CONVERGENCE

Endogenous changes that occurred in Italy are identified by a conjecture according to which corporate tax measures in Italy exhibit features that make them structurally different from those of other countries because of a host of social, cultural, institutional and geo-political factors. There have been two types of endogenous changes. First, changes have been the outcome of a domestic mechanism of generation of corporate tax rules, be it through legislation, case law, practices or a combination thereof. Second, endogenous changes occurred when local modifications to imported policies emerged after a transplant had been made, so that the functional similarity to the foreign solution was not maintained (‘pseudo-transplants’). These two types of endogenous changes in most cases resulted in solutions that were different from those of other countries (‘divergence’), but in some instances they led to ‘spontaneous convergence’ when local measures turned out to have functions similar to those of other countries but idiosyncratic domestic factors were independently responsible for them, rather than actual transplants. Endogenous changes that occurred in Italy have several common features: (i) policy-makers were not aware of policies elsewhere or foreign solutions were not discussed within domestic policy debates; (ii) there were local path-dependent constraints; and (iii) no actual transplant was adopted or pseudo-transplants eventually unfolded. These changes occurred with respect to the design of taxable corporate income (section 1); domestic approaches to limitations of interest deductions (section 2); and CFC rules and worldwide tax consolidation (section 5). With respect to the design of taxable corporate income the double track system aimed at determining the IRES taxable base through tax adjustments to the profit and loss account created a structural gap between tax income reported in the tax return and accounting income reported in the financial statement. Italy belongs through spontaneous convergence to the cluster of European continental countries that generally adopt the double track system because it developed criteria that turned out to have similar functions to those of other double track systems but idiosyncratic domestic factors were independently responsible, rather than actual transplants. Tax adjustments in the domestic dynamics change continuously, reflecting pressures coming from the political system and interest groups affected by tax policies. In addition several main typologies of adjustments are imposed by the TUIR to safeguard revenue-raising interests (a specific tax accrual method, the test of connection with production of income, positive items of income can be directly included in the tax return, timing dis-alignments of tax and accounting items). Tax incentives, accelerated depreciations, tax credits, and the patent box regime further amplify the gap. With respect to limitations of interest deductions in parallel of transplants of thin cap rules and EBITDA ratio, in Italy there has been an evolution of local approaches and doctrines not based on legislative formulas and mainly developed through case law, practices or a combination thereof. These approaches include the test of connection of interest with business activity,

Corporate taxation in Italy  223 the hidden profit distributions/recharacterization doctrines, and transfer price rules and were a form of spontaneous convergence because of the striking similarities with similar approaches developed in other countries combined with the lack of transplants. With respect to CFC rules, initially in 1991 Italy had transplanted the French jurisdictional approach based on a blacklist, but subsequently legislative amendments significantly modified the imported model, so that the initial transplant ex post morphed into a pseudo-transplant. As a result the Italian CFC model is currently a ‘hybrid model’ that combines three triggering factors: (i) control or qualified participation; (ii) type of income (passive income or base company income); and (iii) a test based on effective tax rate differentials. While factor (i) is consistent with the common core of CFC regulations, factors (ii) and (iii) are respectively based on the ‘transactional approach’ (United States and Germany) and ‘jurisdictional approach’ (France). So in the Italian tax system the two approaches are ‘hybridized’ and this has led to a divergence from the original ‘pure’ approaches. This is the idiosyncratic outcome of a complex internal path. Elective worldwide tax consolidation was introduced in 2004 and there is no evidence that this was a transplant: Denmark has a similar system, but there are striking differences. This regime has never been implemented in practice because very few groups made the election. Yet this regime contemplates – discounting the fact that it is an elective system – a ‘global taxation system’ of multinationals which occurs when the home state of the Ultimate Parent Company of a group applies its own tax laws and rates to the current foreign corporate profits and losses of controlled companies and provides a foreign tax credit. Likewise, the non-elective CFC rules constitute an approximation to a global taxation system because they adopt a qualified participation similar to that of worldwide tax consolidation, bringing under the 24 percent IRES tax rate the profits of CFCs if their tax rate on average is lower than 13.95 percent (i.e. 50 percent of the combined IRES and IRAP rates). In conclusion Italy has already endogenously developed – at least in theory – the rules of a global taxation system alternatively in the guise of worldwide tax consolidation or CFC rules. To achieve this goal either set of rules would need to be slightly amended. In fact the 15 percent ‘minimum tax’ to be introduced by OECD Pillar 2 ‘Globe rules’ would be achieved either by (i) making worldwide tax consolidation compulsory at the 15 percent minimum tax rate, or (ii) slightly increasing the current 13.95 percent CFC tax rate up to the15 percent minimum tax rate, also including in the allocation foreign losses. Therefore a marginally modified corporate tax system in Italy could be a model for a ‘country-by-country minimum tax’ in which home states tax multinationals based there on global profits, giving a tax credit for foreign taxes. This model is similar to the current legislative proposal pending in the United States (H.R.5376 – Build Back Better Act 117th Congress, 2021–22). It must be clarified, however, that at this stage the baseline model for the taxation of foreign controlled companies in Italy remains a so-called ‘territorial system’ because under participation exemption the foreign profits of non-resident controlled companies are exempt even when repatriated as dividends, unless (i) dividends ultimately come from low tax jurisdictions, (ii) CFC rules apply or (iii) election for worldwide tax consolidation is made.

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8. CONCLUSIONS The Italian corporate tax system in conclusion exhibits three evolutionary features: ● a common core of basic domestic features (interest deductions based on legislative formulas, profit distributions and consolidation) has been exogenously developed in the last two decades through transplants of foreign solutions and EU models, leading to convergence with other systems; ● endogenous evolution has led to spontaneous convergence with other systems (design of taxable corporate income) or to divergence that was the result of local dynamics (case-by-case approaches to interest deduction and worldwide tax consolidation) or pseudo-transplants (CFC rules); and ● an endogenous transition is potentially under way from a territorial system to a global taxation system bound to meet the OECD Globe tax rules.

BIBLIOGRAPHY Books Roberto Artoni, Elementi di scienza delle finanze (Il Mulino, 2015) Angelo Contrino, Giuseppe Corasaniti, Eugenio Della Valle, Andrea Marcheselli, Enrico Marello, Giovanni Marini and Mauro Trivellin, Fondamenti di diritto tributario (CEDAM, 2022) Carlo Garbarino, La tassazione delle società e dei gruppi (Giappichelli, 2020) Maurizio Leo, Le Imposte sui Redditi nel Testo Unico (Giuffrè, 2020) Francesco Tesauro, Imposta sul reddito delle società (IRES) (Zanichelli, 2007)

Legislation D.P.R. 917/1986 (22.12.86; G.U. 302, 31.12.86): Testo unico delle imposte sui redditi (TUIR) D.Lgs. 446/1997 (15.12.97; G.U. 298, 23.12.97): on IRAP D.Lgs. 461/1997 (21.11.97; G.U. 2, 03.01.98): on a tax regime for income from capital and other income D.Lgs. 58/1998 (24.03.98; G.U. 71, 26.03.98): on financial brokerage regulations D.Lgs. 344/2003 (12.12.03; G.U. 291, 16.12.03): implementing corporate tax reform effective 1 January 2004 D.Lgs. 142/2018 (29.11.18; G.U. 300, 28.12.18): implementing the Anti-Tax Avoidance Directive (2016/1164) (ATAD)

14. Corporate taxation in Canada Scott Wilkie

THIS COMMENTARY The income tax law1 of Canada is considerable and pertinent literature vast. This short commentary focuses on the Income Tax Act (Canada)2 (Act), noting, however, that the provinces and territories of Canada also tax income. It is an attempt to draw out and distill key systemic themes in and though selectively the main legislative features of the tax law as it applies to corporations and their shareholders. An objective of this approach to the complex web of statutory provisions that are ‘the corporate tax system’ is to provide a means for anticipating in a coherent fashion its essential features as they might be expected to arise and apply in specific settings of advice giving. Precision and detail are inevitable casualties of digesting a great deal of law in a short space, though hopefully this sacrifice is balanced by thematic clarity. Corporate tax accounts for a disproportionately small share of total Canadian tax revenues and Canadian Gross Domestic Product. Yet, the fragmented economic unity that is a corporation and its shareholders has consistently attracted outsized attention from the outset of income taxation in Canada. Indeed, possibly surprising as a perspective which has conceptual and practical ramifications, much of the legislative intricacy of corporate taxation is directed effectively to reassembling that economic unity without denying the legal qualities or practical reality of corporate intermediation, that is, without ‘raising the corporate veil’ to ignore corporate intermediates even though that is possible though unusual. The independence of corporations and their shareholders and transactions of various kinds that connect them and their other counterparties as the private law affords are respected though, contrary to common perception, Canadian taxation does not slavishly or blindly adhere to form but respects it provided that taxpayers conduct themselves properly in relation to their selected forms’ requirements.3

1 This commentary addresses only income taxation. Canada and subnational Canadian jurisdictions also impose ‘commodity’ tax in the nature of a value added tax (the Goods and Services Tax or Harmonized Sales Tax, via the Excise Tax Act (Canada)), customs duties and tariffs, sales tax, property tax among possibly others including a provisionally proposed ‘Digital Services Tax’. Also, despite the constitutionally diffused authority to impose income tax at the federal, provincial, and territorial levels, not necessarily with the same effects, these comments focus on the federal tax statute, the Income Tax Act. These comments necessarily are selective and of a summary nature, and attempt to depict and simplify the system of corporate income taxation in Canada for which statutory and other references are meant to be indicative. It is always necessary to refer to the Act to identify and understand that system in its detailed provisions as they may apply in any specific circumstances. 2 Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)). 3 Generally, Canada respects legal formulations for tax purposes, often associated with its adherence to the Duke of Westminster case’s guidance (Duke of Westminster v. Commissioners of Inland Revenue, [1936] AC 1, [1935] All ER Rep 259, 51 TLR 467, 19 TC 490), frequently addressed by Canadian courts adjudicating ‘tax avoidance’ cases, that taxpayers are entitled to order their affairs with tax considerations in mind to reduce their tax liabilities.

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THE CANADIAN LEGAL AND TAX LANDSCAPE It is well understood that taxation is accessory to the general, or private law. The tax law takes these ‘as found’ as the basis then for deriving fiscal effects. When the ensuing tax yields unacceptable fiscal outcomes, the tendency of Canadian tax law is to change the intensity with which items of income are taxed without recharacterizing the circumstances in which the income arises by replacing the legal formulation adopted by a taxpayer for another according to their perceived ‘economic substance’. An important case in point denies the tax benefit of the intercorporate dividend deduction in subsection 112(1) of the Act, which relieves corporate level taxation more than once as an important feature of ‘integrating’ the taxation of corporations and their shareholders. In this way, when a shareholder’s interest revealed by the fixed debt-like terms of shares is more that of a disinterested financier rather than an ulterior proprietor of the business conducted by the corporation, dividends are taxed to corporate recipients otherwise entitled to the intercorporate dividend deduction with the same effect as if they were interest on a debt obligation with the share’s terms without either being so recast. The Act contains a plethora of ‘preferred share rules’ with this effect, directly or indirectly, which identify when a shareholder is more in the nature of a ‘banker’ than an equity owner or should be seen to be trading in corporate tax attributes in the nature of present and anticipated losses and deductions that are not financially useful to the corporate taxpayer.4

SOME NECESSARY BASICS Corporations A Canadian corporation and its relationship with its owners exist according to business corporation laws such as the federal Canada Business Corporations Act or a provincial analogue,

The focus is the dividend received deduction, for intercorporate dividends, in subsection 112(1) of the Act. The legislative machinery to accomplish this deals with ‘term preferred shares’, ‘guaranteed preferred shares’, and ‘collateralized preferred shares’, those last two terms being descriptive of the legislative effects in subsections 112(2.1), 112(2.2), and 112(2.4). Companion preferred share categories are ‘taxable preferred shares’ and ‘short term preferred shares’ the focus of which under Parts IV and VI of the Act is the indirect transfer of the benefit of tax deductions and losses to disinterested shareholder investors, i.e., broadly, shareholders not substantially connected to the corporation as framed legislatively so to be considered as holding unconditional equity as would an ulterior proprietor. The various categories of preferred shares, term preferred, taxable, and short term preferred shares, are defined in subsection 248(1) of the Act; the financial effects of guaranteed and collateralized preferred shares are described in the provisions that deny the dividend received deduction in subsection 112(1). Supplementing these provisions, in part to frame exceptions or establish legislative continuity and transition in light of the incremental evolution of these features of the Act are regulations with some legislative support in the Act in particular with respect to financial institutions and the circumstances in which the shares may be held, notably in the ordinary course of business of those institutions. This is an example of two simple themes, namely interpreting financial accommodations as substantially equity or debt, and confining tax attributes to the circumstances, i.e., the shareholder–corporation axis of pertinent interest in which they arose, requiring detailed legislation to state and explain the compass of restrictions so as to maintain the fiscal ‘purity’ of the elemental themes. 4

Corporate taxation in Canada  227 for example the Ontario Business Corporations Act. It is the private, that is, non-tax law that governs a corporation’s existence organizationally, financially, and operationally. Three Canadian jurisdictions, the provinces of British Columbia, Alberta, and Nova Scotia, provide for the incorporation of ‘unlimited liability corporations’. Unlike the more usual limited liability corporation, the shareholders of an unlimited liability corporation have unlimited personal liability for the corporation’s unsatisfied obligations in certain circumstances. This feature may permit it to be disregarded for relevant purposes of other countries’ tax laws, the United States being the most important common case in point, though not for Canadian tax law. Canadian tax law needs to type foreign legal personalities, notably in the context of the ‘foreign affiliate’ regime in the Act.5 Generally, a corporation so constituted will be so regarded for purposes of the Act even if it may be disregarded or treated more like a partnership or proprietorship under the other country’s laws. An example is a U.S. limited liability corporation, that is, an ‘LLC’. Articles VI and VII of the Canada-United States Income Tax Convention6 modify and may deny the allocation of taxing rights between Canada and the United States for certain transparent or disregarded entities. In some cases, legal constructions that are not corporations may be treated as corporations under the Act according to interpretive inferences drawn from their predominant legal features. Examples are cooperatives or limited partnerships (in the United States, so-called ‘triple L’ partnerships of some states, for example), to determine if they are sufficiently like the Canadian notion of a corporation to be ‘foreign affiliates’ of Canadian interest (‘share’) holders. Tax Jurisdiction The Canadian federal, provincial, and territorial (but not municipal) jurisdictions have income taxing authority. The federal jurisdiction is exercised under the Act for all taxable units – individuals, trusts, and corporations. The provinces and territories exercise taxing authority only for income earned in and otherwise considered to be sufficiently connected to those jurisdictions to warrant provincial or territorial taxation (which excludes withholding tax on payments to non-residents which originate in the province or territory).7 Provincial and territorial income taxation tends to reflect the main terms of the federal income tax law although it may also have features keyed to particular fiscal interests of those jurisdictions. For all but the provinces of Alberta and Québec, provincial and territorial corporate income tax is administered by the federal tax authorities. The Act abates federal tax to ‘make room’ for provincial and territorial taxation. It does this by identifying the connection of income to the provinces and territories otherwise justified to 5 Casually, referred to as the ‘controlled foreign corporation’ rules, found principally in ss 90–95 of the Act and Part LIX of the Income Tax Regulations. 6 Convention between Canada and the United States of America with respect to Taxes on Income and on Capital (1980), as amended. Canada has also ratified and applies with respect to most of Canada’s bilateral tax treaties in accordance with the treaty partners’ mutually selected terms, the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting. 7 Bilateral tax treaties do not apply to provincial taxation directly; provinces and territories lack the constitutional authority to enter into those agreements. However, it is common for provincial tax legislation to adopt the consequences under federal income tax law as modified by the application of a relevant income tax treaty.

228  Research handbook on corporate taxation tax it, using allocation rules in Part IV of the Income Tax Regulations (ITR) that reflect the principal features of Articles V (‘permanent establishment’) and VII (‘business profits’) of most bilateral international tax treaties.8 Residents and Non-Residents Tax liability is established by a taxpayers’ residence. Residents of Canada are taxable under Part I of the Act on all sources of income regardless of where it was earned or otherwise may be considered to arise.9 Non-residents are taxable in an equivalent fashion respecting business, services, and employment income and certain taxable capital gains from dispositions of ‘taxable Canadian property’ (essentially, manifestations of Canadian business property and real property);10 other income, commonly though not exclusively passive or investment, may be subject to non-resident withholding tax.11 Corporations created under Canadian law after early 1965 are deemed to be resident in Canada.12 Canada also determines corporate residence in other cases doctrinally, notably for non-resident corporations, according to where a corporation is ‘centrally managed and

Canada with its constellation of federal, provincial, and territorial national and subnational jurisdictions is an international tax microcosm, in which the same kinds of challenges addressed by the Organisation for Economic Co-operation and Development’s (OECD’s) ‘Base Erosion and Profit Shifting’ and Pillars One and Two initiatives to recalibrate the source of highly mobile income of ‘in scope’ large multinational enterprises and impose a universal corporate minimum tax, respectively – though, it must be said, long before there was Base Erosion and Profit Shifting (BEPS – as that notion guided the OECD’s work in this area most recently from 2012). There is no convenient other place in these comments to note Canada’s intention to amend the Act in line with the OECD’s recommendations concerning deductible financing changes (‘Excessive Interest and Financing Expenses Limitation’, ‘EIFEL’) (https://​fin​.canada​.ca/​drleg​-apl/​2022/​ita​-lir​-1122​-l​-1​-eng​.html explained by https://​fin​.canada​ .ca/​drleg​-apl/​2022/​ita​-lir​-1122​-n​-1​-eng​.html, both accessed 3 April 2023) and ‘hybridity’ (https://​fin​ .canada​.ca/​drleg​-apl/​2022/​ita​-lir​-0422​-l​-eng​.html explained by https://​fin​.canada​.ca/​drleg​-apl/​2022/​ita​ -lir​-0422​-n​-eng​.html, both accessed 3 April 2023).These changes, presently in the form of draft legislation distributed for comments will if enacted further limit excessive financing deductions arising from disproportionate indebtedness of Canadian members of multinational corporate groups the perceived ‘whipsaw’ of amounts being deductible in Canada but not taxed elsewhere within a multinational corporate family. It has also been noted that Canada is prepared to enact a digital services tax if the OECD-led Pillar initiatives, which Canada supports, are not successful. 9 Act, ss 2(1) and 2(2). 10 Act, ss 2(3). 11 Act, Part XIII, according to rates modified by bilateral tax treaties. The distinction addresses non-residents who personally are engaged in income earning activities in Canada more or less in a fashion equivalent to similarly situated Canadian residents, and those whose presence is by making their property and ‘know how’ available for use by Canadian residents for which they earn a return, such as interest on debt, rents and royalties, fees for certain services and other accommodations, and dividends. This tax is assessed by imposing withholding and remittance (to the tax authorities) obligations on Canadian resident payers of these amounts to non-residents in respect of which the payers are also treated as taxpayers to facilitate the enforcement of the withholding tax without possibly (in some cases subject to tax treaties) offending public law limitations on the extraterritorial enforcement of fiscal laws. 12 Corporations incorporated after 26 April 1965. Certain other pre-9 April 1959 corporations with a particular Canadian connection in 1971 when a major tax reform occurred and pre-27 April 1965 corporations incorporated in Canada and that otherwise were resident or carried on business in Canada may also be deemed to be Canadian residents. 8

Corporate taxation in Canada  229 controlled’, that is, generally where the decision making organ of a corporation, its board of directors, discharges its responsibilities.

CORPORATE TAXATIONS AS A FIXTURE OF ‘MODERN’ CANADIAN INCOME TAXATION Canadian income taxation is typically traced to the Income War Tax Act, 1917. Corporations were first, though only briefly, taxable on their income at a relatively modest rate. Their undistributed income, that is, corporate surplus, was imputed and taxable to shareholders unless the Minister of National Revenue was satisfied that retention was necessary for financing business operations.13 Canadian corporate tax law has consistently been concerned with planning to ‘strip’ corporate surplus through artful reliance on private law personalities and constructions to enable access to that surplus without shareholder level tax, including to transform that surplus into capital gains before capital gains were taxable in the period before 1972. After 1971, when capital gains became taxable, the possibility that capital gains could be recast as tax-free distributions of corporate surplus relying on the intercorporate dividend deduction attracted like attention. Shortly after enactment, the Income War Tax Act was modified in foundational ways. Early attention to ‘integrating’ the taxation of corporations and shareholders and mitigating ‘double corporate taxation’ resulted in the earliest intercorporate dividend deduction in the 1920s, a sustained pivotal aspect of Canadian corporate tax (and tax planning) that has spawned many refinements to deter ‘surplus stripping’, that availing shareholders of actual or constructive realizations of undistributed corporate surplus without paying shareholder level tax. The early imputation aspect almost immediately was replaced by a more classical formulation of taxing corporations and shareholders, that is, without accommodating the taxation of each in relation to the other.14 That said, from the outset of corporate taxation, the focus For discussions about the early stages of corporate income taxation in Canada, the essential interstices of which persist in the much more elaborate current formulations in the Act, see: Colin Campbell and Robert Raizenne, A History of Canadian Income Tax: Volume 1 – The Income War Tax Act 1917–1948 (Toronto: Canadian Tax Foundation, 2022); Colin Campbell and Robert Raizenne, ‘The 1917 Income War Tax Act: Origins and Enactment’, in Jinyan Li, J. Scott Wilkie and Larry F. Chapman, Eds, Income Tax at 100 Years (Toronto: Canadian Tax Foundation, 2017), 2:1–96; James Wilson, ‘Canada’s First Corporate Income Tax: The First Ten Years (1917–1926)’, in Jinyan Li, J. Scott Wilkie and Larry F. Chapman, Eds, Income Tax at 100 Years (Toronto: Canadian Tax Foundation, 2017), 7:1–42; J. Scott Wilkie, ‘Three Spirits of Canadian Corporate Income Tax: The Relic, the Remnant, and the Reflection’, in Jinyan Li, J. Scott Wilkie and Larry F. Chapman, Eds, Income Tax at 100 Years (Toronto: Canadian Tax Foundation, 2017), 8:1–36. 14 Alvin Warren, ‘The Relation and Integration of Individual and Corporate Income Taxes’ (1981) 94 (4) Harvard Law Review 719–800, which though reflecting a U.S. tax orientation is a thorough and highly analytical consideration of this distinction. See also Volume 4 of the 1966 Report of the Royal Commission on Taxation (the ‘Carter Commission’). Even though described as or as being in the nature of a classical system in its existence generally until tax reform in 1971, there is another credible construction based on a corporation and its shareholders being essentially a fiscal unit despite their legal separateness. This way of explaining corporate taxation even within a classical framework presupposes, accurately it is contended, that the outlook of the tax law is on the degree of taxation income earned at the corporate level should experience in order to be ‘fully taxed’ within the expectations of the law. Income earned by shareholders as distributions by a corporation is simply a transmission of that underlying 13

230  Research handbook on corporate taxation has been on the degree of tax expected for qualities of income regardless of how the income is organized to be earned and distributed. However, even without overt integration of the taxation of corporations and shareholders, the tax law has reflected an outlook on the expected degree of tax on the income earned in the corporation – shareholder constellation. That is, integration as a notion has been a consistent theme of Canadian corporate taxation. Broadly it is the legislative expectation that taxation of income earned first by a corporation is incomplete without accounting for both corporate and shareholder levels of tax for the economic unit they comprise, even without legislated mechanisms now long present in the Act effectively to combine and rationalize the taxation of the two systematically.15

income; it is not novel in any respect nor is the act of transmission itself income generating. Seen this way, the question becomes when and to what extent should the tax levied on individual shareholders when they receive dividends be reduced to account for underlying corporate tax on that income. The Act as it exists ‘integrates’ the taxation of corporate income distributed as dividends to shareholders, via the intercorporate dividend deduction in subsection 112(1) (and subsection 113(1) for income from ‘foreign affiliates’) and the dividend tax credit under the combined operation of ss 82 and 121 of the Act available to individual shareholders. But a decision not to so ‘integrate’ also manifests a kind of integration where the expected degree of taxation, focusing on the income of the corporation and shareholder as an economic unit, is additive to achieve the expected ‘right’ amount of tax in relation to the income; see J. Scott Wilkie, supra note 13 for a discussion relating to this perspective, reconciling the ‘classical’ and ‘integrated’ approaches to corporation–shareholder taxation. 15 Corporate taxation in Canada has undergone a number of fundamental studies and reforms, though the ‘bones’ of that region of Canadian tax remain intact. See among others, for example, Report of the Royal Commission on the Taxation of Annuities and Family Corporations (1945, the ‘Ives Commission’); the Report of the Royal Commission on Taxation (1966, Carter Commission), and in that regard (among many other commentaries many of them published by the Canadian Tax Foundation in the period leading up to and after the 1971 tax reform) Boris I. Bitker, ‘Income Tax Reform in Canada: The Report of the Royal Commission on Taxation’ (1968) 35 (4) The University of Chicago Law Review 637–659; Proposals for Tax Reform, E.J. Benson Minister of Finance (Canada: Department of Finance, 1969); 1987 proposals to reform the Act described in detail in Stikeman, Elliott, Canadian Tax Reform 1987 (Toronto: Richard de Boo Publishers, 1987); and the Report of the Technical Committee on Business Taxation (1997) (the ‘Mintz Committee Report’, which examined corporate income taxation comprehensively and proposed reforms but nevertheless contains a thorough and highly accessible review of the legislative and public finance elements of corporate income taxation). More recently, in 2017, the taxation of private corporations and their shareholders was examined and changes postulated; see the Department of Finance Canada, ‘Minister Morneau Announces Next Steps in Improving Fairness in the Tax System by Closing Loopholes and Addressing Tax Planning Strategies’ (18 July 2017), accessed 3 April 2023 at https://​www​.canada​.ca/​en/​department​-finance/​news/​2017/​07/​minister​_morne​ auannounce​snextsteps​inimprovin​gfairnessi​nthetaxsys​.html (which included a consultation paper entitled ‘Tax Planning Using Private Corporations’, accessed 3 April 2023 at https://​www​.canada​.ca/​content/​ dam/​fin/​migration/​activty/​consult/​tppc​-pfsp​-eng​.pdf), which attracted wide and critical commentary from professionals via The Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada in highly detailed commentaries submitted to the Department of Finance on 2 October 2017, accessed 3 April 2023 at https://​www​.cba​.org/​CMSPages/​GetFile​.aspx​?guid​ =​355b8a11​-7399​-4f30​-9ec5​-bf0c9ab8dee9. Much of the kind of reform imagined in the government’s discussion document did not proceed and still in important respects are problematic; see, for example, recently enacted but highly unusual changes by a private member’s bill – highly unusual for fiscal matters and arising from an opposition party to the government – to anti-surplus stripping provisions of the Act in sections 55 and 84.1 in order to provide fairly unrestricted opportunities to transfer certain qualifying small (family) businesses internationally, after those affected became impatient with the government’s failure to examine this matter as promised in 2017. In the government’s 2023 federal budget presented in March 2023 significant refinements to the changes made by this way have been proposed with more tai-

Corporate taxation in Canada  231

WHY TAX CORPORATIONS? This is as much an enigma in Canada as elsewhere. Paraphrasing Richard Bird, perhaps Canada’s pre-eminent public economist, it is because we can, it is administratively convenient, and, comparatively in the international environment, we must,16 though the various reasons commonly advanced alone are generally not considered to be compelling and have inspired proposals for substantial revision.17 Moreover the incidence of the corporate tax in Canada is no less problematic than elsewhere, and even so as already noted as a revenue source corporate tax is less consequential than other taxes.18 Fundamentally the question is: What is the fiscal significance of a corporation, seen as the fragmentation of an economic unity into distinct pieces that exist because the law for other purposes says that they do? In light of the objectives of income taxation what is the justification for allowing taxpayers essentially to use the levers of private law to ‘elect’ whether, when, and to what extent they wish to be taxable? The Act does not answer that question directly. But much of the Act’s treatment of corporations and their shareholders denies the fiscal effect of intermediation unless, for business income, a subsidy with presumably broader economic and social implications is justified, in

lored attention to intergenerational business transfers within a family but in the government’s view with fewer opportunities for unwarranted tax avoidance (the budget documents may be accessed at https://​ www​.budget​.canada​.ca/​2023/​home​-accueil​-en​.html, accessed 3 April 2023). 16 Within a vast literature, for penetrating and focused insight, see Richard Bird, ‘Why Tax Corporations?’, Working Paper 96-2 Prepared for the Technical Committee on Business Taxation December 1996 (the Mintz Committee). See also, from a U.S. perspective but universal in his targeted insight, Reuven S. Avi-Yonah, ‘Viewpoint: A New Corporate Tax’, Tax Notes Federal, 27 July 2020, 653–60. In thinking about the fiscal significance of corporations, these quite old papers offer commentary that is as insightful today as when written: G.T. Tamaki, ‘Lifting the Corporate Veil in Canadian Income Tax Law’ (1962) 8 (3) McGill Law Journal 159–166; George T. Tamaki, ‘Form and Substance Revisited’ (1962) 10 (3) Canadian Tax Journal 179–84; and James S. Hausman, ‘The “One Man Company”: Some Principles of Taxation’ (1967) 13 (2) McGill Law Journal 265–276. More recent considerations in relation to corporations and other legal constructions associated with ‘substance’, see Scott Wilkie, ‘New Rules of Engagement? Corporate Personality and the Allocation of “International Income” and Taxing Rights’, in Brian J. Arnold, Ed., Tax Treaties and the BEPS Project: A Tribute to Jacques Sasseville (Toronto: Canadian Tax Foundation, 2018) 349–371, and, using transfer pricing as a catalyst, more recently Scott Wilkie, ‘Recent Developments on Transfer Pricing and Substance’ (originally written and presented as ‘The Substance of “Substance”: Does Law Have a Role in the Economics of Transfer Pricing – Competitor, Combatant or Collaborator?’, in Michael Lang Raffaele Petruzzi, Ed., Transfer Pricing Developments around the World 2022 (The Netherlands: RI. Wolters Kluwer, 2022), ch. 6, 165–211). A very illuminating examination generally of how business income is earned, and the related significance of intermediates is Willard Taylor’s commentary on business formulations for U.S. tax purposes: Willard B. Taylor, ‘Can We Clean This Up? A Brief Journey through the Unites States Rules for Taxing Business Entities’ (2016) 19 (5) Florida Tax Review 323–65. 17 See, for example, Robin Boadway, ‘Policy Forum: Piecemeal Tax Reform Ideas for Canada – Lessons from Principle and Practice’ (2014) 62 (4) Canadian Tax Journal 1029–59; and Robin Boadway, ‘The Canadian Corporate Income Tax at 100 Years of Age: Time for a Change’, in Jinyan Li, J. Scott Wilkie and Larry F. Chapman, Eds, Income Tax at 100 Years (Toronto: Canadian Tax Foundation, 2017), 9: 1–27. 18 See, relatively recently, OECD Revenue Statistics 2022 – Canada, accessed 3 April 2023.

232  Research handbook on corporate taxation the form of a provisional, that is, until income has been distributed to shareholders, tax rate reduction versus the rate that would have applied without incorporation. For other kinds of income, that is, income from incorporated investment and personal services businesses, respect for the legal features of intermediation is muted, particularly for private corporations and their shareholders, by subjecting income other than business income to current taxation to much the same degree as would have applied had the economic units comprising legally distinct corporations and shareholders not been fragmented. Accounting for much of the legislative complexity for taxing corporations, notably private corporations, and their shareholders, relieving excessive taxation of corporate income, that is, taxation more than once at the corporate level while capturing the tax due when income eventually reaches individual shareholders is accomplished through corporate tax rates geared to the nature of income, a regime of refundable tax on investment (including capital gains), and credit at the individual shareholder level for underlying foreign tax paid, such that ultimately and without deferral except for genuine business income, income is taxed at the same time and to essentially the same degree as if the first instance earner, the corporation, had not been created. The effect of integrating the taxation of corporations and shareholders this way is to police unwarranted ‘surplus stripping’19 – a consistent undercurrent of Canadian corporate tax despite all too common but unjustified impressions to the contrary. With little exaggeration, twisting the kaleidoscope of Canadian corporate taxation just a little bit reveals that it may aptly be described as ‘anti-corporate taxation.’ The integration of the taxation of corporations and their shareholders, that is, ultimately individuals, is imperfect even if relevant tax rates are aligned with expectation of a certain effective rate of taxation on corporate income. Amounts may be distributed as dividends even though there is no underlying income or tax. Yet, an individual shareholder will reduce shareholder level tax on a contrary assumption that is legislated precisely in the Act with reference to corporate and shareholder tax rates. Also, even if taxable, the effective and marginal effective rates of taxation may be considerably lower than the headline corporate tax rate; shareholder level tax adjustments to reflect corporate tax are not geared to actual (in the circumstances) versus hypothetical (prescribed) tax. The effect is to distort the financial effects of integration – of the ‘anti’ aspect of corporate taxation – even though the principle of reassembly of the fragmented unity that is a corporation and its shareholders is a useful way to perceive and simplify corporate taxation in Canada.

19 Most recently, the Supreme Court of Canada in Copthorne Holdings Ltd. v. The Queen (2011 SCC 63, at para 118) acknowledged and in this way validated this notion even though whether such an undercurrent exists would require the kind of systemic analysis in relation to particular provisions of the Act that, in that case, the Court found lacking. It would not be correct, however, to view as some do the Supreme Court’s observation as a denial of this notion in Canadian corporate taxation. Among many other commentaries, on ‘surplus stripping’ and its context in Canadian tax law, see G.T. Tamaki, ‘Corporate Surplus Taxation: The Great Professional Dilemma’ (1962) 10 (6) Canadian Tax Journal 434–42; W.R. Jackett, D.J. Kelsey, and S.E. Edwards, ‘Corporate Surplus’, in Report of Proceedings of the Fourteenth Tax Conference: 1960 Conference Report (Toronto: Canadian Tax Foundation, 1961), 285–307; the Report of the Royal Commission on Taxation (1966, Carter Commission) and in particular Appendix D to Volume 4; and Studies of the Royal Commission on Taxation, ‘Number 15: Stripping Corporate Surplus’, 28 November 1963; Blake Murray, ‘The 1977 Amendments to the Corporate Distribution Rules’ (1978) 16 (1) Osgoode Hall Law Journal 155–92; and H. Heward Stikeman and Robert Couzin, ‘Surplus Stripping’ (1995) 43 (5) Canadian Tax Journal 1844–60.

Corporate taxation in Canada  233 Corporations and their shareholders are separately taxable; Canada does not ‘consolidate’ the taxation of corporate groups despite failed attempts at such reform.20 However, the Canadian tax authorities have long countenanced and ruled on transactions undertaken within closely held corporate groups to simulate consolidated taxation episodically, which have no other purpose and therefore inherently are avoidance transactions. These transactions typically are undertaken when separate sibling subsidiaries are, respectively, profitable and loss making/expense generating. Through the engine of the intercorporate dividend deduction, a ‘daylight’ financial accommodation from a lender external to or internal within the group funds an interest bearing loan to and then by the loss making subsidiary to the profitable subsidiary which immediately subscribes for dividend bearing fixed value preferred shares of the loss making subsidiary, which uses those proceeds to repay the daylight loan. The profitable subsidiary pays interest to the loss making affiliate which effectively becomes taxable but does not actually pay tax on the profitable subsidiary’s income, to that extent. The loss making subsidiary uses the interest cash flow to pay dividends to the profitable subsidiary, which are excluded from taxable income by the intercorporate dividend deduction. The financial condition of all concerned is unchanged. When the losses have been absorbed, the process reverses; another daylight borrowing funds a redemption of the shares issued by the former loss making subsidiary, which in turn funds repayment of the intercorporate loan and then, next in turn, repayment of the daylight loan undertaken to seed the transfers.

HOW CORPORATE TAX ‘WORKS’ Corporations as Taxpayers Corporations are separate taxable units from their shareholders.21 A unique extension of corporate taxation essentially assimilates the taxation of the income of certain public trusts and partnerships, that is, ‘Specified Investment Flow Through’ (SIFT) trusts and partnerships, and

20 Two attempts to change this were made, in the mid-1980s and early 2000s. Both did not proceed, largely because of insecurity on the part of the provinces (and territories) about the resilience (and possibly even the extant reliability) of their tax bases. That said, many provisions of the Act are geared specifically and for deliberate fiscal reasons effectively to treating groups of closely connected corporations and their shareholders as units though the elements are legally distinct. This is in order to ensure, among other reasons, that tax expenditures of various kinds, whether delivered by rate reductions or in other ways, are not excessive simply by multiplying the number of legal manifestations of the same economic and tax unit. 21 The other two Canadian units of taxation are individuals and trusts. Partnerships, as such, generally are not taxable units. Income and loss is computed according to the Act for the most part at the partnership level and is allocated to partners who are the accountable tax units under the Act. Trusts are accountable to pay tax on income that has not been distributed to beneficiaries (who include holders of units in commercial trusts) according to a regime in the Act, applicable in several guises to personal, commercial, and foreign trusts that treat trusts as opaque contrasted with transparent partnerships.

234  Research handbook on corporate taxation holders of interests in them to simulated corporate taxation22 without denying the commercial existence or nature of these vehicles as trusts and partnerships.23 ‘Private’ and ‘Public’ Corporations, ‘Canadian Controlled Private Corporations’, Their Shareholders, and Their Income The Act distinguishes between ‘public’ and ‘private’ corporations, between private corporations that are and are not Canadian controlled as determined by the Act, and among various qualities of their income. The most important is the distinction between how business and investment income of private corporations that are, and are not, Canadian controlled are treated. They reflect the construction of corporate tax rates under the Act contemplated by sections 123 (corporate tax rates), 123.3 (the refundable tax on investment income earned by

22 The SIFT rules for trusts and partnerships are found in ss 104(6), 122.1, and 197, respectively. In effect, ‘income trusts’ and like partnerships facilitated the diversion, directly or indirectly, of what otherwise would have been taxable corporate business income by way of deductible charges, to trust and partnership intermediaries. Those intermediaries were not taxable on that income either because, in the case of trusts (opaque legal constructions for purposes of the Act), it was distributed to unitholders as contemplated by the Act so as to make unitholders (beneficiaries) accountable for the income, or, in the case of partnerships (transparent for purposes of the Act), partners were responsible for their shares of partnership income as the Act ordinarily applies. SIFTs manifest a particularly obvious and evidently simple means of ‘surplus stripping’, i.e., diverting what otherwise would be taxed distributable income of corporations without both corporate level tax, because the pathway for the income was via deductible charges, and, in practice shareholder level tax in so far as units of these intermediaries commonly were held by tax-exempt taxpayers. In short, what theoretically might be described as ‘perfect integration’, assuming that that term means, as the Carter Commission contemplated, taxation without the effects of corporate intermediation. As a result of the proscription of SIFTs in a well-known Halloween 2006 announcement, then existing SIFTs were offered a limited opportunity in the Act to become incorporated on a tax-deferred basis, effectively reversing the effects of their former existence and constructively recombining the elements of corporate income taxation that had been fragmented by their existence; see, in the Act, ss 248(1) ‘SIFT trust wind-up event’, ‘SIFT wind-up corporation’, ‘SIFT wind-up entity’, and among others, ss 85.1(7), (8) (tax-deferred exchange of units for shares of a SIFT wind-up entity), 88.1 (winding up into a corporation), and 107(3), (3.1) (descriptively, ‘SIFT trust wind-up event’). For a helpful commentary on income trusts and the ensuing SIFT rules, see the relatively contemporary remarks of Michael Friedman and Todd Miller, Income Trusts Cope with Upheaval, https://​mcmillan​.ca/​ wp​-content/​uploads/​2020/​07/​MFriedman​_TMiller​_IncomeTrustsCope​_0207​.pdf, accessed 3 April 2023 at www​.i​nternatona​ltaxreview​.com, February 2007, 24–26. The nature of ‘income trusts’ and the SIFT notion that eclipsed them, and then the remedial ‘reincorporation’ rules that followed, are examples of the Act’s penetrating perception of the unity of corporations and their shareholders from the standpoint of focusing on the expected degree of taxation of income earned in the first instance by a corporation but without further or for that matter any intervention on their part by shareholders, i.e., ‘owners’, in earning it is finally accounted for by shareholders without ‘double taxation’ within the corporation–shareholders axis. 23 The interest holders in SIFTs commonly were tax-exempt retirement savings and like plans. They made expense generating financial accommodations of various kinds to corporations, often first by acquiring corporate property of which the corporation then required the use. The effect was to shift what would otherwise have been corporate tax base to the investors who, largely, were not taxable, in other words, to ‘base erode’ and ‘profit shift’. While this achieved the equivalent of ‘perfect integration’ by avoiding the fiscal effects of corporate intermediation, it presented a threat to the sustainability of the corporate tax base that became acute when one of Canada’s most notable public corporations announced plans to transform itself into an ‘income trust’.

Corporate taxation in Canada  235 ‘Canadian Controlled Private Corporations’24 (CCPC)), 123.4 (reductions in corporate tax rates), 123.5 (the additional tax on personal services business income), section 124 (the abatement of federal tax respecting provincial tax), section 125 (the ‘small business deduction’), and section 125.1 (the ‘manufacturing and processing profits deductions’), together with provincial and territorial tax rates. A private corporation is not public.25 A public corporation26 has issued shares that are or formerly were listed and posted for trading on a stock exchange, and if shares are no longer publicly traded the corporation has not elected to renounce its public tax status. It is also possible to be a public corporation by satisfying certain criteria set out in the ITR concerning the degree of ‘public-ness’ of a (wide enough) distribution of shares and related accountability to securities regulatory authorities . Both public and private corporations (before accounting for CCPC status) are equivalently taxable on their income regardless of its qualitative or geographic source or origin.27 A CCPC is a particular species of private corporation that both enjoys a tax rate advantage for some of its business income and is subject to the full range of provisions in the Act to integrate the taxation of private corporations and shareholders on business and investment income earned by those corporations, including refundable tax on investment income. The balance of this commentary should be understood this way when addressing private corporations which include but are not limited to CCPCs. It is not controlled by non-residents or public corporations or any combination of them, regardless of whether they have any connection or affiliation among them. For purposes of this commentary, it is helpful to reinforce the difference between CCPCs and other private, and public, corporations. The difference to keep in mind is that not all private corporations are CCPCs, that is, Canadian resident subsidiaries of public corporations and other Canadian resident private corporations controlled by non-residents are ‘private’ but not CCPCs. The difference concerns how closely identified the private corporation is with its shareholders, particularly in respect of investment and incorporated employment (personal services) income. A CCPC is even more seen, though not prescriptively, as a kind of alter ego of or proxy for its ultimate individual shareholders, although with deeply rooted antecedents in how Canadian tax law has from its outset addressed personal corporations this is a pervasive implication of Canadian corporate taxation involving private corporations. It is CCPCs that benefit from a tax rate advantage up to a threshold of active business income and the taxation of investment income which includes a special corporate level tax under section 123.3 of the Act to simulate that income being earned directly by individual shareholders and, with it, a tax refund mechanism to ensure that tax to that degree is not levied more than once. Tax Rates Against this backdrop and with allowances for the multijurisdictional taxation of corporate income and distinctions among its qualities, the corporate tax rates may be summarized this way. Corporations that are not CCPCs are referred to, as they sometimes are in corporate tax 26 27 24 25

Act, s 125, defined in ss 125(7). Act, ss 89(1). Act, ss 89(1). Act, ss 2(1), 2(2), 3, and 4.

236  Research handbook on corporate taxation rate charts, as ‘general corporations’. These rates subsume seamlessly the construction of the tax rates contemplated by the tax rate provisions of the Act mentioned earlier. General corporations Active business (including ‘manufacturing and processing’ (M&P)) – Federal (Act): 15 percent – Provincial/Territorial: Ranging from 2.5 percent (a territorial outlier for M&P) to 16 percent – Combined Federal and Provincial/Territorial: 17 percent (the same territorial outlier) to 31 percent, with most being around 26 percent to 29 percent. Investment – Federal (Act): 15 percent – Provincial/Territorial: 8 percent to 16 percent – Combined Federal and Provincial/Territorial: 23 percent to 31 percent, with most being around 26 percent to 29 percent. CCPCs Small business (threshold is $500,000 for all but one province for which it is $600,000) – Federal (Act): 9 percent – Provincial/Territorial: Ranging from 0 percent to 3.2 percent – Combined Federal and Provincial/Territorial: 9 percent to 12.2 percent. Active business (including M&P) – Federal (Act): 15 percent – Provincial/Territorial: 8 percent to 16 percent – Combined Federal and Provincial/Territorial: 23 percent to 31 percent, with most being around 26 percent to 29 percent. Investment – Federal (Act): 38.7 percent (including 10.7 percent refundable) – Provincial/Territorial: 8 percent to 16 percent – Combined Federal and Provincial/Territorial: 46.7 percent to 54.7 percent, with most between 50 percent and 53 percent. (Illustrating the antideferral control on the taxation of CCPCs’ investment income, the combined Federal and Provincial/Territorial top personal tax rates on interest and ordinary income (income that is not somehow tax preferred) ranges between 48 percent and 54.8 percent, with most being 51 percent and 55 percent.) Distinguishing between Business, and Investment and Personal Services Income Private corporations and their shareholders are subject to an elaborate regime in the Act for identifying, classifying, and tracking their business, small business, incorporated personal

Corporate taxation in Canada  237 services, and investment income with the effect that the separation of fiscal interests otherwise arising from corporations being independent of their shareholders is significantly overcome for all but genuine business income. Hence, for private corporations and their shareholders, incorporated investment and personal services income is generally taxed at the same time and to the same degree as if corporate intermediation did not exist. This is explained more later. It accounts for the elaborate regime that applies to identify and track investment and personal services income earned by private corporations including through tiers of corporations and, once taxed to the same degree as appropriate for individuals but at the corporate level, to avoid ‘double taxation’ on distributions of the previously taxed income.28 Theoretically, the same qualitative distinctions for income could exist for public corporations. However, public corporations present a much less significant risk of being dominated by their shareholders, as extensions or manifestations of them, to defer the taxation of or recondition income. That coupled with the implicit expectation that all income of a business corporation is at least incidental to the business, results in more limited need for effective corporate transparency other than the basic features of integration enabled by the intercorporate dividend deduction and the dividend tax credit for individual shareholders, both to ensure that income earned in the first instance at the corporate level is taxed to the degree expected by the Act without duplication when distributed. Investment (and Personal Services) Income Investment and personal services income of a private corporation are taxed according to the same mechanical regime, but with one significant exception for CCPCs which has the effect of overriding the fiscal significance of the corporation as a person separate from its shareholders and denying the rate advantage generally available to a CCPC on its income compared to how ultimate individual shareholders would be taxed on the same income. Through additional top-up tax, the income of an incorporated employee (a ‘personal services business’)29 is taxed at approximately the same rate, albeit at the corporate level, as if the employed whose corporation it is had earned the income directly, denying the temporal tax rate advantage to individuals who, otherwise, would be able to (and formerly were able to) ‘elect’ out of full taxation on their income for as long as their earnings were retained by the corporation. Similarly, investment income of a CCPC including income of a ‘specified investment business’30 – periodic income and the taxable portion of capital gains, with effects similar to how investment income of ‘foreign affiliates’ of Canadian shareholders effectively is accounted for as if it had been earned directly by them.31

Act, s 129 and Part IV. See, by way of partial explanation, Canada Revenue Agency, Dividend Refund Rules, 2 April 2018, accessed 3 April 2023 at https://​www​.canada​.ca/​en/​revenue​-agency/​ programs/​about​-canada​-revenue​-agency​-cra/​federal​-government​-budgets/​budget​-2018​-equality​-growth​ -strong​-middle​-class/​passive​-investment​-income/​dividend​-refund​-rules​.html. 29 Act, ss 125(7); ‘professional corporations’ (Act, ss 248(1)) are not considered to be subject to the restrictions that apply for ‘personal services businesses’ because professionals are generally not ‘employees’ in the sense contemplated by the definition even though they do provide personal services. The benefits afforded to professional corporations manifest various fiscal policy factors. 30 Act, ss 125(8). 31 Act, s 91 and related provisions; ‘foreign accrual property income’ – investment income and income assimilated to it as well as business income that according to the Act has been displaced from 28

238  Research handbook on corporate taxation The top-up tax on investment income of a CCPC that is the tax on that income at the corporate level achieves the equivalent of tax on that income immediately at the personal tax rate.32 That income is tracked through intermediate levels of corporations between the corporate earner and the ultimate individual shareholders.33 As dividends are paid ostensibly from that income, the ‘extra’ shareholder-related tax is refunded and re-established through a refundable dividend tax process that avoids any tax deferral advantage that otherwise would arise from earning investment income in a private corporation.34 From the earliest days of ‘modern’ income taxation in Canada, the Income War Tax Act, the Act has reflected attention of varying kinds and degrees directed to neutralizing the tax reduction benefits of personal corporations, skeptical that they were not conducting commercial business but instead were private investment portfolios.35 A related regime in the Act applies with respect to capital gains. Under the Act, only half of a capital gain is taxable as a taxable capital gain, to which the usual tax rates apply. The effect is to subject capital gains to taxation at half the rate that otherwise would apply. The other half of the capital gain is not taxed. Where corporate intermediate separates a gain realized at the corporate level from its eventual enjoyment by an individual shareholder who receives it as a dividend, a ‘capital dividend account’ regime applies to segregate the non-taxable portion of the gain and track it to its eventual individual shareholder destination without further taxation

its Canadian source through intra-mural transactions within a closely held foreign affiliate context – is defined in ss 95(1). 32 Act, ss 123.3 and 129. 33 The investment income and tax on it of a private corporation is tracked in two ‘pools’ of accounts, ‘eligible refundable dividend tax on hand’ and ‘non-eligible refundable dividend tax on hand’. The former largely comprises the antideferral tax under Part IV of the Act that has been paid on a dividend for which the payer obtained a tax refund on payment. The latter is tax on investment income, that is, tax that includes a supplement to top up the corporate level tax to approximate the degree of tax an individual would have paid on the income directly. Through these two pools the investment income and tax on it is tracked through chains of corporate intermediation until ultimately dividends are paid to individual shareholders who benefit from the dividend tax credit which reconciles corporate level and individual tax on underlying corporate income to ensure, in principle, that tax at the expected rate for income of the affected quality is paid subject to deferred taxation of business income. Effectively, again in principle, the outcome is as if corporate intermediation did not exist – as if the corporations had no fiscal significance despite whatever commercial role is served by incorporation, as if the corporate tax system in the Act was more aptly dubbed the ‘anti-corporate tax system’. See the Canada Revenue Agency document referred to in supra note 28. 34 Act, s 129 and Part IV. Private corporations and corporations despite being public are disproportionately closely held, and therefore treated as private, are subjected to an antideferral tax on dividends they receive on portfolio dividends, i.e., dividends paid by corporations not ‘connected’ to them, i.e., a comprehensive 10 percent of all shareholder equity or alternatively controlling interest, on dividends that when paid by a lower tier private corporation generate refunds of corporate level tax, which the antideferral tax effectively reinstates while dividends more upward in a corporate chain. The purpose of this antideferral regime, in Part IV of the Act, is to discourage postponement, otherwise, of individual shareholder tax and to subject investment, i.e., portfolio, income essentially to the same tax that individuals who earned that kind of income would have paid. 35 There are particular kinds of pooled investments, notably ‘mutual fund corporations’ and ‘mutual fund trusts’ that afford individual investors the investment benefits of investing through large pools of capital. See Act ss 131 and 132, respectively. But these are public funds that mimic the effect of holding indirectly and jointly securities that in principle held directly without the benefits of scale afforded by the pooling of like-minded investors’ investment capital.

Corporate taxation in Canada  239 (and opportunity for unintended tax shelter that has spawned various legislative and judicial interventions to limit the multiplication of this integration feature or, otherwise, its inappropriate availment by shareholders and in circumstances not meant to be protected).36 The legislatively elaborate distinction between business and investment income of private corporations does not apply to and is not replicated for public corporations. In addition to the presumption that corporations carry on business are two expectations, first that most of the financial resources of a public corporation are deployed in its business operations, and second the publicness of the corporation and how it is regulated do not permit the same kinds of shareholder self-dealing that private corporations offer and, indeed, the Act throughout its history has been (and needed to be) particularly attentive for tax avoidance reasons. Business Income Some of the tax that the Act expects to collect from a corporation–shareholder axis that comports with an economic unity, is deferred. Business income, accordingly, is qualitatively unique in fiscal and tax policy terms.37 There is an evidentiary presumption that corporations carry on business. But, in fiscal and tax policy terms, not all income from what ostensibly are business activities is or should be treated as business income. This is because the connotation of much lower tax rates for corporations, effectively half the rate that would have applied had individual shareholders earned the same income directly without corporate intermediation, is a significant subsidy. This is seen in fiscal terms to be both necessary and desirable (considering among others economic ‘spillover’ consequence) particularly for private corporations that face access limitations to other funding, in a kind of public–private ‘partnership’ though this is not how the Act describes or legislates the effect. Mechanically, business income of a private corporation (which excludes income of an incorporated employee but does include income of an incorporated professional, and also excludes certain investment income earned in what amounts to a closely held ‘family’ cor-

Although beyond the scope of these brief comments, the opportunities for engineering unwarranted tax shelter – tax avoidance – arise any time sheltered income is categorized and effectively segregated. Through private law constructions, inevitably ingenuity turns to ways in which that shelter may be mobilized for the benefit of persons not otherwise connected to it and how it arose, i.e., in effect by ‘selling’ tax attributes. This kind of taxpayer conduct is commonly associated with trading in losses (soon to be adjudicated by the Supreme Court of Canada with primary reference to what corporate control means; see The Queen v. Deans Knight Income Corporation, 2021 FCA 160) but it can, and does, arise with respect to other attributes including the ‘capital dividend account’; see, for example, the well-known case 2530-1284 Québec Inc., et al. v. Her Majesty the Queen, 2008 FCA 398, in which highly structural ‘planning’ had the effect but finally for judicial intervention of offering the unlimited possibly of multiplying the ‘capital dividend account’ (the statutory repository of the portion of capital gains that are not taxable, and therefore are preserved for distribution to private corporation shareholders as if the gains had been realized directly by them). The role of the capital dividend account mechanism in achieving corporation–shareholder integration and insight into the significance of integration for Canadian tax purposes are addressed by the Federal Court of Appeal in The Gladwin Realty Corporation v. The Queen, 2020 FCA 142, notably at paras 59–62. 37 See Ken McKenzie and Charles Taylor, ‘Business Income Taxation’, in Heather Kerr, Ken McKenzie, and Jack Mintz, Eds, Tax Policy in Canada (Toronto: Canadian Tax Foundation, 2012), ch. 7, 7:1-7:51. 36

240  Research handbook on corporate taxation poration) is taxed at a materially lower rate of tax, in the order of 26 percent at the corporate level. The actual rate varies in so far as the corporate tax rate is a composite of the rate under the Act and provincial corporate income tax rates which vary within a relatively narrow band from province/territory to province/territory. The first $500,000 of business income of a CCPC – private corporation that is not controlled by a public corporation or non-residents (including any combination, without regard to relationships among them) – is taxed at an even lower corporate tax rate which, again, varies depending on the province or territory of principal tax accountability. Corporate Distributions When a corporation pays dividends to their shareholders, the balance of the tax the Act expects to levy on business income earned by the corporation within the ‘unity’ of the corporation– shareholder axis, that is, the shareholder level tax, is exacted when it reaches individual shareholders.38 Dividends passing through intermediate corporate shareholders are generally excluded from further taxation by an intercorporate dividend deduction in subsection 112(1). There are limitations to mitigate ‘surplus stripping’ and ‘capital gains stripping’.39 Individual shareholders reduce the tax they would otherwise pay on dividends received by them via a dividend tax credit which accounts for tax paid at the corporate level. Tracking Low and General Rate Income – ‘Perfecting’ Integration Because business income of a CCPC is taxed at different rates below and above the $500,000 income mark (allowing for the allocation of this limit among ‘associated corporations’), the CCPC’s income is tracked in ‘low rate’ (LRIP, or ‘low rate income pool’) and ‘general rate’ (GRIP, or ‘general rate income pool’) accounts. Dividends are assumed by the Act to have been paid from LRIP unless a statutory designation (required for this purpose to be) made under subsection 89(14) qualifies them as GRIP dividends.40 An excessive GRIP designation gives rise to a material penalty tax under Part III.1 of the Act. The reason for the LRIP/GRIP distinction is to ensure that the ‘integration’, otherwise achieved by how corporations and their shareholders are taxed on income earned at the corporate level, is not distorted by crediting shareholders via the dividend tax credit with tax to a degree (rate) of tax that the corporation did not (more accurately, would not legislatively 38 Or is paid, subject to non-resident withholding tax under Part XIII of the Act (principally, subsection 212(2)), to non-residents. 39 See, for example, sections 55 and 84.1, and paragraphs 88(1)(c) and (d), among others. 40 See Act, s 89 for the main provisions of the Act outlining the LRIP and GRIP notions, and Part III.1 of the Act that applies to excessive elections of distributions designated to be from GRIP. When dividends are paid by a corporation, ‘public’ or ‘private’, the ‘tax-source’ of the dividends must be designated if paid out of direct or inherited, i.e., previously designated, ‘general rate income’. The default is that the income funding a dividend has been taxed at the lowest possible corporate rate in order to avoid over-integration through asymmetry of the corporate tax rate and the assumed corporate tax rate for the dividend tax credit taken by individual shareholders. The fiscal and statutory objectives and the tracking mechanisms for this purpose are akin to those used in the foreign affiliate part of the Act to measure and track ‘active business income’ and ‘foreign accrual property income’ (which includes income that has been earned in a business setting but intrinsically has a predominant portfolio mien or connection to a Canadian source).

Corporate taxation in Canada  241 have been expected to) pay on low rate income. Interestingly, as noted earlier, the dividend tax credit available to individual shareholders applies regardless of whether and to what degree tax is actually paid by an underlying corporation on its income or if so whether it was paid at the rate assumed by the dividend tax credit, or indeed, subject to limits in corporate law statutes, whether the corporation has any income to distribute. Corporate Surplus and the Taxation of Corporate Income: Intercorporate Dividends and ‘Paid-Up Capital’ There are two important features of how corporations and their shareholders are taxed under the Act which have an outsized, though possibly understated, influence on but permeate the architecture of the Act. They relate to corporate tax avoidance described as ‘surplus stripping’ or ‘capital gains stripping’.41 These are the intercorporate dividend deduction in section 112(1) of the Act and the notion of ‘paid-up capital’ (PUC) defined in subsection 89(1) of the Act. The importance of the intercorporate dividend deduction as a principal architectural feature of integrated Canadian corporate taxation, and a significant means for unwarranted tax avoidance via transactions that are framed by the most rudimentary private law creations, has been noted. The ‘dividend received deduction’ as it is sometimes described excludes dividends received by a Canadian corporation from another Canadian corporation, in computing the recipient’s taxable income. Corporate income is considered to be sufficiently taxed at the corporate level once, to the corporation that earned it. It is not to be further (‘double’) taxed when the taxed income moves among corporate shareholders as dividends. Little imagination is required to understand how this seemingly simple long-standing fixture of Canadian corporate taxation from its earliest days offers a pathway to channel ‘surplus’ in ways that avoid tax. For example, instead of realizing the disposition of shares or underlying property owned by a corporation the value of undistributed actual and future but yet unrealized surplus might be channeled this way in the absence of statutory constraints, effectively enabling the sale to a third party of a business for proceeds funded constructively by its own resources. Another possibility already broached in these comments is effecting debt financing of a corporation through fixed value preferred shares that also absent statutory constraints would offer corporate financiers compensation for their financial accommodation on a tax-free basis. This seemingly straightforward feature of corporate taxation under the Act has spawned restrictions on availing the intercorporate dividend deduction. They are meant generally to confine it to situations in which a corporation is the legally distinct manifestation of its owners and suppliers of capital, shareholders who hold shares evidencing unrestricted equity interests and therefore are ‘at one’ despite their legal separateness with the corporation in which they hold shares. In particular these restrictions prevent financing charges that would be interest 41 ‘Surplus stripping’ is a controversial phrase. See supra notes 19 and 22. It is largely thought, however, on very infirm foundations if the Act and its genesis are well understood, that ‘surplus stripping’ – the extraction of undistributed corporate earnings and unrealized corporate value without shareholder level taxation – is not proscribed generally by the Act. The Supreme Court of Canada queried this in the Copthorne Holdings case, though that Court was not deciding in an affirmative sense that such a fundamental legislative undercurrent is absent (as many seem to assume or want to understand) but instead observed that in that case its existence had not been demonstrated in relation to the relevant statutory provisions.

242  Research handbook on corporate taxation from being taxed with the preferences applicable to dividends,42 and prevent shareholders from transforming the capital gains they otherwise would realize on a disposition of their corporate business interests and the corporation would realize on a disposition of its business property, into tax-free intercorporate dividends.43 Other restrictions prevent intercorporate dividends being a means to share losses and expenses with third parties when the same return paid in another way would not give rise to a useful tax shelter for the corporate payer.44 ‘Paid-up capital’45 (PUC) is in some respects a statutory anachronism. It is a corporate law attribute of shares issued by a corporation equal, generally, to the amount paid to a corporation by a shareholder (but not necessarily the holder of the share who may have acquired the share in a shareholder-to-shareholder transfer) to subscribe for shares. This distinguishes it from the ‘adjusted cost base’ of shares (and other property) owned by a taxpayer, which is personal to a shareholder; it reflects the particular financial circumstances of the taxpayer regarding the share regardless of the situations of owners of like, that is, shares of the same class. The Act incorporates the corporate law notion of corporate ‘state capital’ under applicable corporate law for this purpose. It is maintained separately for each class of shares and is referable ratably to each share within the class.46 Because PUC is a share class attribute, it ‘blends’ the amounts paid by all shareholders of a class of shares regardless of when they subscribed for them. Implicitly, the capital associated with a shareholder’s shares may fluctuate when more shares of a class are issued, shares of a class are reorganized, shares of a class are redeemed or purchased for cancellation, and the like. The preferred share regimes already discussed, supra note 4. Commonly this could arise on a divisive reorganization in which shareholders divide a corporation or cause certain business divisions to be spun off. But it is a general possibility that section 55 of the Act polices, which requires to be considered for all intercorporate dividends. 44 This has been noted earlier in these comments with reference to ‘taxable’ and ‘short term preferred’ shares, supra note 4. More specifically, as noted earlier, there are two preferred share regimes in the Act that exist to prevent financiers being compensated by dividends rather than interest, either because in economic or financial terms a preferred share financing has all the hallmarks of indebtedness or the putative ‘borrower’ is not able to monetize the value of present and future losses and wants to achieve a financing cost saving by effectively transferring the value of those losses who would receive their return tax-free. 45 Act, ss 89(1). The Copthorne Holdings case, supra note 19, concerned the duplication of PUC through effecting a horizontal rather than a vertical amalgamation of two related corporations. Both kinds of merger by amalgamation are possible. The assumption underlying a horizontal amalgamation is that two corporations have a separate legal existence because they have been independently capitalized; to that extent their stated capital for corporate law purposes and consequently their PUC is combined on the merger. In the case of a vertical amalgamation, at least partly the capital of lower tier corporations in a chain is, indirectly, the ‘same’ capital as that of superior corporations in the chain. Hence, when the distended chain is shortened by a vertical amalgamation, the necessarily duplicative capital reflected in the holding of shares of one of the merging corporations in the other is eliminated. In Copthorne Holdings, the taxpayer engineered a reorganization to shift a corporation in a vertical chain to a sideways position so that ‘its’ capital was preserved upon merger with another member of the chain to create the opportunity for withholding tax-free capital distributions to a non-resident. The Supreme Court applied the General Anti-Avoidance Rule (GAAR) in section 245 of the Act to deny this outcome. In the reasons of the Supreme Court there is a useful discussion of the PUC notion and in that connection of reorganization rules, discussed later in these comments, in all of which preserving the continuity of PUC without creating opportunities for ‘surplus stripping’ is a main feature. 46 For purposes of the Act, a series of a class of shares is a separate class. 42 43

Corporate taxation in Canada  243 The potential planning ‘magic’, and occasionally unwarranted tax avoidance, to which the Act reacts also to limit ‘surplus stripping’ and capital gain transformation for reasons similar to the purposes of limitations on the intercorporate dividend deduction, arises primarily for private corporations and their shareholders.47 Regardless of how much undistributed income a corporation may have when it makes a distribution, holders of private corporation shares are entitled to receive instead, according to the procedures of corporate law, a ‘return’ of capital – in effect, to receive payments back from the corporation of capital subscribed by shareholders although not necessarily the same shareholders, hence the opportunity for alchemy. A ‘return’ of PUC is not taxable to any shareholder. To a much more limited degree the same possibility may exist for shareholders of public corporations. But because there is by the nature of a public corporation a significantly less identity with any particular shareholders contrasted with typically closely held private corporations, the ability afforded by the Act to ‘return capital’ is severely limited. Most distributions by public corporations regardless of their corporate law designation as dividends or returns of capital, including those deemed to arise on most redemptions or purchases for cancellation of shares, are taxable dividends.48 The ability of private corporations to return PUC accounts for considerable legislative complexity, ostensibly directed to limiting PUC increases unless they correspond with value transferred to a corporation which should be considered to be tax paid, but even then when it may be a means in a non-arm’s length setting to extract surplus without tax while continuing to own the corporation.49 Reductions of PUC have been especially problematic respecting

Note that private corporations include subsidiaries of public corporations and also of non-resident corporations. 48 See Act, ss 84(3), (4), and (4.1); among others, companion provisions in section 84 apply to effective distributions by manipulating PUC (84(1)), distributions on a corporate winding up (84(2)), certain amounts received in relation to term preferred and guaranteed preferred shares (84(4.2) and 84(4.3)), and certain shareholder appropriations apart from the generally applicable rule in subsection 15(1) of the Act (84(5)). In some cases, the deemed dividend that would otherwise arise on a corporate share redemption or repurchase of its capital (gain) character if the receipt arises for the shareholder from certain qualifying open market purchases by a public corporation of its shares. Where a deemed dividend arises on a share redemption or repurchase according to ss 84(3), there are two effects taking account of the capital gain provisions of the Act for a holder who holds the share as capital property: the deemed dividend is equal to the difference between the redemption/repurchase proceeds and the PUC of the share, and a capital gain or loss may arise equal to the difference between the net proceeds, i.e., the proceeds reduced by the deemed dividend, and the shareholder’s adjusted cost base of the share. 49 See, for example, ss 84.1 of the Act, recent controversial changes to the Act in Bill C-208, legislated as Statutes of Canada Chapter 21 An Act to Amend the Income Tax Act (transfer of small business or family farm or fishing corporation) and the Perry Wild case, 1245989 Alberta Ltd. v. Attorney General of Canada and Perry Wild v. Attorney General of Canada, 2018 FCA 114. The official summary published with Bill C-208 as enacted says: ‘This enactment amends the Income Tax Act in order to provide that, in the case of qualified small business corporation share and shares of the capital stock of a family farm or fishing corporation siblings are deemed not to be dealing at arm’s length and to be related, and that, under certain conditions, the transfer of those shares by a taxpayer to the taxpayer’s child or grandchild who is 18 years of age or older is to be excluded from the antiavoidance rule of section 84.1.’ The government has now reacted to the significant loosening of limitations on the intergenerational transfer of closely held family business for which the changes to the Act by Bill C-208 are a relatively unlimited pathway. This relatively unrestricted change had been referred to as facilitating ‘surplus stripping’; see Allan Lanthier, ‘New Legislation Puts High-income Tax Avoidance Scheme on Steroids’, Special to the Financial Post, 29 June 2021, accessed 4 April 2023 at https://​financialpost​.com/​opinion/​allan​-lanthier​ -new​-legislation​-puts​-high​-income​-tax​-avoidance​-scheme​-on​-steroids​#:​~:​text​=​from​%20our​%20team​ 47

244  Research handbook on corporate taxation non-resident shareholders. Absent statutory restrictions,50 the fiscal focus of both is ‘surplus stripping’ – enjoying the benefit of accumulated but undistributed corporate surplus comprising undistributed earnings and the unrealized value of corporate property, in ways that avoid tax including by facilitating a transformation of the quality otherwise taxable amounts into taxable but untaxed dividends. Particular ways in which PUC is policed in the Act include: restricting PUC increases generally to correspond to contributions of value to (increases in the value of) a corporation in relation to relevant shares and shareholder interests,51 treating the excess of the proceeds of a redemption or repurchase of corporation shares (or a distribution on a liquidation) relative to PUC as taxable dividend,52 that is, to ensure that undistributed income or unrealized value that when realized will give rise to income bears the degree of tax expected by the Act for it when extracted in favour of shareholders, and policing the circumstances in which PUC may be ‘returned’ to shareholders even if not to ‘the’ shareholders who contributed it in the relevant degree.53 Preserving the continuity of PUC without unwarranted increases also is a main feature of the provisions of the Act concerning corporate reorganizations. Again, this is to prevent ulterior untaxed value transfers among shareholders effected through alterations in the stated capital and hence for tax purposes PUC of shares, in other words discontinuities in the shareholders’ economic and financial positions despite what ostensibly is and is meant to be simply a manifestation of existing interests. Foreign Corporations Owned by Canadian Shareholders ‘Foreign affiliates’54 are foreign corporations in which Canadian shareholders have what the Act considers to be a substantial equity interest, one that justifies considering shareholders to be materially identified with such a corporation. Generally, a ‘foreign affiliate’ of a Canadian shareholder is a foreign corporation in which the shareholder owns at least 1 percent of a class of shares and alone or with certain closely connected others at least 10 percent of those shares; .​-​,Allan​%20Lanthier​%3A​%20New​%20legislation​%20puts​%20high​%2Dincome​%20tax​%20avoidance​ %20scheme​,​%24892​%2C218​%20​%E2​%80​%94​%20the​%202021​%20indexed​%20amount and Allan Lanthier, ‘Ottawa’s Blunder on Business Transfer Taxes Could Cost Billions’, Special to the Financial Post, 27 July 2021, accessed 4 April 2023 at https://​financialpost​.com/​opinion/​allan​-lanthier​-ottawas​ -blunder​-on​-business​-transfer​-taxes​-could​-cost​-billions. As noted earlier in this chapter supra note 15, the government very recently has proposed to respond to the challenges posed by this change to address the long standing issues associated with the intergeneration transfer of family businesses. In the government’s 2023 federal budget presented in March 2023 significant refinements to the changes made by this way have been proposed with more tailored attention to intergenerational business transfers within a family but in the government’s view with fewer opportunities for unwarranted tax avoidance (the budget documents may be accessed at https://​www​.budget​.canada​.ca/​2023/​home​-accueil​-en​.html, accessed 3 April 2023). 50 For example, ss 212.1 of the Act concerning certain circular transfers of shares of Canadian corporations by non-resident shareholders, and ss 212.3 that deals with appropriating the financial resources of Canadian corporations for the benefit of a controlling foreign parent’s business interests, ‘grind’ PUC of cross-border shareholdings to avoid unwarranted tax sheltering opportunities for which the PUC of shares is a means to extract or multiply realized or potential corporate surplus without tax. 51 Act, ss 84(1). 52 Act, ss 84(2) and 84(3). 53 Act, ss 84(4) and (4.1), in particular. 54 Act, ss 95(1).

Corporate taxation in Canada  245 a ‘controlled foreign affiliate’55 is a foreign affiliate controlled by the shareholder, alone or together with certain non-arm’s length persons or, indeed, up to four other Canadians whether or not acting as group. The ‘foreign affiliate’ regime in the Act is addressed particularly to taxing Canadian shareholders on incorporated foreign investment income, ‘foreign accrual property income’,56 without deferral if the foreign affiliate is a controlled foreign affiliate of the shareholder (by considering the shareholders to have received a measure of that income even if not actually distributed) but even so to tax it eventually, according to Canadian tax rules.57 Tax jurisdiction for ‘active business income’ is relinquished through the territorial features of the foreign affiliate regime, in favour of the countries where it is earned. Specifically, Canada generally cedes the entitlement to tax foreign business income (‘income from an active business’58 that does not through transactions within a corporate family or otherwise in certain respects have a Canadian source59 nor is incorporated portfolio – ‘investment business’60 – income) of foreign affiliates created under the laws of and carrying on business in countries with which Canada has a tax treaty or information exchange agreement. This is consistent with international taxation norms that accord primary or source or territorial taxation for business income to the places where factually and legally it is considered to arise. This also is consistent with what essentially would be expected had the income been earned without corporate intermediation via a source country business presence, that is, a ‘permanent establishment’. The ITR house an elaborate tax accounting regime that tracks income of various qualities, notably business versus investment income, for the periods in which shareholders owned shares of foreign affiliates and prioritizes distributions while affording shareholders first to receive a return of their investment, inaptly but conveniently referred to as a return of capital but more accurately a return of the cost of the shareholder’s investment in the foreign affiliate. The parallels with how like income of Canadian corporations is taxed are notable but not coincidental. They are deliberate. They target the same themes as domestic corporate taxation, described in this commentary. Indeed, the basic architecture of the regime for taxing business and investment income of CCPCs (private corporations) and foreign affiliates, including income character preservation rules to allow business income to be transmitted to closely connected corporations without losing its business income character.

TAX ASPECTS OF INCORPORATION The act of incorporating (including where the law permits ‘continuing’ or redomiciling) has no unique tax effects. However, capitalizing the corporation with shares of various classes (including series) and transferring financial and other property to the corporation do.61 Act, ss 95(1). Act, ss 95(1). 57 See Act, ss 91(1) and 113, in particular. 58 Act, ss 95(1). 59 Act, ss 95(2)(a.1)–(a.4), ss 95(2)(b) and 95(3). 60 Act, ss 95(1). 61 Some elements of corporate finance are addressed throughout these comments. The Act contains many provisions concerning deductible charges, in particular interest for debt financing, derivative financial transactions of various kinds, restrictions on deductible charges associated with the capitalization 55 56

246  Research handbook on corporate taxation Acquiring a Business Businesses conducted by a corporation can be acquired principally in two ways, through the purchase of its shares with its assets and undertaking remaining undisturbed, or of its assets and undertaking. The tax effects are, of course, quite different. Where shares rather than assets are purchased, the Act takes steps to avoid writing up the cost of property, except in limited circumstances involving a genuine third party acquisition and winding up of a target incorporated business into a successor ‘acquisition corporation’. The Act also limits increasing the tax cost of depreciable property in non-arm’s length transactions even if fair market value is paid. As with so many features of the corporate tax aspects of the Act, an overarching objective is to preserve the eventual taxation of corporate ‘income’ or its value without distortion or character transformation, both extant and prospective. There is an obvious anti-surplus stripping mien about this. To this end the Act also polices the shifting of a business between the taxable and non-taxable realms otherwise framed by the Act, for example, the tax-deferred and ultimately tax-avoiding transfer of a business from a fully taxable environment to one where a tax-exempt, for example a pension plan, would own or control it at the point where underlying undistributed or untaxed income and other value would be realized and deployed for other purposes.62 More broadly when the circumstances in which business is conducted change, that is, when the ownership of a corporation changes, the Act determines the continuity, or not, of various tax accounts. Acquisition of Control and Tax Attributes Business losses are a main case in point. Upon an ‘acquisition of control’ of a corporation,63 the continuing application of business losses to reduce taxable income is restricted to income from continuing the business in which they were sustained or a similar business. of Canadian corporations by substantially connected non-residents, and recently proposed additional limitations on financing charges deductions related to international proposals to limit ‘base erosion’ through disproportionate indebtedness of certain members of corporate groups and situations in which through the hybridity of transactions amounts charged and deductible in one jurisdiction are not included in a foreign counterparty’s income according to the tax regime that applies in its jurisdiction. It is beyond the scope of these comments to be more expansive, but in considering corporate taxation in practice attention necessarily must be paid to corporate finance considerations. 62 Act, ss 149(10), and also regarding partnerships, s 100, notably 100(1.1); see also the Federal Court of Appeal’s careful parsing, in The Queen v. Oxford Properties Group Inc., 2018 FCA 30, of various reorganization provisions of the Act to conclude, essentially, deferred tax on property transfers according to reorganization undertaken by taxable corporations ends when there is a transition to the non-taxable realm of the Act. The Court explains the underlying expectation of the Act’s orchestration of tax deferral for various property transfers that take place in a reorganization, which presupposes that eventually postponed tax on postponed income arising from the disposition of valuable property while it remains in corporate solution within the alignment with shareholders contemplated by the Act, should end when there is an exit from taxable corporate solution. Again, this is a particular expression of the Act’s fundamental systemic and systematic antipathy to ‘surplus stripping’. 63 This is more uncertain, and more disputed than it should be given the prominence of this for main features of corporate taxation. A case has recently been heard by the Supreme Court of Canada concerning what ‘acquisition of control’ means for purposes of continuing business loss utility after a control change as limited by subsection 111(5) of the Act. The case is Deans Knight Income Corporation v. The King (the Supreme Court docket record can be found at https://​www​.scc​-csc​.ca/​case​-dossier/​info/​

Corporate taxation in Canada  247 Generally, restricting the commoditization and transmission of ‘tax attributes’ beyond the axis of the shareholders and corporation extant when they arose is a continuing concern in the Act even though it is still debated presently in litigation about what constitutes an ‘acquisition of control’ and, more basically, ‘control’ of a corporation, and also whether there is an underlying antithesis in the tax law to the sharing of tax attributes. Amendments are presently proposed to section 256.1 of the Act, which contains a special rule concerning the acquisition of control in circumstances where tax attributes would be ‘conveyed’ for use outside the setting in which they arose, to focus even less on the ‘legalities’ of control by absorbing in the determination various collateral transactions that bear on that outcome operationally or functionally without themselves being the corporate event by which, strictly, control would be determined. For other purposes in the Act, again where the sharing of tax accounts would be implicated, an extended ‘in fact’ notion of control is used. The siloing and effective tracking of tax attributes is a function of the direct and indirect identity of interest between corporations and their shareholders that the Act expends considerable legislative effort to preserve despite fragmentation induced by the separation of an economic unity into legally distinct personalities and transfers. Tax attributes, that is, losses available for application in another period, credits, and other tax accounts, arise in context that fundamentally is that identity of interest, and broadly the Act aims to restrict their commoditization and transmission outside this ‘bubble’. Adopting the ‘anti-corporate tax system’ descriptor, the effect of this containment is to diminish the fiscal significance of a corporation without raising the corporate veil, while nevertheless respecting their and their owners’ and transaction counterparties’ independent personal and transactional existence. Reorganizing a Corporation and Its Business This same influence persists with the same objectives and effects in the detailed provisions regarding corporate reorganizations. The Act envisages the various ways in which, according to applicable corporate law, a corporation may be reorganized. All on a tax-deferred, that is, ‘tax-free’, basis, corporate securities may be converted or exchanged,64 capital may be reorganized,65 and corporations may be combined by ‘merger’, that is, in Canadian legal and tax terms, by an amalgamation66 or a liquidation and winding up of one corporation into another that owns at least 90 percent dock​-regi​-eng​.aspx​?cas​=​39869, accessed 17 April 2023); the Federal Court of Appeal and Tax Court of Canada decisions, respectively, can be found at The Queen v. Deans Knight Income Corporation, 2021 FCA 160, and Deans Knight Income Corporation v. The Queen, 2019 TCC 76. There is a string of cases which establishes that control means ‘legal’, de jure, control – that number of shares, typically 50 percent + 1, sufficient to elect the board of directors. It has become confused whether implicitly, taking account of the cases, this means substantial control, that is, actual and effective decision making, or whether it is a more mechanical test regardless of who may be shown by evidence and by the implications of the terms of shares determines a corporation’s prospects and operations. Unfortunate jargon, like ‘legal’ versus ‘actual’ versus ‘effective’ versus ‘in fact’ control all trying to get to the heart of this fundamental notion, has obscured what ‘acquisition of control’ means. This opacity typically arises in the context of structured tax planning intended constructively to transfer the benefit of losses without being restricted by the limitations on loss transmission. 64 Act, ss 51 and 51.1, and 85.1 for certain share-for-share exchanges. 65 Act, s 86. 66 Act, s 87.

248  Research handbook on corporate taxation (the balance if any owned by third parties) of the liquidating corporation.67 The essence of the detailed reorganization rules is preserving the status quo of the corporate condition in relation to its shareholders and property and undertaking when the corporation–shareholder axis, at the point of the reorganization, remains intact without there having been an economic realization of value at the corporate or shareholder level (including an ulterior shifting of shareholder interests via seemingly benign changes to the PUC of the shares of interested shareholders). To that end, these provisions of the Act are meant to assure continuity of the interests engaged by the corporation–shareholder axis and related tax ‘translations’, that is, tax accounts and attributes, of that axis, which excuses otherwise taxable events from being so, or whether an actual, ulterior, or covert discontinuity has occurred that should and will be taxable. Though mechanically detailed the applicable provisions are conceptually straightforward. Essentially, they are dedicated to maintaining tax accounts at the corporate and shareholder levels in their pre-reorganization condition, so that tax shelter is not gratuitously engineered, for example, by writing up the cost of property on the acquisition of a corporation except in limited circumstances,68 and to preventing changes to shareholder and debt holder interests masking implicit transfers through, for example, adjustments to PUC. Divisive Reorganizations In a directionally similar manner, the Act addresses opportunities to ‘surplus strip’ including to transform capital gains on shares into surplus distributions freed of tax by the intercorporate dividend deduction in subsection 112(1) of the Act, when corporations are divided, that is, ‘split up’ between shareholders or by ‘spinning off’ businesses to achieve various commercial objectives. The divisive reorganization provisions in section 55, which in fact applies more broadly and must be considered with reference to all realignments of corporate interests (but exempts some of them that take place not at arm’s length or satisfy particular ‘split up’ or ‘spin-off’ constraints), polices the transformation of capital gains that otherwise would arise on the sale (acquisition by another) of the shares of a corporation into tax-free intercorporate dividends (and capital reductions) and also the unwarranted preservation of the untaxed condition of the assets and undertaking of a business sold indirectly by a sale of the shares of the corporate owner of the business so as to effect a forward looking ‘strip’ of income that would arise if valuable corporate property were sold to fund distributions to its shareholders. As with so many of the particular features of corporate taxation framed by the Act, the focus is on the shareholder–corporation alignment in which undistributed earnings arose and future earnings may be realized including by selling business property, and then ensuring that shareholder level tax is preserved where it ought to be even though deferred.69 Act, s 88. See post note 69 which identifies when this may be permissible. 69 In important respects paragraphs 88(1)(c) and 88(1)(d), which permit the writing up of the cost of, essentially, real property and shares of subsidiaries to a ratable share of the cost of acquiring the corporation whose property it is to facilitate tax-free sales of the property to be ‘spun away’, i.e., sold, are divisive reorganization rules equivalent conceptually to section 55 and developed at the same time legislatively. For helpful commentary on these divisive reorganization rules, see: Mark Brender, ‘Subsection 55(2): Then and Now’, in Report of Proceedings of the Sixty-Third Tax Conference: 2011 Conference Report (Toronto: Canadian Tax Foundation, 2012), 12:1–35; and Paul Stepak and Eric C. Xiao, ‘The 67 68

Corporate taxation in Canada  249

CORPORATE TAXATION IN CANADA – A REGION WITHIN A SYSTEM This very quick tour of Canadian corporate taxation must conclude, incomplete though it may be. However, the objective of these comments has been to sketch the architecture of this ‘system within a system’, with regard for the importance of appreciating the ‘system’ of the Act and the essential simplicity of its corporate taxation features. The essential themes of corporate income taxation are straightforward. Elegantly the Act confronts the fiscal significance of corporations, notably as devises to facilitate the fragmentation and manipulation of economic unities, by denying it, effectively recombining corporations and shareholders except for genuine business income, that is, the kind of income from conducting business with third parties. There, the Act conveys a subsidy, a deferral of shareholder level tax until, if the income still exists to be distributed, individual shareholders receive it. That subsidy is the product of deliberate economic and fiscal policy that envisages corporate business corporations as engines of growth and opportunity deserving of public support and contribution. On the other hand, much of the regime for taxing private corporations and their shareholders, like equivalent aspects of the ‘foreign affiliate’ (controlled foreign corporation) part of the Act, is devoted to identifying and tracking investment income despite corporate intermediation to ensure no undue deferral compared to the outcome had the corporation(s) not been involved. Regardless of popular mythology about ‘surplus stripping’, a fundamental feature, then, of corporate taxation under the Act is to avoid corporate taxation as a silo, systemically, and to preserve income due still to be taxed at the individual shareholder level, in the condition where that will occur, that is, to police and mitigate ‘surplus stripping’ – the diversion of income the Act expects to be taxed at each of the corporation and shareholder levels in order for it to be adequately taxed within the system of corporation taxation. These observations are not theoretical. Having an appreciation of the essence of a system, any system, and its objectives can only be helpful in making hard judgments in applying the law that the law demands be made, by taxpayers and their advisers and by tax authorities and adjudicators. It is the objective of these comments to offer this sense of system in a way that is not typical when speaking about corporate taxation. This commentary concludes with a final question: Is the corporate tax system in the Act, if thoroughly and properly understood, the ‘anti-corporate tax’?

Paragraph 88(1)(d) Bump: An Update’, in Report of Proceedings of the Sixty-Fifth Tax Conference: 2013 Conference Report (Toronto: Canadian Tax Foundation, 2014), 13:1–60.

15. Corporate taxation in Turkey Funda Başaran Yavaşlar

1. INTRODUCTION In Türkiye, business incomes are subject to three taxes: personal income tax (PIT), corporate income tax (CIT) and digital service tax (DST): 1. The income of sole proprietorships and partnerships owned by natural persons is subject to PIT as the income of the owners or partners of the enterprises (Article 37 et seq. of the Türkish Personal Income Tax Law (PITL)1); 2. The income of enterprises – whether they have legal personality or not – that are considered as taxpayers under CIT is subject to CIT (Article 2 of the Türkish Corporate Income Tax Law (CITL)2); 3. The income of digital service providers, which is generated by the services determined in Law No. 71943 and offered in Türkiye, and which constitutes TRY 20 million or more in Türkiye or EUR 750 million or more, is subject to DST. By their very nature, PIT and CIT are compatible and complementary taxes, including in Türkiye. The CITL refers to the provisions of the PITL regarding business income in terms of both tax object and determination of tax base. The taxable event is the generation of income in both, and the taxation procedure is very similar. However, while flat tax is adopted in CIT, a five-digit progressive tariff is adopted in PIT. The economic double taxation arising from

1 Personal Income Tax Law No. 193 (Gelir Vergisi Kanunu), dated 31.12.1960, OG of 06.01.1961, No.10700. 2 Corporate Income Tax Law No. 5520 (Kurumlar Vergisi Kanunu), dated 13.06.2006, OG of 21.06.2006, No.26205. 3 According to Article 1, para.1 of the Law No. 7194 (dated 23.05.2019, OG of 07.12.2019, No.30971) the object which is subject to the Turkish Digital Service Tax is ‘gross income’. Gross income includes earnings and specified receivables of the enterprise for its services that fall within the scope of the DST before expenses, costs and taxes are subtracted (Article 5, para.1 and para.2 of the Law No. 7194 and Article 39, para.1 of the PITL). Moreover, Law No. 7194 (Article 5, para.2) prohibits the specific indication of DST in invoices and invoice substitute documents, and does not foresee a legal reflection mechanism for DST as in value added tax (VAT). See Funda Başaran Yavaşlar, Neue Digitale Service-Steuer in der Türkei, ISR, 2020/2, p.73; Altan Rençber, Dijital Hizmet Vergisi, İlk İzlenimler, Sorun ve Sorunsallar, VSD S.376 (Ocak 2020), p.34; However, in Schedule B annexed to the Turkish Central Government Budget Laws, the revenue from DST is shown in the group of ‘taxes on goods and services levied internally’, in other words, taxes on expenditures. See e.g. 2002 Central Government Budget Law, Schedule B, accessed 29 March 2023 at https://​www​.resmigazete​.gov​.tr/​eskiler/​2021/​ 12/​202112​-B227​.pdf. For the characterization of DST as a hybrid tax see Joachim Hennrichs, Digital Service Tax – neue Hybridsteuer nicht empfehlenswert!, Tax Compliance, TLE, 17 October 2018, accessed 29 March 2023 at https://​www​.tax​-legal​-excellence​.com/​digital​-service​-tax​-neue​-hybridsteuer​ -nicht​-empfehlenswert/​.

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Corporate taxation in Turkey  251 dividends distributed to partners or natural persons from income on which CIT is levied is partially eliminated at PIT level. Taxpayers of DST, whose structure is relatively close to that of CIT, are also PIT or CIT taxpayers. The taxable event is generation of income (Article 1, para.1 and Article 2, para.1, no.c of the Law 7194). However, the tax object is ‘gross income’, and this is also the tax base (Article 5, para.1 and para.2 of the Law 7194).4 The DST rate is 7.5 percent (flat tax); no deduction is allowed from the tax calculated by applying this rate to the tax base (Article 5, para.3 and para.4 of the Law 7194). The problem of double taxation in the legal sense arising from PIT or CIT levied on the same income is partially solved by allowing the DST paid to be deducted as an expense in determining the net income subject to PIT or CIT (Article 6, para.7 of the Law 7194). This tripartite system of taxation on business income has gradually emerged in line with economic, commercial and political developments. Shariah and customary taxes imposed during the Ottoman Empire were not based on income, but mainly on land and the products derived from it.5 While the ashar tax (tributum mukasem) was a tax in kind levied on the product produced, the tributum muvazzaf, levied in return for the use of the land, and the jizya (tributum capitis), levied on the assets of non-Muslims in return for non-military service and the provision of their security by the state, were fixed taxes.6 Taxation on business incomes, and more precisely on the income of merchants, tradesmen and farmers – based on estimations – began with the Tahrir-i Umumi Regulation in 1860.7 In the Ottoman Empire, large companies were owned by foreigners who were granted significant tax exemptions due to capitulations.8 It was only in 1914 that a comprehensive taxation system encompassing foreign-owned business incomes could be realized with the dividend tax, introduced by the Dividend Tax Regulation announced in 1907.9 Both the dividend tax and the earnings tax, which was introduced in 1926 – after the establishment of the Turkish Republic on 29 October 1923 – and replaced the dividend tax, covered the income of legal enterprises (partnerships and companies) as well as natural persons.10 Therefore, a single system was adopted. While the

This is contrary to the principle of ability to pay stated in Article 73, para.1 of the Turkish Constitution (TC, Law No. 2709, dated 18.10.1982, OG of 09.11.1982, No.17863 (rep.)), and limits the right to property in violation of the principle of proportionality (Article 13 of the TC). See Başaran Yavaşlar, supra 3, p.74. 5 Abdullah Mutlu, Tanzimattan Günümüze Türkiye’de Vergileme Zihniyetinin Gelişimi, Maliye Bakanlığı Strateji Geliştirme Başkanlığı, 2009, p.56. 6 Mutlu, supra 5, p.47. 7 Mert Cemal Aygin, Osmanlı Devleti’nde Kazancın Vergilendirilmesi Teşebbüsleri (1907–1914), 2019, pp.23, 33, accessed 29 March 2023 at http://​nek​.istanbul​.edu​.tr:​4444/​ekos/​TEZ/​ET000497​.pdf. 8 In order to prevent unfair competition and tax loss for domestic enterprises due to this situation, there were multiple attempts to levy a Patent Tax (inspired by the French Patent Tax) on the income of foreign merchants and tradesmen, beginning on 23 June 1879, but this could not be implemented due to the objections of foreign states. See Aygin, supra 7, pp.19, 41–2; Şevket Pamuk, Osmanlı Ekonomisinde Bağımlılık ve Büyüme 1820–1913, İş Bankası Publishing House, 2018, pp.65, 208. 9 This Regulation is an amended version of the Dividend Tax Regulation that entered into force on 4 April 1907. See Aygin, supra 7, pp.55–6, 63. 10 Aygin, supra 7, p.53; Kenan Bulutoğlu, Türk Vergi Sistemi, Fakülteler Printing House, 1971, pp.25 et seq.; Mutlu, supra 5, p.78; Fritz Neumark, Türkiye’de ve Yabancı Memleketlerde Gelir Vergisi, Teori-Tarihçe-Pratik, İsmail Akgün Printing House, 1946, p.100. 4

252  Research handbook on corporate taxation dividend tax was based on presumption and the lump-sum method, the earnings tax envisaged a declaration method for most taxpayers. In terms of taxes on income, the transition from a single to dual system took place on 1 January 1950. Earnings tax was abolished and replaced with personal income tax to tax the income of natural persons via the PITL No. 5421,11 while corporate income tax was introduced to tax the earnings of corporations as specified in law by the CITL No. 5422.12 The reasons given in the justification of the law for the enactment of a CITL that covers only corporate income while the PITL exists can be summarized as the necessity for diverse taxation principles, rules and techniques to be applied simultaneously due to the different characteristics and large number of taxpayers, both natural persons and corporations.13 To this reasoning should be added the desire to modernize through harmonization with comparative law14 and the need to create a revenue source to meet the public expenditures that emerged post-World War II, even though Türkiye itself did not actually enter the war.15 The justification of the current CITL No. 5520, in force since 2006, does not explain the need for a separate CIT,16 which is probably simply that it represents a key pillar of the tax system after more than 50 years of implementation and one which provides the state with meaningful revenue. As a matter of fact, as of September 2022, the number of CIT taxpayers in Türkiye is 1,042,168.17 In 2022, the revenue obtained from CIT was 523,880,239,000 TL and its share of total tax revenues was 19.3 percent.18 Türkiye’s second CITL No. 5520 is a better systematized version of its predecessor, with rejuvenated language and more responsive to economic developments in the world. Its characteristics can be briefly listed as follows: 1. Taxpayers are only the enterprises (/corporations) listed in the CITL. Legal personality is not the determining factor for defining taxpayers. 2. The economic double taxation arising from the principle of separation (the recognition of enterprise with legal personality and their shareholders as separate legal persons with different financial powers (ability to pay)) is eliminated by partial exemption and an off-

Personal Income Tax Law No. 5421, dated 03.06.1949, OG of 09.06.1949, No.7228. Corporate Income Tax Law No. 5422, dated 03.06.1949, OG of 10.06.1949, No.7229. 13 The Justification of the Law No. 5422, Revenue Administration Presidency (Gelir İdaresi Başkanlığı (GİB)), accessed 29 March 2023 at https://​www​.gib​.gov​.tr/​fileadmin/​user​_upload/​Gerekceler/​ 5422​_sayili​_kanun​_gerekcesi​.pdf, pp.3–4. 14 The three main laws (PITL, CITL and Tax Procedure Law (TPL)) drafted at that time were influenced by German Tax Law due to Fritz Neumark, who was among the scientists who fled Nazi Germany and took refuge in Türkiye. See Fritz Neumark, Zuflucht am Bosporus, Deuthsce Gelehrte, Politiker und Künstler in der Emigration 1933–1953, Knecht, 1980. 15 Mahmut İnan, Türkiye’de Kazanç Vergisinden Gelir ve Kurumlar Vergisine Geçiş Süreci: 1946–1960 Dönemi, Maliye Dergisi, No.158 (2010), p.354. 16 The Justification of the Law No. 5520, GİB, accessed 29 March 2023 at https://​www​.gib​.gov​.tr/​ fileadmin/​user​_upload/​Gerekceler/​5520​_Sayili​_Kanun​.pdf. 17 GİB, accessed 29 March 2023 at https://​www​.gib​.gov​.tr/​sites/​default/​files/​fileadmin/​user​_upload/​ VI/​AIGMS/​2022/​TABLO​_9​.xls​.htm. Türkiye’s population is 84,680,273, see https://​data​.tuik​.gov​.tr/​ Bulten/​Index​?p​=​Dunya​-Nufus​-Gunu​-2022​-45552, accessed 17 April 2023. 18 GİB, accessed 30 March 2023 at https://​www​.gib​.gov​.tr/​sites/​default/​files/​fileadmin/​user​_upload/​ VI/​CVI/​Tablo​_78​.xls​.htm. 11 12

Corporate taxation in Turkey  253 setting system for the dividends distributed to natural person shareholders,19 and by the full exemption method20 for the share of participation obtained from the corporations in which that corporation is a shareholder. 3. Corporate income consists of income subject to PIT. 4. The corporate tax base is determined in two stages. A catalog method is adopted for deductible and non-deductible expenses, and only prior year losses are taken into account in the determination of net corporate income. 5. There is a multiple flat tax: the general tax rate is 20 percent. However, there is an increased tax rate of 25 percent for some taxpayers and a reduced tax rate of 1 percent for some incomes. 6. During the taxation period, advance tax is levied, as well as tax withholding on many payments. 7. The principle of ex officio examination applies in the taxation procedure, together with a number of duties to provide information to the tax administration in order to determine the taxable event, taxpayer and tax base. 8. There are regulations against aggressive tax planning mostly in line with the Base Erosion Profit Shifting (BEPS) actions (3, 4, 5, 8–10, 13) developed by the Organisation for Economic Co-operation and Development (OECD)/G20.21 This chapter aims to explain the structure of Turkish Corporate Income Tax in general terms.

2.

CHARACTERISTICS OF TURKISH CORPORATE INCOME TAX

2.1

Taxpayers

Taxpayers of CIT are the corporations listed in numerous clauses in the CITL. These are companies, cooperatives, public economic enterprises, economic enterprises belonging to

A partial exemption and offsetting system is accepted for the dividends distributed by the corporations to its natural person shareholders. Half of the dividend distributed to natural person shareholders after the CIT is deducted is exempt from Personal Income Tax (Article 22, para.2 of the PITL). However, withholding tax (at the rate of 10 percent) is imposed on the dividends distributed, including the exempted income (Article 94, para.1, no.6 of the PITL). Withholding tax on the exempted income is deducted from the calculated PIT, provided that if the non-exempt half of the dividend – together with other incomes or alone if there is no other income – exceeds the amount in the second income bracket of the progressive tariff of the PIT (declaration limit), the entire non-exempt half of the dividend is to declare. Withholding tax, including withholding tax on the exempt part of the dividend, is deducted from the calculated PIT. The five-digit progressive tariff of the PIT starts at 15 percent and ends at 40 percent. The rate on the second step of the tariff is 20 percent. 20 See 2.3 below. 21 Mandatory disclosure rules are not accepted in Türkiye, but there is a mutual agreement procedure (Additional Article 14 et seq. of the TPL No.213 (Vergi Usul Kanunu), dated 04.01.1961, OG of 10–12.01.1961, No.10703–5). 19

254  Research handbook on corporate taxation or affiliated with associations and foundations, and joint ventures (Article 1 of the CITL). Pursuant to Article 2 of the CITL: 1. Companies are joint stock companies, limited liability companies, limited partnership companies with capital divided into shares, and funds subject to the regulation and supervision of the Capital Market Board (e.g. mutual funds, asset finance funds, pension investment funds, venture capital investment funds, and real estate investment funds).22 While companies have legal personality, mutual funds do not (Article 52, para.1, Article 58, para.1, and Article 61/B, para.2 of the CML23). Foreign institutions and funds with similar characteristics are also recognized as companies. 2. Cooperatives are partnerships with variable shareholders and variable capital established by natural and legal persons with legal personality for the purpose of providing and protecting the specific economic interests of their members, and in particular the needs of their profession or livelihood, through mutual assistance, solidarity and suretyship with their labor and monetary contributions (Article 1 of the Cooperative Law). Foreign cooperatives of this nature are also included in this category. 3. Public economic enterprises are commercial, industrial and agricultural enterprises which are owned or affiliated to the state, special provincial administrations, municipalities, other public administrations and organizations, and whose activities are continuous, and which are not in the form of a company or cooperative. Belonging refers to capital and being affiliated refers to administrative affiliation. The purpose of regulating them as taxpayers is to ensure equality of competition with private sector enterprises. Economic enterprises belonging to or affiliated with foreign states, foreign public administrations and organizations are also considered as public economic enterprises. 4. Economic enterprises belonging to associations or foundations are commercial, industrial and agricultural enterprises and similar foreign enterprises that are owned or affiliated to an association or foundation and whose activities are continuous and which are not companies or cooperatives. Under Turkish law, the association or foundation itself is not a taxpayer. 5. Joint ventures are the partnerships established by other corporate income taxpayers among themselves or with partnerships or natural persons in order to jointly undertake the joint performance of a specific task and to share the profits. Since these are ordinary partnerships, they do not have legal personality. The concept of corporation is not defined in the CITL, but it is stated that not aiming at profit, not having a legal personality, not having independent accounting, not having a permanent establishment (PE) or capital allocated to it, and its activities being among the duties assigned by law do not affect the CIT liability of economic enterprises belonging to or affiliated with economic public institutions, associations or foundations (Article 2, para.6 of the CITL). When all these are taken into consideration along with the fact that partnerships are not recog22 2021 Annual Report of the Turkish Capital Markets Board, accessed 30 March 2023 at https://​ spk​.gov​.tr/​data/​61e48​f651b41c60​d1404d687/​2021​%20Yılı​%20SPK​%20Faaliyet​%20Raporu​.pdf, pp.6, 15–17, 19, 46, 88. Article 5 of the CITL provides for an exemption for the portfolio management incomes of most of these funds. 23 Capital Market Law No. 6362 (Sermaye Piyasası Kanunu), dated 06.12.2012, OG of 30.12.2012, No.28513.

Corporate taxation in Turkey  255 nized as corporate income taxpayers despite having legal personality (as per Article 125 of the TCC24),25 it is evident that there is not a homogeneous structure for corporate income taxpayers in Türkiye. The only common element applicable to all corporate income taxpayers is that they are economic enterprises.26 Therefore, a corporation has the following minimum characteristics: it carries out an activity (1) based on labor and predominantly on capital, (2) to generate income (which may be even a receipt, but not profit!), and it does so (3) independently, (4) continuously and (5) within an organization. For corporations other than joint ventures, the timeframe for becoming a taxpayer is based on opening a PE, that is, when commercial or industrial activities are started in a fixed place, or when a business is registered in the trade registry, even if a PE is not opened. In these cases, the TPL recognizes ‘commencement of business’ (Article 154) and imposes tax obligations (Article 153). The fact that the joint stock company is accepted as a pre-company until the registration with the trade registry in Article 335 of the TCC supports the possibility of being a CIT taxpayer before the acquisition of legal personality. Since the CIT liability of the joint venture is a choice, CIT liability starts with the registration as taxpayer made upon its application (Article 2, para.7 of the CITL). CIT liability ends in the case of permanent cessation of the business,27 when the liability must be canceled (Article 160, para.1 of the TPL). If the taxpayer does not cancel his/her tax liability despite closing the business, the tax administration performs ex officio cancellation (Article 160, para.2, c.1 of the TPL). As long as the commercial company in such a situation is not liquidated and its legal entity is not terminated, some obligations such as insurance continue, but tax law obligations do not.28 In the event that the company whose taxpayer registration is deleted subsequently enters the liquidation process, the taxpayer registration is re-registered as of the liquidation date.29 The liquidated enterprise retains its legal personality limited to this purpose until liquidation is complete (Article 269, Article 533, para.2 of the TCC), and its tax liability continues until all tax-related transactions are finished (Article 162, para.1 of the TPL, Article 17 of the CITL). At the end of the liquidation process, the trade name of the company is deleted from the trade registry (Article 302 and Article 545 of the TCC). In parallel with the PIT, two different forms of tax liability are recognized in the CIT: limited tax liability and unlimited tax liability. In line with comparative law, taxpayers with unlimited liability (TPUL) are subject to CIT on all income generated globally, while taxpayers with limited liability (TPLL) are subject to CIT only on their income generated in Türkiye.30 TPUL

Turkish Commercial Code No. 6102 (Türk Ticaret Kanunu), dated 13.01.2011, OG of 14.02.2011, No.27846. 25 Shareholders of partnerships are secondarily liable for the debts and commitments of the partnership with all their assets (Article 236, para.1 and Article 237, para.1 TCC). 26 Funda Başaran Yavaşlar, National Report of Türkiye, in: Corporate Income Tax Subjects, Ed. Daniel Gutmann, IBFD, 2015, p.517. 27 Article 161, para.1 of the TPL: ‘The complete cessation and termination of the transactions that require to be subject to tax refers to cessation of business.’ 28 Maliye Bakanlığı GİB, Internal Circular on Implementation serial number 2009/3, dated 17.04.2009, accessed 30 March 2023 at https://​kms​.kaysis​.gov​.tr/​(X(1​)S(upw2nsv​2cvz2ux4tg​t5st2mp))/​ Home/​Goster/​68687​?AspxAut​oDetectCoo​kieSupport​=​1. 29 Maliye Bakanlığı GİB, supra 28. 30 See 2.4 below regarding the realization of taxable events by taxpayers with limited liability. 24

256  Research handbook on corporate taxation are corporations whose legal headquarters or business center is situated in Türkiye (Article 3, para.1 of the CITL). While the legal headquarters is the location indicated in the presidential decree, bylaw or statute of the corporation, the business center is the site of management and administrative business processes (Article 3, para.5 and para.6 of the CITL).31 Article 4 of the CITL regulates the corporations exempted from CIT in 17 subparagraphs. In particular, public economic enterprises that provide semi-public goods and virtuous goods are exempt from CIT. However, a 10 percent withholding tax exists for dividends distributed to CIT-exempt institutions (Article 15, para.2 of the CITL). 2.2

Concept of Income

The income of corporations subject to CIT ‘consists of the income categories subject to income tax’ (Article 1, para.2 of the CITL) which are as follows (Article 2 of the PITL): business income, agricultural income, self-employment income, wages, income from movable capital, income from immovable capital, and other income and profits (value increase gains and incidental income). This enumeration is restrictive and each income category is defined in the PITL (Article 37 et seq.). Given that the enterprise carries out the activity independently, corporate income taxpayers cannot earn a wage (clearly stated in Article 3, para.3 of the CITL regarding TPLL). By linking the concept of corporate income to the seven income categories in the PITL, the Turkish CITL excludes taxpayer incomes not subsumed by one of these income elements. Indeed, the TCC does not accept the ultra vires principle, a business enterprise may engage in any activity that is not prohibited. Thus, all of an enterprise’s transactions and acts are accepted as business activities (Article 3 of the TCC) and all of its income, regardless of the source, constitutes business income in terms of the TCC. However, the concept of business income in the TCC is not the same as the concept of corporate income in the CITL, such as default interest received by the corporation from its shareholders due to unjust enrichment which does not fall within any of the income elements in the PITL.32 The CITL (Article 6, para.3) stipulates that the capital contributed by shareholders to prevent the bankruptcy of a struggling joint stock company is not included in the corporate income. As for the incomes exempted, as of 24 October 2022 the CITL includes 20 exemptions which are quite comprehensive, ranging from developing industrial property to supporting education, incentives to register assets abroad or in Türkiye, and strengthening corporations’ financial structures. Among these exemptions, which must be regulated by law (Article 10, para.1, Article 73, para.1 and para.3 of the TC33), there is also the exemption for participation incomes to prevent economic double taxation (Article 5, para.1, no.a and no.b of the CITL). In other words, regardless of the rate and duration of the participation, the participation income derived by a corporation (with full or limited liability) from the corporation in which

See and compare e.g. Cihat Öner, Dar Mükellefiyette Ticari Kazancın Türkiye’de Elde Edilmiş Sayılmadığı Haller Üzerine, AÜHFD 63/2 (2014), p.377. 32 Funda Başaran Yavaşlar, Anonim Şirketlerde Kâr Payı Dağıtımı Sınırlaması/Yasağı ve Buna Uyulmamasının Vergi Hukuku Bakımından Sonuçları, VSD, No.380 (2020), pp.16–17. 33 Article 73, para.4 of the TCC allows the President of the Republic to make changes to the provisions on exemptions (regarding taxpayers or tax objects), deductions and rates of taxes within the upper and lower limits specified by law. 31

Corporate taxation in Turkey  257 it is a shareholder is fully exempt from CIT if the shareholder is a TPUL in Türkiye. On the other hand, if the shareholder has limited liability in Türkiye (/foreign subsidiary) and its legal structure is in the form of a joint stock company or a limited liability company, the participation income derived from the foreign subsidiary will be outside the scope of the CIT if the following conditions are met: (1) the TPUL should own at least 10 percent of the paid-in capital of the foreign subsidiary, (2) the TPUL should hold the participation share for at least one year without interruption, (3) the participation income should bear a burden of tax similar to PIT or CIT at a rate of at least 15 percent in accordance with the tax law of the country in which the subsidiary operates, and (4) the participation income should be transferred to Türkiye by the date when the annual CIT return is due.34 The full exemption of the corporate income generated by a corporation through its permanent establishments or representatives is subject to the conditions that it bears a burden of tax similar to PIT or CIT at a rate of at least 15 percent in accordance with the tax regulations of the country where it is generated, and that it is transferred to Türkiye until the required submission date for the annual CIT return for the accounting period in which it is generated (Article 5, para.1, no.g of the CITL). The fact that an income is exempted from the tax does not mean that no tax is withheld from it. This is because withholding tax has been stipulated on some of the exempted incomes (e.g. incomes derived from industrial property rights (Article 5/B, para.5 of the CITL)). 2.3

Taxable Event

A taxable CIT event is ‘earning income’ by the corporate income taxpayer (Article 3 and Article 6 of the CITL). CIT is a periodic tax and covers all income generation by the corporation within an accounting period (Article 16, para.1, Article 25, para.1 of the CITL). The normal accounting period is a calendar year (Article 174, para.2 of the TPL). The accrual principle applies in determining the time of income generation (Article 6, para.2 of the CITL). The Council of State describes the accrual as: the realization of the transaction and event that makes the income and expense legally claimable, together with the finalization and personalization of the nature and amount of the income and expense. Finalization in terms of its nature and amount refers to the entitlement to the amount determined by mutual agreement that through fully fulfilling the obligations in the existing commercial relationship between the parties has emerged, and the finalization of this amount by becoming certain. The determination of the identity of the creditor and debtor of the receivable and debt, the creditor and debtor refers to the personalization, and the debt or receivable reaching the stage where it can be requested by the addressee refers to the legal requestability of the debt or receivable.35

34 If the participation income, which is exempt from CIT due to the fulfillment of these conditions, is distributed by a TPUL to a TPLL (limited liability company or joint stock company), 7.5 percent withholding tax will be applied (Article 30, para.4 of the CITL). On the other hand, dividends distributed by a TPUL to a TPLL (even if it is exempt from CIT) are subject to withholding tax at the rate of 15 percent (Article 30, para.3 of the CITL). If a TPLL – which submits a tax return or a special declaration – wishes to transfer the profit earned in Türkiye to its head office, 15 percent withholding tax will be imposed on the amount transferred to the head office from the amount remaining after deducting the calculated CIT from the corporate income before deductions and exemptions (Article 30, para.6 of the CITL). 35 Decision of the Council of State Unification Board of Jurisprudence (DİBKK), dated 22.12.2004, E.2004/1, K.2004/1, OG of 19.04.2005, No. 25791.

258  Research handbook on corporate taxation Therefore, the fact that income has been received or not received, and that expenses have been paid or not paid has no effect on the accrual. Instead, the main quality of the accrual is that payment (income or expense) is ‘legally claimable’. If the time of payment is due, then the receivable and the debt will have accrued as soon as they are due and claimable.36 Since only TPLL income earned in Türkiye is subject to CIT, the realization of the taxable event (income earning) in Türkiye is significant. This is determined for each income category as follows (Article 3, para.2, para.4 of the CITL and Article 7 of the PITL with the reference herein): 1. For business income: the foreign corporation must have a PE or representative in Türkiye and the business income must be derived from business carried out at this establishment or through these representatives.37 2. For agricultural income: the agricultural enterprise must be located in Türkiye and the agricultural activity must be carried out in Türkiye.38 3. For self-employment income: the self-employment activity must be carried out in Türkiye or assessed in Türkiye. 4. For income from real estate (/rental income from the lease of immovable, rights and movable property in Türkiye): immovable and movable property must be located in Türkiye and these goods and rights must be utilized or assessed in Türkiye. 5. For income from movable capital: the movable capital must be invested in Türkiye. 6. For other incomes: the activity or transactions giving rise to the income should be performed in Türkiye or must be assessed in Türkiye. ‘Assessment in Türkiye’ means that the payment is made in Türkiye or, if the payment is made in another country, there is a transaction (entry or exit) in the account (in Türkiye) of the payer or the receiver, or the payment was set aside from the profits of the payer (Article 7, para.2 of the PITL). 2.4

Tax Base (/Taxable Income)

The Turkish Constitution (Article 73, para.1) stipulates the principle of ability to pay for all taxes. Therefore, the tax base must be determined in accordance with actual ability to pay (/ actual income). The CITL follows a two-stage method for the determination of the tax base (Article 6–Article 13 of the CITL in conjunction with Article 37–Article 41 of the PITL). In the first stage, the net income is determined, while in the second, the tax base is obtained by making special deductions permitted by law from the net income.

Decision of the Unification Board of the Council of State, supra 35. If a TPLL, which has a permanent establishment or representative in Türkiye, only and directly exports the goods purchased in Türkiye, the income arising from this export is excluded from the CIT (Article 3, para.3, no.a of the CITL). If the buyer or seller or both are in Türkiye or the sales contract is concluded in Türkiye, CITL accepts that the income is derived in Türkiye. 38 Herewith the aim is to tax the income derived from the shares of the taxpayer with limited liability who is a partner of an agricultural enterprise. See https://​www​.gib​.gov​.tr/​fileadmin/​user​_upload/​ Gerekceler/​5520​_Sayili​_Kanun​.pdf, accessed 30 March 2023, p.5. 36 37

Corporate taxation in Turkey  259 2.4.1 First stage – determination of net income In Turkish Tax Law, there is no obligation to determine net corporate income based on business income under commercial law. However, since Article 37 et seq. of the PITL (to which Article 6, para.1 of the CITL refers) regulates the determination of net income based on the method of determining business income by a taxpayer, in practice, most taxpayers determine their net income by making the changes required by tax regulations on the commercial balance sheet. Balance sheet and valuation scales are regulated both in the TCC and in the TPL.39 Taxpayers, who must determine their corporate income on a balance sheet basis (Article 177, para.1 of TPL), are obliged to ascertain their net business income by making an equity comparison (Article 38, para.1 of PITL). Pursuant to Article 192 of the TPL, equity is the difference between the total assets and liabilities on the balance sheet. The enterprise’s equity at the beginning of the accounting period is compared with its equity at the end of the accounting period, and the values withdrawn from the enterprise during this time period and the expenses that cannot be deducted in the calculation of the tax base are added to the difference (Article 8–Article 11 of the CITL and Article 40–Article 41 of the PITL). Any value added to the enterprise by the owner(s) during the period and tax-exempt incomes are then detracted from this difference (Article 38, para.1 and para.2 and Article 41 of the PITL, Article 11 of the CITL). Thus, a transition from a commercial balance sheet to a tax balance sheet occurs.40 CIT taxpayers who are allowed to ascertain their net income according to the business account method and therefore should keep only a business account book without preparing any financial statements (Article 176 and Article 178 of the TPL)41 shall deduct their expenses from the gross income obtained in an accounting period (Article 39, para.1 of the PITL42). The positive difference is business income. If the enterprise is engaged in the purchase and sale of commodities, the value of the commodities at the end of the accounting period is added to the income, and the value of the commodities at the beginning of the accounting period is added to the expenses (Article 39, para.2 of the PITL). The above explanations regarding income that cannot be deducted from the tax base (in accordance with the CITL) and income that is not subject to CIT (e.g. tax-exempt income) also apply here. The legislator has chosen to determine the deductible expenses from gross income through the enumeration method, and only the expenses listed in Article 8 of the CITL and Article 40 of the PITL with reference to Article 6, para.1 of the CITL can be taken into consideration. Introducing a regulation stipulating that all income-related expenses within the same period be The TCC (Article 69) stipulates that year-end financial statements shall be prepared in accordance with Turkish Accounting Standards (TAS), which are in line with International Accounting Standards. In addition, for large and medium-sized enterprises that are subject to independent audit and do not apply TAS, the Financial Reporting Standard is in force to be applied as of 1 January 2018. The TPL (Article 175, para.1) regulates the preparation of accounting and financial statements in accordance with the Uniform Chart of Accounts. See Özlem Nilüfer Karataş Araci and İsmail Bekçi, MSUGT, TMS/ TFRS ve BOBİ FRS Açısından Kavramsal Çerçeve ve Finansal Tabloların Sunuluşu Standartlarının Değerlendirilmesi, Muhasebe ve Vergi Uygulamaları Dergisi, 12/3 (2019), p. 857. 40 The main differences between these two balance sheets lie in the concept of income, provisions, accruals, amortization and valuation scales. 41 These are the traders who are not covered by Article 177 of the TPL and who are permitted by the Ministry of Finance to keep their books on a business account basis. They keep only business account books and do not prepare any financial statements. 42 Pursuant to Article 39, para.1 of the PITL, ‘Gross income represents the income earned and the receivables accrued; expenses represent the amounts paid and the amounts owed.’ 39

260  Research handbook on corporate taxation deducted from the gross income would have been more closely in line with the Constitution. However, this shows that the ‘causality principle’ is accepted in terms of deductible expenses and thus the principle of ability to pay is taken into consideration to a great extent, since Article 40 of the PITL allows the deduction of ‘general expenses incurred for the generation and maintenance of business income’ as well as of expenses ‘related to the business’, ‘related to the enterprise’ or ‘related to the economic assets of the enterprise’ and ‘depreciation’. Similarly, Article 8 of the CITL permits the deduction of ‘establishment and organization expenses’, ‘expenses incurred for general assembly meetings’, ‘merger, acquisition, division, dissolution and liquidation expenses’, ‘dividend of the limited partner in limited partnership companies with capital divided into shares’ and ‘securities issuance expenses’ among other deductible expenses. Unfortunately, controversial situations remain, such as whether the cost of stolen goods can be written off as expenses.43 The numerus clausus principle is valid not only for deductible expenses but also for their non-deductible counterparts (Article 41 of the PITL and Article 11 of the CITL). Non-deductible expenses include, inter alia,44 for example, interest on equity, amounts exceeding the arm’s length price in transactions between related persons, interest on disguised capital, reserve funds, expenses and depreciation of vehicles unrelated to the enterprise’s main activity, and amounts exceeding the deductible interest limitation regarding foreign resources surpassing equity. Except for financial expenses relating to the acquisition of subsidiary shares (including those incurred after the transfer, Law No. 7440 dated 12 March 2023), it is forbidden to deduct the expenses related to the exempted incomes from non-exempt corporate income (Article 5, para.3 of the CITL). Therefore, any expenses incurred in order to obtain income exempt from CIT can only be deducted in the determination of that income. From the amount determined as explained above, the losses (if any) included in the tax files for the previous years (not exceeding a five-year period) will be decreased (Article 9, para.1, no.a of the CITL). Losses arising from foreign operations may also be diminished (Article 9, para.1, no.b of the CITL). In cases of acquisition or complete spin-off, it is also permitted to deduct losses that do not exceed the amount of equity of the acquired corporates as of the date of acquisition, along with any losses that do not exceed the total equity of the spin-off corporates as a result of the complete spin-off process providing that these are proportionate to the acquired asset (Article 9, para.1, no.a of the CITL). On the other hand, losses incurred during the earning of CIT-exempt income cannot be deducted from non-exempt corporate income

While the tax administration refuses to deduct the cost expenses of stolen goods, there are judicial decisions and doctrinal opinions arguing in both directions. See e.g. for the pro position Recep Güneş, Leyla Ateş and Hakan Erkuş, Ticari Kazancın Tespitinde Hırsızlık ve Dolandırıcılıktan Doğan Kazançların Gider Yazılması, Muhasebe ve Denetime Bakış, Ocak, 2008, p.1, and contra Mehmet Maç, Vergisel Açıdan Çalınan veya Kaybolan Mallar, VDD, S.223 (2022), p.72. 44 These are also non-deductible expenses: fines and tax penalties based on the priority given to the legal interest protected by criminal law; indemnities arising from the crimes of partners/managers/ employees; indemnities paid for material and non-pecuniary damage arising from acts committed through the press or radio and television broadcasts; advertisement and advertising expenses related to alcohol and tobacco products; expenses for advertisements paid to those who are banned from advertising based on the Law No. 5651; money withdrawn from the enterprise or other values received in kind by the partners, spouses and children of partnerships and sole proprietorships; salaries, wages, bonuses, commissions and compensations paid to them. 43

Corporate taxation in Turkey  261 (Article 5, para.3 of the CITL). Under the Turkish CIT system, only forward loss carrying is possible. Unless otherwise stipulated by law, the rules applicable to TPULs shall apply to the determination of the net income of TPLLs obtained through PE or representatives (Article 22, para.1 of the CITL).45 2.4.2 Second stage – arriving at the tax base from the net profit Special expenses that are of public benefit can be deducted even though they are not related to the business activity and income. These expenses are listed in numerous clauses within Article 10 of the CITL, and mainly include expenses such as donations, aids, sponsorship, wages paid to handicapped people employed, as well as construction of facilities in the fields of education, culture, arts, science, health, nature or social solidarity. In addition, some incentive expenses are also included in this list.46 2.5

Tax Rate and Tax Liability

The flat tax is accepted in the CITL, and there is a multiple tax rate system. Namely: 1. The general CIT rate is 20 percent (Article 32, para.1, s.1 of the CITL).47 However, due to an increasing need for state revenue, this rate has been raised to 23 percent for 2022 incomes (temporary Article 13, s.1 of the CITL); 2. The CIT rate is 25 percent for the incomes of banks, financial leasing companies, factoring companies, financing companies, savings financing companies, electronic payment and money institutions, authorized foreign exchange institutions, asset management companies, capital market institutions, insurance and reinsurance companies and pension companies – starting from the corporate incomes of the year 2022 (Article 32, para.1, s.2 and temporary Article 13, s.3 of the CITL);48 3. There is a 1 percent reduced tax rate for the export incomes of exporting enterprises and incomes derived from the production activities of enterprises holding industrial registry certificates (Article 32, para.7 and para.8 of the CITL);49 45 However, TPLL are not permitted to deduct the following expenses (Article 22, para.3 of the CITL): (1) interest, commissions and similar payments made to the headquarters or branches outside Türkiye for purchases and sales realized for the TPLL, (2) shares allocated according to the distribution keys to be determined in accordance with the arm’s length principle and which are related to the acquisition and maintenance of the institution’s income in Türkiye, and (3) shares allocated for participation in the general administrative expenses or losses of the headquarters or branches outside Türkiye, except for the travel expenses of authorized persons sent from foreign countries for the audit of the enterprise in Türkiye. 46 These are the following: (1) part of the venture capital fund, which does not exceed 10 percent of the declared income; (2) a certain amount (defined by law) of the cash capital added or increased in newly established companies or companies that boost their cash capital; (3) 50 percent of the income of enterprises that provide services to non-residents in Türkiye in certain fields – services that are provided in Türkiye and exclusively benefited from abroad. Regarding the cash capital deduction, see also Provisional Article 15, para.13 of the CITL. 47 Pre-2006, under the old CITL, this rate was 40 percent. 48 Article 25 and Article 26 of the Law No. 7394, dated 08.04.2022, OG of 15.04.2022, No.31810. 49 It is possible to benefit from this deduction after the other deductions in Article 32 of the CITL are applied (Article 32, para.9 of the CITL).

262  Research handbook on corporate taxation 4. A 2 percent reduced tax rate is imposed on the income of corporations (with the exception of banks, financial leasing companies, factoring companies, financing companies, payment and electronic money institutions, authorized foreign exchange institutions, asset management companies, capital market institutions, insurance and reinsurance companies and pension companies) whose shares (min. 20 percent) are offered to the public for the first time to be traded on the Borsa Istanbul Equity Market, for five accounting periods starting from the accounting period in which the public offering took place (Article 32, para.6 of the CITL); 5. Reduced tax rates for incomes deriving from investments are subject to an investment incentive certificate lasting from the accounting period in which the investment started partial or full operation until the investment contribution amount is reached (Article 32/A, para.1 and para.2 of the CITL). It is possible for a taxpayer to benefit from more than one reduced tax rate opportunity at the same time (Article 32/A of the CITL).50 Lately, a one-time additional CIT was accepted to address the revenue needs arising after the earthquakes in Türkiye in February 2023 (Art. 10 of the Law No. 7440 dated 12 March 2023). Accordingly, for the year 2022, a 10 percent CIT will be imposed on some deductions and exemptions excluded from CIT, without being associated with the period income, and a 5 percent CIT will be imposed on the income subject to subsidiary income exemption as per 5/1-a of the CITL and on the subsidiary income obtained abroad which is subject to tax at the rate of 15 percent at least. From a theoretical point of view, differentiating between taxpayers in terms of the rate to be applied is contrary to the principle of substantive equality (/the principle of ability to pay). The flat tax already ensures that those who earn more pay more tax. Applying a higher rate of CIT to corporations earning above the ordinary profit margin in the market or, on the contrary, a lower rate of CIT to corporations engaging in certain behaviors specified in law is then only compatible with the Constitution if there is a proportionate relationship between this purpose and the public interest.51 The CIT liability (tax assessment) is calculated by imposing the CIT rate on the tax base. However, the tax liability does not represent the tax owed by the taxpayer since the latter has already paid advance CITs and withholding tax,52, 53 during the tax period. After reducing the taxpayer’s tax liability in order to prevent double taxation in a legal sense, the amount of the CIT due can be ascertained (Article 32, para.2 and Article 34, para.1 and para.2 of the CITL). In addition, foreign tax credit (if applicable) can be also considered at this stage (Article 33, para.1 of the CITL).

50 GİB, CITL, General Communiqué serial no.1, 32.1.2, accessed at https://​www​.gib​.gov​.tr/​ fileadmin/​user​_upload/​Tebligler/​5520/​32​.html. 51 Ömer Faruk Bayrakçi, Ölçülülük İlkesi Işığında İktisadi Amaçlı Vergi Teşviklerinin Meşruluğu, Institute for Social Sciences of Marmara University, Yetkin Publishing House, 2022, p.52. 52 In the cases specified in Article 15 and Article 30 of the CITL, those who make payments to the corporate income taxpayer are required to make withholding tax on this payment at rates ranging from 1 percent to 30 percent. Withholding tax is applied on gross income (Article 30, para.11, s.1 of the CITL). 53 While the TPULs have the possibility to deduct the tax paid through withholding tax (except for dividends distributed to tax-exempt corporations under Article 75, para.2, b. 1–3 of the PITL), the TPLLs have the possibility to deduct only some withholding tax (Article 34 of the CITL). See below 4.2.5.

Corporate taxation in Turkey  263

3.

TAXATION PROCEDURE AND PAYMENT OF TAX

The ex officio principle is valid in tax procedure law in Türkiye, by which the tax administration is responsible for determining the taxable event, taxpayer, tax base and tax liability as well as for tax collection (Article 3, para.3/B, Article 4 and Articles 20–21, 127, 134 of the TPL, Article 16, para.3 and Article 28, para.2 of the CITL).54 The heavy burden this places on the tax administration is balanced by the large number of tasks imposed on taxpayers and third persons. Taxpayers – and third persons as specified by the law – are obliged to submit significant amounts of information and documentation, either on their own (as required by law) or at the administration’s request.55 Indeed, taxpayers are under the obligation to declare the commencement of their business/work,56 to keep books or ledgers, to prepare financial statements, to use specific documents (prepared by themselves or obtained from the transaction counterparty), to record their incomes and expenses, to declare their tax base, to provide any information requested by the tax administration, and to fulfill any documentation and notification responsibilities, the latter which undergo a sizeable increase in the case of cross-border transactions. CIT is a periodic tax; the taxation period is the accounting period, which, as a rule, corresponds to a calendar year. Taxpayers submit their tax file to the authorized tax office in April of the year following the taxation year (Article 14, para.3, Article 16, para.1 and Article 25, para.1 of the CITL). In addition, taxpayers are required to declare their quarterly tax base via an advance tax declaration submitted every three months and to pay an advance CIT (Article 32, para.2 of the CITL). Each taxpayer submits a single tax file even if they have branches, agencies, trading offices and stores, manufacturing plants or other affiliated businesses with independent accounting processes and capital (Article 14, para.4 and Article 24, para.2 and para.3 of the CITL). The taxpayer is notified by the tax administration regarding the amount of CIT liability (Article 21, Article 25, Article 28 and Article 34 of the TPL), which must be transferred by the end of the month in which the tax file is submitted (Article 21, para.1 and Article 29, para.1, no.a of the CITL). If the CIT paid by the taxpayer during the taxation period is higher than his/ her CIT liability at the end of this period, the difference is refunded to the taxpayer (Article 112, para.4 of the TPL). Taxpayers who comply with tax laws are granted a 5 percent tax deduction (Article 121 of the PITL).

Tuğçe Karaçoban Güneş, Vergi Usul Hukukunda Re’sen Araştırma İlkesi, Seçkin Publishing House, 2017, p.79; Turgut Candan and Tuğçe Karaçoban Güneş, National Report of Türkiye, in: Tax Procedures, Ed. Pasquale Pistone, IBFD, 2020, p.1018. 55 Failure of the taxpayer to fulfill his/her tasks does not eliminate the duty and burden of proof of the tax administration, but it reduces its measure of proof, see Karaçoban Güneş, supra 54, p.154. 56 This notification is automatically executed through the trade registry offices (Article 153, para.2 of the TPL). 54

264  Research handbook on corporate taxation

4.

MEASURES AGAINST AGGRESSIVE TAX PLANNING IN THE CITL

4.1

General Anti-Avoidance Rule

The so-called principle of economic approach is regulated in the TPL (Article 3, para. B/1), which contains general rules applicable to all tax types: ‘In taxation, the real nature of the taxable event and the transactions related to this event are substantial.’ This principle, which should be taken into account both in the interpretation of legal regulations (/teleological interpretation) and in the characterization of taxable events,57 has the function of a general preventive rule against circumvention of the law in the case of both domestic and cross-border taxable events. It is more commonly understood and applied in doctrine and by the judiciary as substance over rule.58 4.2

Special Anti-Avoidance Rules

4.2.1 Disguised profit distribution by transfer pricing Disguised profit distribution is reregulated in the CITL No. 5520 (Article 13) in line with OECD standards.59 The central principle implemented in relation to transfer pricing is the arm’s length principle which states that the price applied in the purchase or sale of goods or services with related persons60 should be in accordance with the price that would have occurred in the absence of such a relationship (so-called arm’s length price (ALP)). If this is violated, the amount exceeding the arm’s length price is classed as disguised distributed income and its deduction from the tax base is prohibited (Article 11, para.1, no.c of the CITL). The ALP requires an internal or external comparable transaction which is sometimes not easy to obtain, particularly when it concerns unique intangibles. To determine the ALP, one of the following methods is applicable according to the Turkish CITL: the comparable price method, cost plus method, resale price method or the transactional profit methods (transaction-based net profit margin method and profit split method). If the ALP is unavailable,

57 Mualla Öncel, Ahmet Kumrulu, Nami Çağan, and Cenker Göker, Vergi Hukuku, Turhan Publishing House, 2022, p.29. 58 Funda Başaran Yavaşlar, Mustafa Sevgin and Namık Kemal Uyanik, National Report of Türkiye, in: Tax Avoidance Revisited in the EU BEPS Context, Ed. Ana Paulo Dourado, IBFD, 2017, p.718. 59 In CITL No. 5422 from 1949 (Article 17) this issue was also regulated under the subheading of ‘disguised profit’ and by taking into account the ‘arm’s length price’. However, the method to be applied in determining the arm’s length price was not regulated, and there was no criterion for determining the natural or legal person to whom the taxpayer company was directly or indirectly related or whose influence it was under in terms of management, supervision or capital. 60 A related person is defined as (1) shareholders of the corporation, the natural person or enterprise to which the corporation or its shareholders are related, and the natural person or enterprise to which the corporation or its shareholders are directly or indirectly related in terms of management, supervision or capital, or which is under the influence of the natural person or enterprise (at least 10 percent shareholding or voting or dividend rights are required), (2) spouses of the shareholders, their or their spouse’s, (3) persons residing in countries or regions in a list declared by the President of the Republic (the countries to be included in this list are determined by taking into account whether they provide for taxation at the same level as the taxation in the Turkish tax system and the exchange of information) (Article 13, para.2 of the CITL).

Corporate taxation in Turkey  265 one of these methods (that most appropriate to the nature of the transaction) is applied; if none of them is appropriate, the taxpayer may use a method of its own choosing in accordance with the nature of the transaction. Taxpayers have an increased duty of documentation and Country by Country Reporting (CbCR) in this context. Advance pricing agreements are possible. As of the last day of the accounting period in which the conditions in Article 13 of the CITL are met, disguised income distributed, in whole or in part, through transfer pricing is considered either as dividends distributed or for TPLL as the amount transferred to the headquarters for limited taxpayers (Article 13, para.6, c.1 of the CITL). CITL rules regarding disguised profit transfer through transfer pricing also apply to transactions between related persons in Türkiye. 4.2.2

Thin capitalization rules

4.2.2.1 Disguised capital Disguised capital is considered as the part of the loans obtained directly or indirectly from the shareholders or related persons to shareholders61 and used in the enterprise, which exceeds three times the equity of the corporation at any time during the accounting period (Article 12, para.1 of the CITL (conclusive presumption)).62 It is forbidden to deduct the interest paid or calculated on the disguised capital from the CIT base (Article 11, para.1, no.1 of the CITL). For the purposes of Income and Corporate Tax Laws, interest and similar payments, excluding exchange rate differences, shall be deemed to be dividends distributed for both the borrower and the lender, or – for the TPLL – an amount transferred to the headquarters as of the last day of the accounting period in which the conditions for thin capitalization are met (Article 12, para.7, s.1). Article 12 of the CITL is valid also for thin capitalization between related persons who are both TPUL in Türkiye. 4.2.2.2 Limitation on the deduction of interest As of the beginning of 2021, a limitation on the deduction for interest expenses has been applied in Türkiye.63 If foreign resources used by the enterprise (excluding credit institutions, financial institutions, financial leasing, factoring and financing companies) exceed its equity,64 10 percent of the total amount of expenses and costs (such as interest, commission, dividend, 61 A person related to a shareholder is (1) an enterprise in which the shareholder directly or indirectly holds at least 10 percent of the shareholding, voting or dividend rights, or (2) a natural person or enterprise that directly or indirectly holds at least 10 percent of the capital, voting or dividend shares of the shareholder or the enterprise related to the shareholder (Article 12, para.3, no.a of the CITL). In determining whether the debt used by a limited taxpayer corporation in the enterprise is obtained from a person related to the partner, the capital or voting right requirement is not required (Article 22, para.4 of the CITL). 62 CITL No. 5422 from 1949 (Article 16) regulated thin capitalization; however, it required that the ratio between the corporation’s debt and its equity capital should be ‘clearly different from that of peer corporations’ and the debt should be used continuously in the enterprise. It was sufficient if the debt was obtained from a real or legal person who had a direct or indirect company relationship or a continuous and close economic relationship with the taxpayer organization. 63 Law No. 6322, dated 31.05.2012, OG of 15.06.2022, No.28324. A similar rule previously existed between 1996 and 2003. 64 When determining whether foreign resources exceed equity, the portion of foreign resources added to the investment cost is not included in the calculation.

266  Research handbook on corporate taxation exchange rate difference) is not permitted to be deducted from the total net income (Article 11, para.1, no.i of the CITL). This prohibition is valid only for the portion of foreign resources exceeding the equity. The President has the authority to change the limit of this non-deductible amount up to 10 percent of the total expenses and costs. Many disputes regarding this limitation are still pending before the judiciary, since the regulation of the CITL is controversial in various ways, particularly the concepts of ‘foreign resources’ and ‘expenses and costs’ and ambiguities in the calculation method. The interest limitation rule for CITL in Türkiye differs from the OECD BEPS Action 4 and EU Directive 2016/1164. This is because, on the one hand, it prohibits the deduction of interest for loans from persons who are not related to the enterprise, and therefore it does not aim to prevent the erosion of the tax base through transactions between related parties that are intended to circumvent tax law. On the other hand, it does not limit the maximum net interest deduction in an accounting period to a fixed percentage of the taxpayer’s earnings before interest, taxes, depreciation and amortization (EBITDA). 4.2.3 Controlled Foreign Company (CFC) rules Pursuant to Article 7, para.1 of the CITL, the income of foreign subsidiaries controlled directly or indirectly, separately or together, by natural persons and corporations with unlimited liability holding at least 50 percent of the capital, dividends or voting rights, whether distributed or not, are considered ‘dividends’ in Türkiye. They are subject to CIT under the following conditions: (1) 25 percent or more of the total gross income of the CFC is considered to be passive income such as interest, dividends, rents, license fees and other income other than business, agricultural or self-employment activities; (2) the CFC is subject to an effective tax (similar to income or corporate tax) burden of less than 10 percent in its country of residence; (3) the annual gross income of the CFC exceeds the equivalent of 100,000 TL. If the dividend, which is taxed in Türkiye, is subsequently distributed by the foreign corporation, the taxed portion of the dividends is deducted from this amount and the untaxed portion is subject to corporate tax (Article 7, para.5 of the CITL). In order to prevent double taxation, it is stipulated that the taxes such as PIT and CIT paid by the CFC where it has residency shall be deducted from the CIT calculated over the income of the CFC to be taxed in Türkiye (Article 33, para.2 of the CITL).65 However, this deduction cannot be more than the CIT to be paid in Türkiye for its income earned abroad; if it is more, the tax that cannot be deducted in the relevant accounting period can be deducted until the end of the third accounting period following this period (Article 33, para.4 of the CITL). The CITL also targets payments made by the Turkish enterprise to its CFC by introducing a 30 percent withholding tax, if this CFC has a residency or activity in the countries declared by the President of the Republic (Article 30, para.7 with reference to Article 34, para.3 of the CITL).66 Withholding tax is withheld on all payments made in cash or accrued on account, regardless of whether the payment is subject to tax, or whether the enterprise to which the payment is made is a taxpayer (Article 30, para.7 of the CITL). The CFC may deduct this withholding tax from its CIT bases on its tax file in Türkiye (Article 34, para.3 of the CITL). 65 This rule also applies to the CIT to be paid in Türkiye on dividends received from foreign subsidiaries in which TPUL directly or indirectly holds 25 percent of the capital or voting rights (Article 33, para.3 of the CITL). 66 Regarding this authority of the President, see supra 60.

Corporate taxation in Turkey  267 However, the withholding tax to be deducted cannot be more than the CIT of the CFC on its income subject to this withholding tax. 4.2.4 Industrial property rights Fifty percent of the income derived from inventions based on research, development, innovation and software activities carried out in Türkiye is exempt from CITL (Article 5/B,67 para.1 and para.2 of the CITL).68 The income exempted is that generated from (1) leasing, (2) transfer or sale, (3) mass production in Türkiye and marketing, and (4) the part of the income derived from the sale of the product that is used in the production of another product in Türkiye attributed to a patented or utility model certified invention or inventions of the taxpayer. In order for the exemption to apply, the following conditions must be met: (1) a patent or utility model certificate must have been obtained for the relevant invention, and (2) the persons who can benefit from the exemption must be the owner of the patent or utility model certificate or have a special monopoly license on it, provided that they are authorized to develop the patented or utility model certified invention. The CIT exemption does not prevent withholding tax on income derived from industrial property rights (Article 5/B, para.5, no.1 of the CITL). However, self-employment income and real estate capital income derived from the invention for which a patent or utility model certificate has been obtained are subject to a 10 percent – reduced – withholding tax (Article 5/B, para.5 of the CITL). If the withholding tax is the final tax, the reduced tax deduction is limited to a period of five years (Article 5/B, para.5, no.3 of the CITL). In addition to Article 5/B of the CITL, the income of corporate taxpayers operating in the technology development zone from software, design and research and development (R&D) activities within this zone is exempted from CIT until 31 December 2028 by the Technology Zones Development Law (provisional Article 2).69 Corporate taxpayers can benefit from either this exemption or the exemption in Article 5/B of the CITL (Article 5/B, para.6 of the CITL). 4.2.5 Withholding tax Withholding tax is widely used as a tool to provide quick tax revenues to the treasury, to reduce the workload of the tax administration and, in some cases, to prevent tax evasion. Its use to prevent aggressive tax planning is particularly relevant in cases where withholding tax on the gross income of TPLL is the final tax (Article 30, para.9 of the CITL). Some major situations

Article 82 of Law No. 6518, dated 06.02.2014, OG of 19.02.2014, No.28918. Law No. 5520 stipulated that taxpayers may deduct 40 percent of the amount of research and development expenditures related to new technology and information. This deduction is transferred under Law No. 5746 on Supporting Research, Development and Design Activities, dated 28.02.2002, OG of 12.03.2028, No.26814, and its scope expanded. 69 The Law No. 4691, dated 26.06.20201, OG of 06.07.2001, No.24454. 67 68

268  Research handbook on corporate taxation regarding withholding tax, where it has not been set that such a withholding tax might be deducted from the CIT assessed in Türkiye (Article 34 of the CITL),70 are above mentioned.71

5. CONCLUSION Thoughts of abolishing or radically changing the CIT are not found in doctrine, practice or policy. CIT constitutes an important tax in the Turkish tax system. Rather, efforts are mostly focused on responding to international developments in line with the OECD approach. However, this does not mean that the problems related to the existence and characteristics of the CIT have been completely resolved. Aside from issues relating to the very existence of a CIT, such as double taxation in the economic sense and whether, given its complexity and the financial and administrative burden it creates for both taxpayers and the tax administration, the CIT is a sufficiently productive tax, the main problem with the CIT arises in relation to the principle of equality, more specially the principle of tax neutrality in Türkiye. A CIT system should have legal form neutrality, funding neutrality, neutrality of income use and focus on the ability to pay of enterprises.72 However, there is inequal treatment based on differences in legal structure of enterprises, on their source of financing, on their use of income generated (retention or distribution to shareholders) and on the basis of their field of activity, which also hinders the competition neutrality of the CIT in a system based on freedoms and, in this context, a free market economy. This inequality manifests such as exemptions, low or high tax rates or in the application of withholding tax as final CIT in some situations. None of the arguments in favor of CIT have been able to provide a compact solution. Although enterprises also enjoy fundamental rights and freedoms – insofar as they are compatible with their nature73 – these inequalities find their existence in the broad discretionary power of the legislature in taxation matters – which is accepted by the judiciary – and in the fear of harming the state by reducing its revenue sources. Considering that a natural person can establish not only a solo proprietorship but also a company with high capital, determination of the corporate income taxpayer based on the size of capital and turnover may be a starting point to build a better CIT system, provided that

Except for business and agricultural incomes, submitting a tax file is optional, in accordance with Article 24 or Article 26 of the CITL for the incomes whose tax is withheld according to this article. Similarly optional is including such incomes in the tax file to be submitted for income not covered by Article 30 of the CITL (except incomes regulated in Article 75, para.2, nos.5, 7, 14 of the PITL and dividends from participation certificates of funds and shares of investment trusts) (Article 30, para.9 of the CITL). 71 E.g. Article 30, para.3, para.4, para.6 and Article 5/B, para.5 of the CITL. See supra 34 and 4.2.4. 72 ‘Leave them as you find them-rule of taxation’ of J. Stuart Mill (Fritz Neumark, Grundsätze gerechter und ökonomisch rationaler Steuerpolitik, Mohr Siebeck, 1970, p.33). See Joachim Lang, Perspektiven der Unternehmenssteuerreform, Brühler Empfehlungen zur Reform der Unternehmensbesteuerung, Bericht der Kommission zur Reform der Unternehmensbesteuerung, Bundesministerium der Finanzen, Heft 66, 1999, Anhang Nr.1 ve Anhang 2 zu Anhang Nr.1, p.17. 73 For a review based on the European Convention of Human Rights, EU law, German and Turkish laws on this issue, see Funda Başaran Yavaşlar and Markus Heintzen, Freiheitsgrundrechte und Unternehmensbesteuerung aus deutscher, türkischer und europäischer Sicht, Ubg 1/2021, p.2. 70

Corporate taxation in Turkey  269 it takes the principle of equality and thus neutrality into maximum consideration.74 After all, as the economic activity of an enterprise grows, the quantity and quality of its transactions change and a more complex structure emerges.

REFERENCES Özlem Nilüfer Karataş Aracı and İsmail Bekçi, MSUGT, TMS/TFRS ve BOBİ FRS Açısından Kavramsal Çerçeve ve Finansal Tabloların Sunuluşu Standartlarının Değerlendirilmesi, Muhasebe ve Vergi Uygulamaları Dergisi, 12/3 (2019), p.857 Mert Cemal Aygın, Osmanlı Devleti’nde Kazancın Vergilendirilmesi Teşebbüsleri (1907–1914), 2019, accessed 29 March 2023 at http://​nek​.istanbul​.edu​.tr:​4444/​ekos/​TEZ/​ET000497​.pdf Funda Başaran Yavaşlar, National Report of Türkiye, in: Corporate Income Tax Subjects, Ed. Daniel Gutmann, IBFD, 2015, p.509 Funda Başaran Yavaşlar, Anonim Şirketlerde Kâr Payı Dağıtımı Sınırlaması/Yasağı ve Buna Uyulmamasının Vergi Hukuku Bakımından Sonuçları, VSD, No.380 (2020), p.9 Funda Başaran Yavaşlar, Neue Digitale Service-Steuer in der Türkei, ISR, 2020/2, p.72 Funda Başaran Yavaşlar and Markus Heintzen, Freiheitsgrundrechte und Unternehmensbesteuerung aus deutscher, türkischer und europäischer Sicht, Ubg 1/2021, p.29 Funda Başaran Yavaşlar, Mustafa Sevgin and Namık Kemal Uyanık, National Report of Türkiye, in: Tax Avoidance Revisited in the EU BEPS Context, Ed. Ana Paulo Dourado, IBFD, 2017, p.695 Ömer Faruk Bayrakçı, Ölçülülük İlkesi Işığında İktisadi Amaçlı Vergi Teşviklerinin Meşruluğu, Institute for Social Sciences of Marmara University, Yetkin Publishing House, 2022 Kenan Bulutoğlu, Türk Vergi Sistemi, Fakülteler Printing House, 1971 Turgut Candan and Tuğçe Karaçoban Güneş, National Report of Türkiye, in: Tax Procedures, Ed. Pasquale Pistone, IBFD, 2020, p.1003 Recep Güneş, Leyla Ateş and Hakan Erkuş, Ticari Kazancın Tespitinde Hırsızlık ve Dolandırıcılıktan Doğan Kazançların Gider Yazılması, Muhasebe ve Denetime Bakış, Ocak, 2008, p.1 Joachim Hennrichs, Digital Service Tax – neue Hybridsteuer nicht empfehlenswert!, Tax Compliance, TLE, 17 October 2018, accessed 29 March 2023 at https://​www​.tax​-legal​-excellence​.com/​digital​ -service​-tax​-neue​-hybridsteuer​-nicht​-empfehlenswert/​. Joachim Hennrichs, Dualismus der Unternehmensbesteuerung aus gesellschaftsrechtlicher und steuersystematischer Sicht, Oder: Die nach wie vor unvollendete Unternehmenssteuerreform, StuW, 2002, p.201 Mahmut İnan, Türkiye’de Kazanç Vergisinden Gelir ve Kurumlar Vergisine Geçiş Süreci: 1946–1960 Dönemi, Maliye Dergisi, No.158 (2010), p.349 Tuğçe Karaçoban Güneş, Vergi Usul Hukukunda Re’sen Araştırma İlkesi, Seçkin Publishing House, 2017 Joachim Lang, Perspektiven der Unternehmenssteuerreform, Brühler Empfehlungen zur Reform der Unternehmensbesteuerung, Bericht der Kommission zur Reform der Unternehmensbesteuerung, Bundesministerium der Finanzen, Heft 66, 1999, Anhang Nr.1 ve Anhang 2 zu Anhang Nr.1 Mehmet Maç, Vergisel Açıdan Çalınan veya Kaybolan Mallar, VDD, S.223 (2022), p.72 Abdullah Mutlu, Tanzimattan Günümüze Türkiye’de Vergileme Zihniyetinin Gelişimi, Maliye Bakanlığı Strateji Geliştirme Başkanlığı, 2009 Fritz Neumark, Türkiye’de ve Yabancı Memleketlerde Gelir Vergisi, Teori-Tarihçe-Pratik, İsmail Akgün Printing House, 1946 Fritz Neumark, Grundsätze gerechter und ökonomisch rationaler Steuerpolitik, Mohr Siebeck, 1970

74 For the view that in the taxation of business income it should be considered whether the enterprise is a listed company or not and a special law should be created for listed companies see Joachim Hennrichs, Dualismus der Unternehmensbesteuerung aus gesellschaftsrechtlicher und steuersystematischer Sicht, Oder: Die nach wie vor unvollendete Unternehmenssteuerreform, StuW 2002, p.212.

270  Research handbook on corporate taxation Fritz Neumark, Zuflucht am Bosporus, Deutsche Gelehrte, Politiker und Künstler in der Emigration 1933–1953, Knecht, 1980 Mualla Öncel, Ahmet Kumrulu, Nami Çağan and Cenker Göker, Vergi Hukuku, Turhan Publishing House, 2022 Cihat Öner, Dar Mükellefiyette Ticari Kazancın Türkiye’de Elde Edilmiş Sayılmadığı Haller Üzerine, AÜHFD 63/2 (2014), p.365 Şevket Pamuk, Osmanlı Ekonomisinde Bağımlılık ve Büyüme 1820–1913, İş Bankası Publishing House, 2018 Altan Rençber, Dijital Hizmet Vergisi İlk İzlenimler, Sorun ve Sorunsallar, VSD S.376 (Ocak 2020), p.27

16. Corporate taxation in New Zealand Craig Elliffe1

I.

CORPORATE ENTITY TAX

Corporate tax forms an important part of the New Zealand tax system. Corporate taxation in New Zealand represents approximately 17.5 per cent of the country’s core tax revenue.2 This contribution to the government’s coffers, compared to the Organisation for Economic Co-operation and Development (OECD) average corporate income tax revenues representing just 9.6 per cent of total tax revenues, is significant.3 The combination of the importance of corporate tax, the absence of a general capital gains tax, and an increase in the rate of tax for personal income has made the company-shareholder interface one of the most pressing tax policy issues in New Zealand. To understand the corporate taxation in New Zealand and the important challenges for corporate tax discussed later in this chapter, it might be helpful to understand other features of the New Zealand tax landscape, so we begin with a brief general overview. 1.1

Important Features of the New Zealand Tax System Influencing Corporate Tax

The New Zealand tax system is generally simple and perhaps even elegant relative to other jurisdictions because there are really only two major tax types. The main sources of tax revenue are derived from, first, an income tax on individuals and other taxpayers (primarily companies) and, secondly, a consumption tax on goods and services (GST).4 These taxes are imposed under the Income Tax Act,5 the Goods and Services Tax Act,6 and collected by New Zealand’s government department, the Inland Revenue Department (IRD). The administration, collection, and responsibilities of the IRD are set out in the Tax Administration Act 1994.7 The primary tax legislation is therefore found in just these three statutes.8 Importantly,

The author would like to acknowledge the assistance of Harry Miller in writing this chapter. The Treasury ‘Interim Financial Statements of the Government of New Zealand for the 10 Months Ended 30 April 2022’ (8 June 2022) at p 19. 3 OECD Revenue Statistics 2021: Initial Impact of COVID-19 on OECD Tax Revenues (1st ed, OECD publishing, Paris, 2021), accessed 17 March 2023 at https://​www​.oecd​.org/​tax/​revenue​-statistics​ -2522770x​.htm. 4 There is an excellent description of the New Zealand tax system found online in Tax Working Group ‘Future of Tax: Submissions Background Paper’ (14 March 2018) at p 22, accessed 17 March 2023 at https://​taxworkinggroup​.govt​.nz/​resources/​future​-tax​-submissions​-background​-paper​.html. 5 Income Tax Act 2007 (NZ). 6 Goods and Services Tax Act 1985 (NZ). 7 Tax Administration Act 1994 (NZ). 8 This ignores some of the very much smaller duties and tax imposts imposed under special legislation taxing the consumption of specific goods and services (excise taxes imposed on sales of tobacco 1 2

271

272  Research handbook on corporate taxation for the sake of comparison with other jurisdictions, it is important to understand that there is no provincial or state taxation. Income tax for individuals is taxed progressively according to their income under the conventional principles of New Zealand source (for non-residents) and worldwide income for New Zealand residents. The top individual tax rate for individuals is 39 per cent for income earned over NZ$180,000 and the lowest rate is 10.5 per cent for income under NZ$14,000.9 Individual income is taxed on a pay-as-you-earn (PAYE) withholding basis – employers are required to withhold tax from salary and wages paid and forward it to the IRD. There is no requirement to file a tax return for most individuals that earn only employment income, or where their income is deducted at the source.10 In the 2017 tax year, approximately 1.4 million people with PAYE income did not file a tax return.11 Hence, this system maintains simplicity and ensures compliance as the average salary earner does not have to file a tax return, instead placing the burden on employers to deduct and remit the tax and report that payment. Companies are taxed simply at a flat rate of 28 per cent in New Zealand.12 This is irrespective of size, so there are no special concessions to speak of for small and medium-sized businesses. This corporate tax is based under substantially the same jurisdictional principles of source and residence. The rate of tax is the main difference between corporate income tax (CIT) and individual income tax and this differential relationship, between 28 per cent and the highest marginal personal tax rate of 39 per cent, is a significant feature which will be analysed in section III. New Zealand’s GST system also echoes simplicity, at least in theory. GST is taxed at a flat rate of 15 per cent and added to the price of most goods and services, including imports.13 Businesses that supply goods and services can register to claim back GST expended in producing these items as it is a consumption tax intended to be borne by the final consumer. Overall, the New Zealand tax system is attractive for its simplicity, but notable also for several omissions. Namely, it does not have inheritance tax or gift duties, regional taxes (except for property rates to local authorities), social security tax, or a healthcare tax. Nor does New Zealand have a comprehensive capital gains tax – this is particularly unique as most other jurisdictions do and, as will be discussed below, it creates an interesting dynamic in the New Zealand tax system when the differential between corporate tax and individual income tax rates are high.

products, alcoholic drinks, and motor fuels, et cetera). New Zealand also has 40 bilateral tax treaties which obviously need to be consulted in respect of cross-border transactions. 9 Income Tax Act, sch 1 cl 1. 10 PWC ‘New Zealand: Individual Tax Administration’ (21 July 2022) accessed 17 March 2023 at https://​taxsummaries​.pwc​.com/​new​-zealand/​individual/​tax​-administration. 11 Tax Working Group ‘Future of Tax: Final Report Volume I – Recommendations’ (21 February 2019) at p 83, accessed 17 March 2023 at https://​taxworkinggroup​.govt​.nz/​sites/​default/​files/​2019​-03/​ twg​-final​-report​-voli​-feb19​-v1​.pdf. 12 Income Tax Act, sch 1 cl 2. 13 Goods and Services Tax Act, s 8.

Corporate taxation in New Zealand  273 1.2

Key Features of Corporate Income Tax in New Zealand

The company regime CIT is a tax on the assessable income of a company less any expenses and deductions. There is no special enactment for corporate tax, a company is a ‘person’ for the purposes of the Income Tax Act. This means that all the general rules of income and expenditure apply universally to individuals and companies unless there are specific features of the tax regime required because of the nature of the company. Furthermore, the CIT provisions apply to all companies, resident or non-resident, large or small, without significant variation. That is, there are no special rates for small and medium-sized entities, nor any major concessions for entities that operate at lower thresholds of turnover, employees, and so on.14 Separate taxable entity and shareholders The nature of the corporate entity as a standalone taxpayer requires that it is subject to special types of rules when the company distributes its profits to shareholders. Such distributions are usually taxable to an individual taxpayer. Even though the general provisions for income and deductions are generic, sprinkled throughout the Income Tax Act are special rules relating to dividends, interest deductions, imputation, branch equivalent tax account (BETA) regimes, loss carry forward and group company offsets, tax credit consolidation, and amalgamations.15 There are also some particular rules concerning changes in residency as it is possible for New Zealand companies to both immigrate and emigrate (provided of course the foreign jurisdiction has similar corporate laws).16 The New Zealand corporate tax imputation system is relatively uncommon in modern tax jurisdictions, a rarity the New Zealand tax system shares with its Australian neighbour. The imputation system was introduced to avoid double taxation on shareholder dividend income. What is a company? For tax purposes, a ‘company’ is defined as a body corporate that has separate legal existence from its members, whether it is created or incorporated in New Zealand or elsewhere.17 This can include some specialist entities which are not companies per se, for example unit trusts, public or local authorities, and Māori Authorities (a unique type of entity designed to assist the ownership of assets by the indigenous Māori people).18 The company definition excludes a partnership. A company acting in its capacity as a trustee is taxed as a trustee and not a company. A look-through company is a special form of transparent tax entity which enables losses and capital profits to be passed out to the shareholders in a way similar to a partnership.19

There are some concessionary provisions which mean that closely held companies can be ‘looked through’. Such rules, discussed shortly, mean that the entity is not regarded as a company for tax purposes. 15 Income Tax Act, ss CD 4(1), DB 7(1), CD 15(1), OE 1, IA 2(2), IC 5(1), OB 83(1), FM 2(1), OA 14. 16 Section EX 24. 17 James Coleman, Sam Davies, Craig Elliffe, Ranjana Gupta, Alistair Hodson, Lisa Marriott, Tony Marshall, Lindsay Ng, Frank Scrimgeour, Andrew Smith and Lin Mei Tan New Zealand Taxation 2022 (19th ed, Thomson Reuters, Wellington, 2022) at ch 15. 18 Income Tax Act, s YA1. 19 Sections CX 63, YB 13. 14

274  Research handbook on corporate taxation Income definition Income is not explicitly or pragmatically defined in the Income Tax Act although certain specific areas of income are codified.20 Taxable income is calculated by deriving the taxpayer’s assessable income less deductions and any tax losses or credits. All receipts of money which come in to the corporate entity are considered the starting point for assessing the income liability of the taxpayer. However, capital and windfall gains are non-income transactions and are excluded from this assessment.21 Some specific receipts are considered exempt or excluded income – these are also non-income transactions.22 The distinction between revenue and capital receipts is critical in the corporate tax base. Because CIT is generally only levied on revenue and does not include capital it is common for New Zealand-based companies to exclude capital profits from their taxable income. Corporate residence Significant mobility restrictions were imposed in New Zealand on its citizens by the government in response to the Covid-19 pandemic in an attempt to prevent the spread of the virus. The social changes have resulted in an increasing focus on the question of corporate residency. Originally, this was borne out of necessity with foreign and New Zealand directors and employees being stranded away from their usual homes, but the current issues arise from the increased flexibility of online working, remote management, and flexible governance. The rules in the New Zealand legislation have yet to respond to the rapidly changing business environment. A company will be a resident in New Zealand if any of the listed factors apply: ● ● ● ●

It is incorporated in New Zealand; or Its head office is in New Zealand; or Its centre of management is in New Zealand; or Its directors, in their capacity as directors, exercise control of the company in New Zealand, even if the directors’ decision making also occurs outside New Zealand.23

A New Zealand company’s residency is therefore comprehensively defined. A critical test in practice is that which determines the company’s centre of management.24 Case law suggests that determining the centre of management means assessing where the company ‘really keeps house and does business’,25 or rather, where its central high-level management and control is

Contained in Part C of the Income Tax Act. Above n 17, at ch 3.1.9, p 92. 22 Income Tax Act, s BD 1. 23 Income Tax Act, s YD 2. 24 See Chapter 8, ‘The Residence of a Company’, in C Elliffe International and Cross-Border Taxation in New Zealand (1st ed, Thomson Reuters, Wellington, 2018), at 8.2.4, 95. 25 De Beers Consolidated Mines Ltd v Howe (Surveyor of taxes) [1906] AC 455, at 455 (per Lord Loreburn LC). 20 21

Corporate taxation in New Zealand  275 located.26 Another New Zealand Court of Appeal decision, Vinelight Nominees,27 held that an assessment of the administrative day-to-day management could also be helpful in finding out where management actually abides. In that case, involving a private company which was controlled by the patriarch and matriarch of a family, day-to-day acts of management, instruction, and compliance in a hands-on and practical manner were also important in discerning central management and control.28 Another significant test in determining corporate residency involves determining where the directors have exercised their directorial decision-making control. The term director is broadly defined as it encompasses any person occupying the position of director with whatever title that may be used, persons in accordance with whose instruction the director is accustomed to act, deemed directors, or directors of entities deemed or assumed to be companies.29 Losses Unlike many other jurisdictions, a New Zealand company may only carry a loss forward to deduct it against future years profit (i.e. it cannot, generally, carry the loss back). The company must meet the shareholder continuity test in order to carry forward losses – this requires 49 per cent of the shareholding to remain the same as when the company made the loss to the year it claims the loss. Recent amendments to the Income Tax Act (made during the Covid-19 pandemic) introduce a new and more concessionary regime for carrying forward losses. This was proposed by the New Zealand government’s Tax Working Group (TWG) in 2019. Where the shareholder continuity test is not met, the company may still retain its losses when the ownership is changed if there is a continuity of business. There are various areas of judgement required in assessing whether the same business is being continued because of the obvious risk of loss trading and the new continuity of business rules tread a courageous, but nervous, line between trying to assist new start-ups who are seeking to raise capital from new shareholders and preventing exploitation of the tax base through the sale of tax losses. A company may also ‘group’ its losses for tax purposes as long as there is a common shareholding with the other company that is above 66 per cent. Wholly owned groups of companies have special concessions that mainly include exempting inter-group dividends.30 Returns Companies must file a tax return for each tax year when business or rental income is received (IR4). This must be accompanied by the company’s financial statements or a financial statements summary (IR10). The worldwide income of a resident company is assessable, whereas a non-resident company must only return its New Zealand sourced income. Companies with

De Beers, ibid, at 458 where it was clearly established that the majority of directors lived in England, and in the directors’ meetings in London the ‘real control’ was exercised in practically all the important business of the company. The New Zealand Forest Products Finance NV v Commissioner of Inland Revenue [1995] 2 NZLR 357 (HC) similarly looked at where the important senior management decisions were undertaken, this being at board level outside New Zealand in the Netherlands Antilles. 27 Vinelight Nominees Ltd v The Commissioner of Inland Revenue [2013] NZCA 655. 28 Vinelight, ibid, at 22. 29 Income Tax Act, s YA 1. 30 Above n 17, at ch 15.2.3. 26

276  Research handbook on corporate taxation annual revenue of NZ$30 million or less and assets of NZ$60 million or less are required to prepare financial accounts that meet the IRD’s minimum financial reporting requirements.31

II.

SHAREHOLDER TRANSACTIONS

In contrast to the taxation of the company itself, the taxation relationship between a company and its shareholders is the more complicated part of the New Zealand corporate tax regime. At its most general and simplistic form, the relationship is governed by codified rules relating to ‘dividends’ which attempt to capture any transactions resulting in a benefit being derived by shareholders or associated persons.32 New Zealand has a regime of ‘imputation credits’ to avoid the double taxation of company profits upon distribution as dividends. Imputation credits attach to dividends to represent income tax paid by the company.33 Shareholders can then utilise these imputation credits to reduce their own tax liability in respect of their dividend income.34 2.1

Dividends and Imputation

What is a dividend? The concept of ‘dividends’ centres around the idea of a transfer of ‘value’ from a company to its shareholders (or associated persons). This transfer of value is the result of having a shareholding in the company.35 Generally, a dividend is a distribution of company profits. The definition of ‘dividends’ is broad, and it has constantly expanded to capture company transactions that benefit shareholders. Thus the code in the Income Tax Act attempts to list all conceivable transactions that transfer value to shareholders.36 When a dividend is paid to a shareholder, it is considered income for the shareholder and liable to income tax.37 A New Zealand company paying dividends to a resident shareholder must normally withhold resident withholding tax (RWT) upon payment of the dividend.38 If a New Zealand company pays a dividend to a non-resident shareholder, then a non-resident withholding tax (NRWT) is deducted as a final tax.39

Tax Administration (Financial Statements) Order 2014 (NZ). Income Tax Act, s CD. 33 Inland Revenue Department ‘Income Tax: Interest and Dividends’ (6 January 2021), accessed 17 March 2023 at www​.ird​.govt​.nz/​income​-tax. 34 PWC ‘Individual: Other Tax Credits and Incentives’ (2023), accessed 17 April 2023 at https://​ taxsummaries​.pwc​.com/​new​-zealand. 35 Income Tax Act, s CD 4. 36 Above n 17, at ch 15.3.1. 37 Income Tax Act, s BE (1)(2). 38 Ibid. 39 Section RF 2. 31 32

Corporate taxation in New Zealand  277 Dividend definition A transfer of company value is deemed a dividend if:40 ● There has been a ‘transfer of company value’, which is widely defined to be a transfer of money or money’s worth,41 to a shareholder (or associate); and ● The transfer was caused by a ‘shareholding relationship’ in the company;42 and ● No specific exclusions apply. The most important of these exclusions are discussed below including returns of capital.43 Transfers of value and cooperative companies The general test of whether a transfer of value is caused by a shareholding relationship does not apply to producer boards and cooperative companies in New Zealand.44 These entities play an integral part of the New Zealand economy, with the gross revenue of New Zealand’s top 30 cooperatives representing approximately 20 per cent of the country’s GDP.45 These entities are owned by people who produce similar products – farmers being a significant part of this. This form of ownership allows cooperating producers greater leverage over buyers through combining resources to better market their products.46 And hence a cash distribution or deductible transaction with a member is not caused by a ‘shareholding relationship’.47 However, the cooperative company may elect to attach imputation credits to the distribution and the member receives a dividend.48 Imputation of corporate tax to shareholders As indicated above, New Zealand does not exempt shareholders from tax but instead relieves double taxation through a notional tax credit. New Zealand’s imputation system therefore has an integral function to New Zealand’s dividend taxation. The Australian franking credit system operates very similarly and the Mexican withholding mechanism for dividend taxation is analogous to imputation.49 It is a practical regime that largely eliminates the double taxation of company profits when they are distributed as dividends to shareholders. This system allows New Zealand resident companies to pass on the benefits of its income tax paid to its shareholders. This is achieved by attaching an imputation credit to the shareholders’ dividend which represents the amount of tax that has been paid on this distribution of profits. If a dividend is

Section CD 4(1). Section CD 5(1). 42 Section CD 6. 43 Sections CD 22 to 36. 44 Income Tax Act, s CD 13; and above n 17, at ch 15.3.2(4). 45 EURICSE and International Co-operative Alliance World Co-operative Monitor Report (2020). 46 New Zealand Institute of Directors ‘Co-operatives in New Zealand’, part of Four Pillars of Governance Best Practice for New Zealand Directors (2021), accessed 17 March 2023 at https://​www​ .iod​.org​.nz/​resources​-and​-insights/​guides​-and​-resources/​co​-operatives​-in​-new​-zealand/​#. 47 Income Tax Act, s CB 33. 48 Sections OB 73, 78, 79, 82. 49 Deloitte ‘International Tax: Mexico Highlights 2019’ (January 2019), accessed 17 March 2023 at https://​www2​.deloitte​.com/​content/​dam/​Deloitte/​global/​Documents/​Tax/​dttl​-tax​-intl​-tax​-mexico​ -highlights​-2019​.pdf; and Australian Taxation Office ‘Dividends and Franking Credits’ (3 June 2022), accessed 17 March 2023 at https://​www​.ato​.gov​.au/​individuals/​investments​-and​-assets/​in​-detail/​ investing​-in​-shares/​refunding​-franking​-credits​-​-​-individuals/​. 40 41

278  Research handbook on corporate taxation fully imputed, the company distributing the dividend has paid the entire 28 per cent of CIT liability associated with it. The resident shareholder can then claim a tax credit for the total amount of the imputation credit attached to the dividend against their own individual tax rate. This ensures that company profits are only taxed once and effectively at the shareholders’ marginal tax rates. Imputation credit account New Zealand resident companies are required to maintain an imputation credit account (ICA) to record their payments of income tax and allocation of imputation tax credits to their shareholders.50 The principal credits to this account are for income tax paid by the company, or other imputation credits received. Hence, credits in the ICA not only represent the tax paid but therefore the amount that is available for distribution to shareholders as imputation credits attached to dividends. Alternatively, the principal debits to this account are for the amount of imputation credits attached to dividends distributed from the company to its shareholders. This represents the utilisation of imputation credits by the company and reduces the available credits for allocation. A company generally can only receive a refund for overpaid income tax to the level of the credit balance in its ICA, this would be a debit entry to the ICA. The ICA operates on an annual basis from 1 April to 31 March as the imputation year, regardless of the company’s financial year. Imputation ratio Upon distribution of a dividend, the ICA company can determine the amount of imputation credit, if any, that it attaches to the dividends. Allocation rules limit the level of imputation credits that can be attached to each dividend for each shareholder. The ratio of imputation credits attached to the net dividend cannot exceed 28/72. So, when the company has paid the entire 28 per cent of CIT associated with the distributed dividend, and then attaches this accordingly as the maximum imputation credit allowed, the dividend is considered fully imputed. As stated earlier, the ICA company is free to choose the rate of imputation credits it attaches to the dividends so long as it does not exceed the maximum permissible ratio. However, the rate at which the first dividend is imputed in the imputation year sets the required ratio for the subsequent dividends. Otherwise known as the ‘benchmark dividend’. This rate must remain the same throughout the year unless a ratio change declaration is filed with the CIR. Carry forward of imputation credits In general, a shareholder that receives dividends with imputation credits uses these credits to offset against their income tax liability. However, imputation credits are not refundable but can be converted into an amount of net loss for carry forward to the subsequent tax years. In order for an ICA company to continue to carry forward imputation credits, the company must satisfy shareholder continuity requirements.51 In the time that the credit is made to when it is used and cancelled out, there must remain a group of persons who hold an aggregate minimum voting interest of at least 66 per cent in the company for the entire period the credit

Income Tax Act, s OB. Income Tax Act, s OA 8; and above n 17, at ch 15.4.7.

50 51

Corporate taxation in New Zealand  279 is carried forward. This ensures that the same group of shareholders retain the benefit of the imputation credits as the group that are liable for the company’s tax liability.52 Resident withholding tax (RWT) and imputation credits Since dividends are passive income for the shareholder, it is necessary to comply with the RWT requirements. The amount of RWT is dependent upon the amount of imputation credits attached to the dividend.53 RWT is calculated at a rate of 33 cents of every dollar on the gross dividend (gross dividend includes credits attached to it). The RWT is then reduced by any imputation credit attached or dividend withholding payment credit attached.54 2.2

Relevant Exclusions from Dividends – Return of Capital

A distribution from a company is excluded from the definition of dividend, and thus taxation, if their tax liability for a distribution of its profits is a valid return of capital, a distribution of available subscribed capital or of capital profits upon liquidation, or if it is a distribution of treasury stock. This has mainly arisen from the introduction of the Companies Act 1993 that allows a company the ability to repurchase its share capital, hence returning capital back to shareholders.55 The repurchase, acquisition, redemption, or other cancellation of share capital is not considered a dividend for tax purposes so long as either an on-market repurchase is transacted through the stock exchange or an off-market repurchase meets certain criteria. On-market share repurchase – return of capital So long as the transaction occurs on a recognised stock exchange, the amount distributed to the extent of the available subscribed capital per share cancelled is not taxed as a dividend.56 If the distribution exceeds the available subscribed capital per share cancelled, then the balance is taxed as a dividend. Off-market share repurchase – return of capital Similarly, if a company distributes an amount to a shareholder not on the stock exchange for a share repurchase (redemption or cancellation), so long as the company is not in liquidation, the distribution is not a dividend if it does not exceed the available subscribed capital per share.57 However, in an off-market transaction, the company must also meet a bright line test as well as ensure that any anti-avoidance rules regarding dividends in lieu do not apply to exclude the distribution from dividend tax liability.58 In this context, the bright line test requires a relatively substantial return of capital highlighting a structural difference between this type of return and the normal and regular payment of a dividend. Above n 17, at ch 15.4.7. Above n 17, at ch 15.4.9. 54 Inland Revenue Department ‘Resident Withholding Tax (RWT) on Dividends: Payers Guide’ (September 2020), accessed 17 March 2023 at https://​www​.ird​.govt​.nz/​income​-tax/​withholding​-taxes/​ resident​-withholding​-tax​-rwt/​payers. 55 Above n 17, at ch 15.3.10. 56 Income Tax Act, s CD 24. 57 Section CD 22. 58 Section CD 22(2). 52 53

280  Research handbook on corporate taxation For an off-market share repurchase to avoid classification as a dividend, the distribution must be part of a pro rata cancellation that results in a 15 per cent capital reduction for the company.59 Or if the cancellation is not pro rata, it must result in the shareholder suffering a 15 per cent interest reduction. Finally, a share buyback will still be a dividend if any part of the payment is in lieu of a dividend.60 This is decided by the assessment of the Commissioner after consideration of the nature and amount of dividends paid by the company both before and after the cancellation, the purpose of the cancellation, whether more shares are issued after the cancellation, or any other relevant factors. Treasury stock A company can acquire and hold up to 5 per cent of a class of shares as treasury stock without treating the amount paid as a dividend.61 However, this is generally impractical for a company that wants to make a significant distribution to shareholders as it is a relatively small portion, hence treasury stock is not usually utilised for significant capital distributions. Capital distributions upon liquidation Capital paid to shareholders upon liquidation of a company is treated as a dividend for tax purposes if it is more than the available subscribed capital per share. Capital gains are also not treated as dividends when distributed by a company on liquidation.62 Inter-company dividends Dividends that are derived by a New Zealand resident company are exempt income.63 This includes dividends derived from a non-resident company by a corporate shareholder.64 So, dividends paid between a wholly owned group of companies in New Zealand are exempted from liability to tax.65 The purpose of the intra-group dividend exemption within a wholly owned group is to facilitate the movement of capital around a wholly owned group, without taxation being a distortionary factor.66 However, since the 2011 amendment removed the requirement for a common balance date for dividends paid within a wholly owned group, in practice these companies that do not meet the balance date requirement tend to use other non-dividend methods to move capital around the group instead of using this provision.67

Section CD 22(3). Section CD 22(6). 61 Income Tax Act, s CD 25; and Companies Act 1993 (NZ), ss 67A to 67C. 62 Income Tax Act, s CD 26. 63 Section CW 10(1). 64 Section CW 9. 65 Section CW 10. 66 Inland Revenue Department ‘Dividends Paid within a New Zealand Wholly Owned Group’, accessed 17 March 2023 at https://​www​.taxtechnical​.ird​.govt​.nz/​en/​new​-legislation/​act​-articles/​taxation​ -tax​-administration​-and​-remedial​-matters​-act​-2011/​remedial​-matters/​dividends​-paid​-within​-a​-new​ -zealand​-wholly​-owned​-group. 67 Above n 65. 59 60

Corporate taxation in New Zealand  281

III.

ASSESSING THE NEW ZEALAND CORPORATE TAX REGIME

As a response to some of the economic consequences arising from the pandemic, it seems clear that many social and political changes are in the wind. One example is the 2020 introduction of the higher rate (39 per cent) on higher individual income earners.68 The New Zealand corporate tax rules are relatively simple and this is a significant strength in its own way. All taxpayers are largely subject to the same tax treatment and there is no significant concession to small and entrepreneurial taxpayers by way of either a lower corporate rate or other special preferences. Very few exceptions or exemptions are found in the regime. Despite this preference to keep things simple, the New Zealand government and tax policy officials have been open to suggestions from business and government working groups for reform where appropriate. Flexibility to respond to commercial imperatives can also be found. A good example of this is the expansion of the rules enabling companies to carry forward losses.69 The introduction of the continuity of business tests exemplifies sensible tax policy: enabling loss-making companies, particularly in the area of start-ups and high technology, to raise fresh capital whilst retaining their valuable tax losses. This brings us to the imputation regime which has many positive features. An often overlooked virtue of the regime is that it is a natural incentive against profit shifting. The regime contains a bias for domestic New Zealand shareholders: for a New Zealand company it is better to pay New Zealand corporate tax than foreign tax. The reason for this is the availability of imputation credits for the utilisation by shareholders. When a New Zealand company pays foreign tax on its worldwide income and this income is subject to New Zealand tax (because it is resident in New Zealand) then it will receive a foreign tax credit.70 Relief from the foreign tax results in lower New Zealand CIT. Lower CIT leads to a reduction in imputation credits. This reduction of imputation credits means that the shareholders will pay more New Zealand tax on any profits distributed. New Zealand companies are thus incentivised to minimise their foreign tax and maximise New Zealand corporate tax. To a lesser extent this is also true for non-resident shareholders of a New Zealand company.71 Profits retained in a New Zealand company can be paid free of withholding tax if they are repatriated as fully imputed dividends.72

68 Taxation (Income Tax Rate and Other Amendments) Act 2020 (NZ) on 7 December 2020 bringing in the new 39 per cent top marginal tax rate on income earned over $180,000. Income above that level was previously taxed at 33 per cent prior to this change. 69 Taxation (Annual Rates for 2021–22, GST, and Remedial Matters) Act 2022 (NZ), enacted 30 March 2022 with application from the 2020/21 income tax year. 70 Income Tax Act, s LJ. 71 Foreign controlling shareholders might prefer that profits are paid in other jurisdictions outside of New Zealand. However, if the corporate taxes are paid in New Zealand then it will be of benefit to foreign shareholders. 72 Income Tax Act, s RF 11 B.

282  Research handbook on corporate taxation 3.1

Tax Policy Tensions Caused by Differentials between the Corporate and Individual Tax Rates

New Zealand has long prided itself on maintaining a tax system which has been described as ‘broad base and low rate’.73 The benefits of having few exemptions and a lower rate include comparative simplicity in types of tax and legislation. Importantly, as highlighted by the TWG, the broad base allows substantial revenue to be raised without resorting to higher tax rates:74 Having a broad tax base allows New Zealand to raise substantial tax revenue with relatively low tax rates. Fewer exemptions also means a simpler tax system and less opportunity for tax avoidance. The top income tax rate in New Zealand is currently 33 per cent, which is low for developed countries. Our GST rate of 15 per cent is also low internationally.

As indicated previously, in 2020 the New Zealand government introduced a new highest personal tax rate of 39 per cent for income above NZ$180,000. This new tax rate could be viewed as a necessary levy to provide funding for the economic disruption caused by Covid-19 where the government provided substantial support to individuals and the business community.75 The new rate was a well-signalled policy prior to the 2020 election designed to make the tax system more progressive. The previous 33 per cent individual rate was noted by the TWG to be low for developed countries,76 however, the current 39 per cent rate is not necessarily high when compared to other countries.77 The TWG were asked to consider and advise the government whether it would be in New Zealand’s interests to cut the corporate tax rate from the current 28 per cent.78 The TWG accepted the Secretariat’s recommendation not to cut this corporate tax rate noting that whilst a lower tax rate could increase foreign direct investment and labour productivity, whilst reducing profit shifting, it would also provide a windfall for non-residents on existing investments, and reduce taxation on location-specific economic rents for those same non-resident investors.79 Another key factor in the minds of the TWG was that a reduction in corporate tax would cause problems with maintaining the coherence and integrity of the New Zealand tax system and introduce concerns about fairness.80 The question of whether to reduce the New Zealand corporate tax rate from 28 per cent was reconsidered by the Policy and Regulatory Stewardship of Inland Revenue in their draft In the documentation of the New Zealand Tax Working Group, ‘Future of Tax: Submissions Working Paper’ (2018/2019) at ch 4, the 2018 New Zealand tax system was described as follows ‘New Zealand’s “broad-based, low-rate” system, with few exemptions for GST and income tax, has been in place for over thirty years’. 74 Ibid, at ch 4. 75 See the introductory comments in a government discussion document, Inland Revenue Dividend Integrity and Personal Services Income Attribution (March 2022), at 5, accessed 17 March 2023 at https://​taxpolicy​.ird​.govt​.nz/​publications/​2022/​2022​-dd​-dividend​-integrity​-psa. 76 Ibid, fn 93. 77 For example, at the time of writing (August 2022) Australia and the United Kingdom have a 45 per cent highest marginal tax rate, and the United States has 37 per cent (on very much more substantial thresholds of income). 78 Tax Working Group, Meeting 6, Appendix 2: Company Tax Rate Issues (March 2018), accessed 17 March 2023 at https://​taxworkinggroup​.govt​.nz/​resources/​twg​-bg​-appendix​-2​-​-company​-tax​-rate​ -issues​.html. 79 Ibid, at page 10. 80 Ibid. 73

Corporate taxation in New Zealand  283 long-term insights briefing presented to a Select Committee of Parliament in 2022.81 This thoughtful analysis noted that corporate tax has a dual role:82 ● To tax income earned by non-resident investors through foreign direct investment and foreign portfolio investment; and ● To support the coherence of personal tax settings and make sure that high income earners do not pay very low rates of tax through the utilisation of corporate structures. Policy and Regulatory Stewardship acknowledge the relationship between the proximity of the company rate to the top personal rate and the coherence of the tax system. The tax system becomes less coherent and more unfair if wealthy and high income earning taxpayers can ‘shelter’ income in companies to avoid the top personal tax rate.83 The New Zealand 11 percentage point gap between corporate and top marginal tax rates is not that large when compared with other OECD countries.84 The key difference between New Zealand and other OECD countries is the fact that New Zealand does not have a capital gains tax, meaning that shareholders are not, generally, subject to tax on the sale of their shares. This absence of tax at the shareholder level is a critical point of differentiation as it puts considerable pressure on the tax interface between companies and their shareholders. 3.2

Horizontal Equity and Dividend Integrity

Part of this chapter set out the rules for taxable distributions from New Zealand companies to shareholders and identified transactions which are non-taxable. The current settings, identified above, mean that rational shareholders will seek to receive the economic return from their investment in the company in one of two ways: ● Returns of capital (involving a tax-free distribution of the available funds in the company); or ● Via the proceeds of sale (through economic return on the sale of the shares). The difference between the highest marginal tax rate and no taxation has led some publicly listed companies in New Zealand to announce significant restructures and returns of capital via off-market share repurchases.85 This is a particularly effective tax strategy in circumstances where the company has no available imputation credits. The rules around tax effective returns by way of return of capital are robustly protected by anti-avoidance provisions and, in certain

81 Policy and Regulatory Stewardship, Inland Revenue Tax, Foreign Investment and Productivity: Draft Long-Term Insights Briefing (February 2022), accessed 17 March 2023 at https://​taxpolicy​.ird​.govt​ .nz/​-/​media/​project/​ir/​tp/​publications/​2022/​2022​-other​-draft​-ltib/​2022​-other​-draft​-ltib​-pdf​.pdf​?modified​ =​20220223232341​&​modified​=​20220223232341. 82 Ibid, at 6.3, 45. 83 Ibid, at 6.22, 49. 84 Ibid, at 6.25, 49, noting that only six other OECD countries had a smaller gap than this in 2020. 85 For example, the New Zealand stock exchange listed insurance company, Tower Ltd, under a High Court sanctioned arrangement organised a return of capital by way of a share cancellation for 10 per cent of its ordinary stock. This returned NZ$30.4 million tax-free to shareholders in March 2022. See this in ZX stock exchange announcement, New Zealand Stock Exchange Announcement 13 December 2021, accessed 17 March 2023 at https://​www​.nzx​.com/​announcements/​384545.

284  Research handbook on corporate taxation circumstances, need Inland Revenue approval. Much greater tension arises in the area of sales of shares. Under the New Zealand tax rules, the absence of a capital gains tax means that the owner of the shares can sell the shares thus realising the economic benefits of a distribution without necessarily triggering either the payment of a dividend or generating a taxable gain. This sale transaction can be achieved either with a legal and economically associated entity or by virtue of an arm’s-length transaction. An example of the former situation would be a shareholder who owns all the shares of a New Zealand resident company (Co A) incorporating a new holding company and selling all the shares of Co A to that holding company for a debt back. Co A can pay an untaxed dividend to the holding company using the inter-corporate dividend exemption.86 The holding company can then repay the purchase price to the shareholder. The net effect of this transaction is the retention of the same economic ownership of the company, whilst the distribution of Co A’s profits and reserves has occurred without taxation. The same transaction can be achieved with an arm’s-length third party owning the holding company, although the ownership of the company will pass to the third party and thus might necessitate a transfer of assets back to the original owner of Co A. It may be possible that the type of assets transferred are reasonably substitutable or that the transaction is a genuine sale. A recent government discussion document on dividend integrity highlights this ‘dividend stripping’ problem and proposes a controversial solution.87 Anti-dividend stripping rules already exist in the New Zealand legislation.88 These rules have been effective in some circumstances as evidenced by the High Court decision in Beacham.89 In that case the shareholders introduced a new holding company which they owned (similar to the former transaction referred to in the previous paragraph) in a relatively straightforward arrangement which clearly fell foul of the anti-avoidance provisions. Notwithstanding a robust anti-avoidance framework consisting of a powerful general anti-avoidance rule, the specific dividend stripping rule, and a clear Revenue Alert statement following the Beacham case,90 the discussion document acknowledged that such anti-avoidance rules are ‘complex to administer and costly to litigate’ before suggesting a proposal to tax a deemed dividend portion of proceeds on a controlling shareholders sale of shares.91 Effectively the proposed new rules would recharacterise a share sale as dividends in the hands of the controlling selling shareholder.92 Some companies were excluded from the application of the proposed rules, including those owned by non-residents, listed companies, and portfolio investors.93

Income Tax Act, s CW 10. Inland Revenue Dividend Integrity and Personal Services Income Attribution (March 2022), accessed 17 March 2023 at https://​taxpolicy​.ird​.govt​.nz/​publications/​2022/​2022​-dd​-dividend​-integrity​ -psa. 88 Income Tax Act, s GB 1 (arrangements involving dividend stripping) and the general anti-avoidance rule in s BG 1. 89 Beacham v Commissioner of Inland Revenue [2014] 26 NZTC 21-111. 90 Revenue Alert, RA18/01 (2018), accessed 17 March 2023 at https://​www​.taxtechnical​.ird​.govt​.nz/​ en/​revenue​-alerts/​ra​-1801​-revenue​-alert. 91 Dividend Integrity and Personal Services Income Attribution, n 87, at 2.7 on p 16. 92 Ibid, n 87, at 3.22 on p 26. A controlling shareholder would have ownership of more than 50 per cent of the voting interests of the company. 93 Ibid, n 87, at 3.19–3.23 on p 26. 86 87

Corporate taxation in New Zealand  285 These proposals were met with considerable concerned opposition from professional bodies and firms. The major objections could be summarised as follows: ● That the proposals on share sales are in essence a capital gains tax. This is despite the government having ruled out the recommendation for capital gains tax from the TWG. The dividend integrity rules had even more onerous tax consequences than a conventional capital gains tax, operating to tax retained earnings from years earned prior to the marginal tax rate increase; ● That the measures would capture more tax than just the amount which is being eroded through avoidance measures including completely legitimate and arm’s-length transactions as well as associated persons transactions in ordinary family succession arrangements; ● That the anti-avoidance measures sought already exist, and should be improved instead of adding additional rules; ● That a large number of the taxpayers affected, small and medium-sized enterprises, may not have the resources or expertise to deal with the complex calculation and assessment rules required under these proposed dividend deeming provisions. Originally it was contemplated that these new proposed dividend integrity rules would proceed, after consultation, and form part of an August 2022 Income Tax Bill. The government quickly realised that these proposals needed more consideration and refinement.94 The question of how to address the tensions of corporate tax and shareholder non-taxation is a conundrum. On the one hand it seems very important to preserve the integrity of the tax system by not allowing the diversion of income which should properly be taxed in the hands of the high earning individual at 39 per cent. On the other hand, a strong case can be made for legitimate investment in the asset protecting corporate entity and maintaining a corporate tax rate which is both internationally competitive and encourages productive reinvestment. A suggested reform to reconcile these competing demands, in the absence of a capital gains tax, is made in the final section of this chapter. 3.3

Horizontal Equity and Wealth and Tax Distribution

There is a backdrop to this important debate which informs part of the government’s concerns about the use of entities, primarily companies but also trusts, to circumvent the highest personal tax rate. Back in 2018, the TWG received a report released under special provisions of the Official Information Act concerning high net wealth individuals and their wealth accumulation and income tax payments.95 According to the findings of that report the Inland Revenue analysed that a small group of high net worth individuals (those with net wealth of NZ$50 million or more) paid 5 per cent of their net income individually, 19 per cent in trusts they controlled, and 74 per cent in companies they controlled. This is perhaps unsurprising given that such individuals would retain profits in their commercial entities and only need a small portion of their wealth to maintain their sustenance and lifestyle.

94 At the time of writing, the end of August 2022, the proposals have yet to resurface in a, presumably, revised format. 95 Inland Revenue HWI–Wealth Accumulation Review (June 2016), accessed 17 March 2023 at https://​taxworkinggroup​.govt​.nz/​sites/​default/​files/​2018​-05/​High​-wealth​-individuals​.pdf.

286  Research handbook on corporate taxation Similar figures are contained in the Dividend Integrity discussion document released in 2022 with a larger sample (350 high net worth individuals relating to the 2018 income tax year). This group of individuals paid NZ$26 million in tax (3 per cent), whilst their companies paid NZ$639 million of tax (83 per cent), and their trusts NZ$102 million (13 per cent).96 It is likely that the 39 per cent tax rate change in 2020 will result in even less tax being paid in individual returns from this group of taxpayers. As income tax is largely paid by entities controlled by high net wealth individuals at an 11 per cent discount from an individual tax rate.97 It is also likely that this group of taxpayers also enjoys the majority of untaxed capital gains, it is perhaps unsurprising that some commentators, including the Minister of Revenue,98 have raised concerns about the fairness of the tax system and increasing inequality.99

IV.

A SUGGESTED WAY FORWARD: EXTENDING THE FAIR DIVIDEND REGIME OR THE COST METHOD

The preferred vehicle for business is a corporate entity. This is true for small and medium-sized organisations as well as large companies. Limited liability is the key attribute that is sought by businesspeople and entrepreneurs. Feedback in respect of the dividend integrity proposals suggest that targeting small and medium-sized enterprises when they are involved in reorganisations and family succession planning is regarded as overreach and stifling to ordinary commercial and entrepreneurial activity. At the heart of the concerns here is the absence of dividend payments in circumstances, not where the funds are being retained by the company because they are essential for reinvestment, but where they are being channelled for the aggregation of wealth. Very wealthy people do not need to access the funds from their large corporate entities and they can afford to reinvest in an entity which enjoys a lower tax rate whilst waiting until an arm’s-length crystallisation of their investment to take a tax-free capital profit. Back in 2007/08, the absence of a taxable flow of dividends was also a feature of the tax landscape which confronted New Zealand tax policymakers in respect of the taxation of foreign investment funds. New Zealanders investing in foreign portfolio companies, particularly those based in the US which did not pay dividends, enjoyed their returns by way of untaxed capital growth.

Dividend Integrity and Personal Services Income Attribution, n 87, at 1.11 on p 7. A study by the London School of Economics and Political Science, International Inequalities Institute, by David Hope and Julian Limbergh analysed the effect of reductions in tax progressivity in looking at 18 OECD countries from 1965 to 2015 (including New Zealand). They concluded that tax cuts for the rich push up income inequality and that cutting taxes on the rich has little effect on economic performance. D Hope and J Limbergh, ‘The Economic Consequences of Major Tax Cuts for the Rich’, LSE International Inequalities Institute (2020). 98 Hon David Parker ‘Shining a Light on Unfairness in Our Tax System’, speech at Victoria University of Wellington (26 April 2022), accessed 17 March 2023 at https://​www​.beehive​.govt​.nz/​ speech/​shining​-light​-unfairness​-our​-tax​-system. 99 See also Max Rashbrooke Too Much Money: How Wealth Disparities Are Unbalancing Aotearoa New Zealand (Bridget Williams Books, Wellington, 2021) where the author discusses questions of wealth inequality and tax. 96 97

Corporate taxation in New Zealand  287 It is suggested that the accumulation of profits and absence of dividends found in the foreign investment fund regime might be a similar problem to that of wealthy New Zealanders aggregating corporate profits. The fair dividend regime deems a taxable return of 5 per cent based on the market value of a New Zealand resident’s portfolio of foreign shares.100 Where the market value of the shares is not readily ascertainable, the cost method operates by taxing 5 per cent of the cost of the person’s investment (this cost base increased by 5 per cent per annum is a broad proxy for the growth in the shares’ value).101 Any deemed income taxed in this way could be carried forward to exempt the shareholder when actual dividends were paid out from the company. That is, to the extent that the shareholder had received this fair dividend income, they would not be subsequently taxed on an actual distribution, but if the dividend income exceeded the 5 per cent, then it would be subject to the normal rules. To overcome some of the problems involving succession planning and ordinary commercial transactions, these suggested rules would only apply to wealthier New Zealand owned groups of companies. Obviously work would need to be done to establish what was an appropriate threshold, but as an illustrative suggestion, the new rules would only apply to groups of companies with a turnover that exceeded NZ$30 million. Net assets might also be considered as an appropriate threshold to engage the application of the new rules. Smaller corporate entities (with a turnover below NZ$30 million) and those companies with widely held shareholdings or owned by non-residents would only be subject to the normal anti-avoidance rules on dividend stripping, which may be modified as a result of the dividend integrity project. The taxation interface between companies and shareholders captures key tensions between the taxation of labour income, capital income, and increasing wealth inequality. This makes it a very important area for future tax development in New Zealand.

100 101

Income Tax Act, s EX 52. Section EX 56.

17. Corporate taxation in Japan Yoshihiro Masui

1. INTRODUCTION This chapter is intended as a handy research guide to corporate taxation in Japan. It first outlines the basic structure of corporate income tax in Japan (2). It then selectively discusses three issues of policy significance in the design of corporate taxation. The three topics are: ● The integration of corporate and shareholder taxes (3), ● The Japanese version of tax expenditure analysis (4), and ● Japan’s half-territorial system of taxing foreign income (5). The last section briefly concludes (6). Ault, Arnold and Cooper (2019) contains the leading commentaries in English on Japan’s current law with regard to corporate-shareholder taxation and international taxation. It naturally forms the basis of discussions in this chapter. This chapter is an extension of Masui (2021) which traced the evolution of Japan’s corporate taxation from 1995 to 2021 with an emphasis on corporate reorganizations and group taxation. This chapter discusses some of the more policy-oriented topics. At the outset, readers are kindly reminded of the fact that the Japanese language is used throughout the process of tax legislation and adjudication in Japan. However, this chapter omits citation to sources written in Japanese language.1 It also avoids technical legal discussions, and instead concentrates on the broad features of Japanese law that are noteworthy from a comparative perspective.

2.

BASIC STRUCTURE

2.1

General

The corporate income tax (CIT), defined loosely as a tax on corporate profits, was first introduced in 1899 in Japan. The CIT used to be Japan’s biggest revenue generator for many years after the Second World War, when the Japanese economy expanded rapidly. Despite its diminishing role as a revenue raiser compared with the rising value added tax (VAT), the CIT still plays a significant role as a backstop to the personal income tax. Japan’s percentage of

1 The English translation of the Supreme Court decisions, referred to in this chapter, is available at https://​www​.courts​.go​.jp/​app/​hanrei​_en/​search. For other English materials on Japanese taxation, including primary and secondary sources, see http://​www​.masui​.j​.u​-tokyo​.ac​.jp/​english​.html. All URL links cited in this chapter were accessed on 28 August 2022.

288

Corporate taxation in Japan  289 corporate tax revenue is above the OECD average both as a percentage of total tax revenues and as a percentage of GDP.2 Japan’s CIT consists of national and local taxes. The national government imposes the Corporation Tax. The Corporation Tax is piggybacked by several local taxes, including prefectural inhabitants tax, municipal inhabitants tax, enterprise tax, and local corporate tax. The revenue from these local taxes is sizeable. In terms of basic structure, however, they are no different from the Corporation Tax, the only exception being the enterprise tax which is composed of a capital levy, a value-added levy, and an income levy. Moreover, these local tax bases and rates are streamlined nationwide under the Local Tax Act (Law No.226 of 1950). Local authorities rarely use local tax incentives to purse their policy objectives. Therefore, this chapter discusses the Corporation Tax at the national level. The statutory basis for the national level Corporation Tax is the Corporation Tax Act (CTA, Law No.23 of 1965). The Income Tax Act (ITA, Law No.33 of 1965) governs the taxation of individuals and the withholding tax on various items of payments including dividends. Quite a number of incentive measures, as well as a special regime for taxing financial income, are provided for in the Special Tax Measures Act (STMA, Law No.26 of 1957). The National Tax Agency (NTA) is in charge of administering the CTA, the ITA, the STMA, and other statutes concerning national taxes. Academic lawyers and economists in Japan, as would be the case in many other countries, are enchanted by, and studied in depth, various innovative blueprints for fundamental reform of business taxation, including those in the Meade Report and the Mirrlees Review, the American Law Institute’s study on integration, the U.S. Treasury’s 1992 Comprehensive Business Income Tax (CBIT), Hall and Rabushka’s Flat Tax, Bradford’s X-Tax, Kleinbard’s Business Enterprise Income Tax (BEIT), and the more recent Destination Based Corporate Cash Flow Tax, to name a few. So far, however, such fundamental reforms have not been seriously considered as a policy option in the real-world tax policymaking in Japan. 2.2

Taxpayer

Entities subject to corporate level tax are very broadly defined in Japan. Unlike the treatment under the U.S. check-the-box regulation, it is impossible for taxpayers to make an election between a partnership and a corporate tax treatment. Commercial companies formed under Japan’s Company Act (Law No.86 of 2005) are automatically deemed as an independent taxpayer for corporate tax purposes. Among the various business organizations prescribed by the Company Act, the joint stock company dominates the whole business scene, ranging from tiny mom-and-pop businesses to gigantic and often multinational enterprises. Therefore, the joint stock company is the single most important form of conducting business in the whole area of corporate taxation in Japan. The definition of corporate taxpayer is so broad in Japan that it covers even those companies some or all of whose equity-holders assume unlimited liability toward creditors to whom the companies are liable. Almost all companies are taxed as a corporate taxpayer subject to the Corporation Tax. This broad coverage is in sharp contrast with some European Civil Law jurisdictions where such ‘personal’ companies are generally regarded as a pass-through

2



OECD (2021) 5 and 7.

290  Research handbook on corporate taxation entity and are subject to the respective partnership tax treatment. The difference from these foreign jurisdictions is striking because Japan’s company law was originally transplanted from European countries in the 19th century. Pass-through entities are rarely used in business practice. Consequently, partnership tax rules are relatively undeveloped in Japan.3 The rigidity of definition of corporate taxpayers was apparent in a case involving foreign entities. A case in point is the Supreme Court Decision of 17 July 2015, which held that a Delaware Limited Partnership was a corporate taxpayer for Japan’s CTA purposes. This decision affirmed the position of the NTA which had denied the utilization of losses incurred by the Delaware Limited Partnership to the hands of Japanese resident partners. Later, however, an unintended consequence was discovered in the treaty application to items of income derived through a U.S. Limited Partnership by Japanese resident partners such as Japanese pension funds. In February 2017, the NTA announced that it would no longer pursue any challenge to their fiscally transparent treatment.4 2.3

Tax Base

The tax base of Japan’s Corporation Tax is the return which would accrue to the shareholders of a company. The tax base arises from the profit-and-loss transactions conducted by the company with its stakeholders other than shareholders. In general terms, the book/tax conformity prevails. Since 1967, the CTA has the basic provision under which the amount of revenues and expenses is to be computed according to the generally accepted accounting principles (GAAP). The taxable income of a corporation is calculated based on the profit-and-loss statement prepared in accordance with the Company Act, with adjustments required by the CTA. The accounting provisions dictated by the Company Act, in turn, are based on GAAP. Beginning with the 2000 tax reform which introduced a mark-to-market regime for financial instruments, there has been a conspicuous increase in the number of provisions of the CTA which explicitly diverge from accounting rules. The gap between book profits and taxable income is even wider when various tax incentive measures under the STMA are applied. The debt/equity bias exists in favor of debt due to the general deductibility of interest expenses incurred on corporate debt. The earnings stripping rule, which applies to net interest payment to both resident and non-resident entities, is inapplicable if the interest is taxable on the payee side. As a result, most domestic loans are immune from the earnings stripping rule. On the deduction side of the corporate tax base, one of the most well-known cases in corporate taxation in Japan concerns the write-off of bank loans after the burst of the ‘real estate bubble’ in the early 1990s. The Japan Industrial Bank claimed as much as 376 billion yen of bad debt loss in its corporate tax return for the taxable year 1995. The NTA disallowed the deduction. The Supreme Court Decision of 24 December 2004 eventually affirmed the bank’s position, stressing the fact of the case that the bank was unable to assert its legal position against other creditors as a matter of a socially accepted norm.



3



4

See Masui (2000). See https://​www​.nta​.go​.jp/​english/​tax​_information​.pdf.

Corporate taxation in Japan  291 2.4

Tax Rate

The current statutory tax rate is 23.2 percent. A reduced rate of 15 percent applies to taxable income below 8 million yen for small and medium companies with the amount of capital less than 100 million yen. This rate structure has been in effect since 2016. The corporate tax rate at the national level used to be as high as 43.3 percent in the middle of the 1980s. In the face of global pressures from tax competition, Japan’s corporate tax rate has been successively reduced since 1988. The current national rate of 23.2 percent is the result of such development. The tax rate for the whole CIT, with national and local taxes combined, is slightly less than 30 percent after the fiscal year 2016. This is comparable to the corporate tax rates in G7 countries, but higher than the OECD average. In the course of rate reductions, the corporate tax base has been broadened to compensate for the loss in tax revenue. Significantly, the scope of exemption of intercorporate dividends was tightened for non-controlling corporate shareholders. Also, restrictive ceilings were placed on the deductible amount of net operating losses that were carried forward from past years. 2.5

Tax Administration

Under a self-assessment system, corporate taxpayers are required to file a tax return. In contrast, most individual taxpayers are not required to file a tax return due to the extensive network of withholding taxes. Wage income is subject to a withholding tax at source, which is elaborately adjusted to approximate the amount of individual income tax otherwise declarable at the end of the year. Income from household financial assets, most notably interest income, is subject to a flat and final withholding tax. Consequently, the income tax revenue from self-assessment is much smaller than the withholding tax revenue. The fact that many individuals are non-filers forms a significant background for the discussion of corporate and shareholder taxes on dividends in the next section. Japan does not have a Mandatory Disclosure Rule (MDR) that requires intermediaries to report their aggressive tax planning schemes. On the other hand, there exist some generally worded anti-abuse provisions in the CTA and the ITA, while the scope of their target is restricted to family corporations, corporate reorganizations, group relief, and calculation of profits attributable to a permanent establishment. These provisions enable tax directors to recalculate the amount of income, losses, and taxes if they find that a taxpayers’ act or calculation ‘unfairly reduces’ the amount of the Income Tax or the Corporation Tax.5 There is a long list of litigated cases, especially with respect to the anti-abuse provision for family corporations. Most recently, the Supreme Court Decision of 21 April 2022 (Universal Music case) adopted an economic reasonableness test and affirmed the position of taxpayers in a debt push-down case involving a family corporation. On the other hand, the Supreme Court Decision of 29 February 2016 (Yahoo case), which disallowed the carryover of unused net operating losses in a corporate merger, used a similar but somewhat different test in applying the anti-abuse provision in corporate reorganizations.



5

See Nagato (2017).

292  Research handbook on corporate taxation

3.

INTEGRATION OF CORPORATE AND SHAREHOLDER TAXES

3.1

Rough and Ready Relief

According to the survey over 11 jurisdictions,6 imputation systems have fallen out of favor and have been increasingly replaced with some sort of ‘rough and ready’ integration relief. Indeed, the Japanese system can be characterized as adopting a ‘rough and ready’ relief in the following manner.7 The ITA has a system of tax credit for individual shareholders who report their dividend income on their annual tax return. Individual shareholders with income below 10 million yen are granted a tax credit of 10 percent of the amount of dividends received. For individual shareholders with income above 10 million yen, the credit is limited to 5 percent of the dividends in excess of 10 million yen and 10 percent of the remaining amount of the dividends. This tax credit, called a ‘dividend credit,’ is non-refundable. Note that there is no gross-up procedure in the computation of the dividend credit. It applies to the amount of dividends including the amount of withholding tax but excluding the amount of Corporation Tax attributable to the dividends. With the 10 percent credit, the degree of integration of corporate and shareholder taxes is incomplete for almost all individual shareholders. Moreover, the Corporation Tax is not integrated with shareholder level income tax on capital gains. In practice, the dividend credit is rarely used by individual shareholders who receive a small amount of dividends or who invest in listed companies. This is because the taxation of financial income is governed by the STMA, which excludes the application of dividend credit. The measures in the STMA are multi-faceted and are subject to detailed conditions. In essence, they permit individual shareholders either (1) not to report a certain small amount of dividends and an amount of dividends from listed companies or (2) to file their income tax returns on dividend income from listed companies separately from other sources of income. If they elect (2), they may offset the amount of dividends with capital losses from listed shares. The consequence of applying these measures in the STMA is not only the non-availability of dividend credit. Because the outgoing dividends are subject to the 20.315 percent withholding tax (15 percent national tax, 5 percent local tax, plus additional 0.315 percent tax for the recovery from Great East Japan Earthquake), such withholding tax becomes final for those shareholders who elect the option (1) of non-reporting. Also, when they elect the option (2) of separate filing, the applicable tax rate under the STMA is set at the same rate as the withholding tax rate, resulting in no additional tax that needs to be collected at the shareholder level. All in all, therefore, the STMA creates an electable regime of taxing dividends from listed companies with a flat 20.315 percent rate, collected by the corporation paying the dividends. The STMA’s special regime for taxing individuals’ financial income is an exception to the otherwise comprehensive personal income tax with a progressive tax rate structure ranging from 15 percent to 55 percent (when a flat 10 percent local inhabitants tax is added to the national rate). A flat tax rate of 20.315 percent (national and local taxes combined) is obviously beneficial for high income earners whose marginal tax rate is higher.



6 7

Ault, Arnold and Cooper (2019) 529. Matsuda and Ino (2003) report on the rule immediately before the 2003 reform.

Corporate taxation in Japan  293 Even when the underlying corporate level tax is factored in, the escape from the progressive tax rate by the STMA makes the after-tax proceeds better off, for individual taxpayers who reach a top income tax bracket. A numerical illustration may help understand why this is so. As a first step, let us consider the case where the dividend credit is fully available under the ITA. Even in this case the degree of integration is incomplete. Suppose that the corporate level marginal tax rate is 30 percent, which is a realistic assumption under Japan’s current statutory rate. When a company earns its taxable income of 100 in a particular tax year, the CIT of 30 is due. After tax, the company has the remaining amount of 70 in its corporate solution. Suppose further that the company declares and pays the whole amount of 70 as dividends to its sole shareholder. If the applicable tax rate at the shareholder level is 55 percent at the highest tax bracket, the shareholder tax is 38.5 (= 70 x 55 percent) before dividend credit, and 31.5 (= 70 x 55 percent − 70 x 10 percent) after the dividend credit of 10 percent. The sum of corporate level tax (30) and of shareholder level tax (31.5) is 61.5. The shareholder is left with the after-tax proceeds of only 38.5. The combined taxes are heavier than an income tax alone which might have been imposed if the shareholder conducted the same business as a sole proprietor. This is the case under the assumption that the shareholder is fully entitled to the dividend credit of 10 percent. It is more likely for a top bracket taxpayer to use a reduced 5 percent rate of credit on a certain portion of dividends. In that case the excess burden on dividends is even larger. As a next step, let us move on to the case where the STMA’s special regime applies due to the taxpayer’s election. In this case high income taxpayers enjoy a bonus tax reduction. For the sake of argument we ignore the fact that the sole shareholder scenario in the last paragraph is technically misleading for shareholdings in listed companies. We use the same scenario and concentrate on the effect of STMA which is to reduce the shareholder tax rate. Suppose a flat 20 percent rate applies to dividends received by the individual shareholder in the above illustration. Here again, for the sake of simple exposition, the 20 percent rate instead of a technically correct 20.315 percent rate is used. The shareholder tax is 14 (= 70 x 20 percent) and no dividend credit is available. Adding the corporate level tax of 30, the sum of corporate and shareholder taxes is 44, with the after-tax proceeds of 56. Because this individual would have faced a marginal tax rate of 55 percent under the normal tax rate structure under the ITA, the aggregate tax amount of 44 means that this lucky taxpayer received a bonus tax reduction of 11 percentage points. The relief is imprecise. It also is harsh towards the population in the lower end of income distribution. For most of the population paying the income tax, the applicable tax rate is 5 percent or 10 percent (15 percent or 20 percent if national and local taxes are combined). The flat 20 percent rate is not advantageous for this group of people. Moreover, those individuals who are below income tax thresholds and do not file income tax returns nevertheless are burdened with the 20 percent withholding tax, which is final. Adding the corporate level tax in the calculation, they are even worse off. This simple example shows that the STMA gives a ‘rough and ready’ relief to the individual shareholder at the top end of income tax brackets. Note that the illustration above disregards several conditions including income tax thresholds, personal deductions, and other details in the ITA and the STMA.

294  Research handbook on corporate taxation 3.2

Historical Overview

The present form of ‘rough and ready’ relief is a result of historical developments. It was in 2003 that the STMA’s special regime was introduced as part of a tax reform streamlining the taxation of financial income for individual taxpayers. The ITA’s dividend credit is older and dates back to 1948. As demonstrated below, different methods have been experimented in constructing the relationship between corporate and shareholder taxes throughout the past 120 years of corporate taxation in Japan. There was no tax on corporate income in Japan’s first 1887 income tax.8 When taxation started in 1899, corporate income was taxed only once on the corporate level with a flat rate of 2.5 percent. Dividends were exempt on the individual shareholder level. Capital gains on the shares were not included in the personal income tax base in the first place. This system continued for some time. In 1905, an additional levy was imposed on corporate income in order to finance the public expenditures for the Japan-Russo War. In 1906, the government examined and rejected the proposal to tax individual shareholders on the dividends they receive from a company. Subsequently, the 1913 reform distinguished between the two categories of corporate income. On one hand, a progressive rate structure was applied to the income of unlimited partnership companies, limited partnership companies, and joint stock companies with 20 or less shareholders. On the other hand, a flat rate was applied to the income of joint stock companies with 20 or more shareholders. The objective was to assimilate the tax treatment of closed corporations with that of sole proprietorships. In 1920, dividends received from a corporation started being taxed as income of individual shareholders. Only 60 percent of the amount of dividends was included in their taxable income. This was the beginning of an individual shareholder level tax in addition to a corporate level tax on dividends. On the corporate side, the two categories adopted in the 1913 reform were replaced by the four-tier classification of excess income, retained income, dividend income, and liquidation income. Excess income was an amount of income above 10 percent of the amount of capital. Retained income was an amount of income not distributed as dividends. A progressive rate structure applied to excess income and retained income of the company. In 1940 there was an overhaul of the whole tax system in the face of fiscal needs in the Second World War. As part of the overhaul, the tax on corporate income was moved from the ITA to the newly legislated CTA (Law No.25 of 1940). The classical system of taxing corporate profits continued. The 1950 tax reform was significant because it was based on the 1949 Recommendation by the Shoup Mission, which viewed corporations as a particular kind of aggregation of individuals and which emphasized the tax neutrality between different forms of conducting business. The individual shareholders were granted a 25 percent tax credit on the dividends received. The rate was set to eliminate the excess burden on dividends at the top bracket of individual income tax. This shareholder level relief is the origin of the current dividend credit, while specific percentages of the credit have been modified by later reforms. It must be added that the 1950 tax reform started to tax individual shareholders on their capital gains fully in the same manner as other sources of income. The full taxation of capital gains/losses was an Income Tax Act (Imperial Decree No.5 of 1887). Hammer (1975) 321 incorrectly states that the system was along the lines of a classical system when income taxation was first introduced in Japan in 1887. 8

Corporate taxation in Japan  295 integral component of the package recommended by the Shoup Mission. As early as 1958, however, capital gains/losses on shares were made exempt and were replaced by an excise tax on share transactions. In 1961, the split rate system was introduced for corporations to mitigate the debt/equity bias in corporate finance. As an alternative to the dividend-paid deduction for corporate taxpayers, the corporate tax rate for the portion of corporate income distributed as dividends was reduced to 3/4 of the normal corporate tax rate. Correspondingly, the dividend credit for individual shareholders was reduced to 3/4 of its previous level. This system tried to mitigate the excess burden on dividends at the corporate level (1/4) and at the shareholder level (3/4). The 1988 tax reform abolished the split rate system and reinstated the single basic rate for taxing corporate income. The dividend relief was granted solely at the shareholder level in the form of dividend credit. Individual shareholders started to be taxed on their realized capital gains/losses on shares, even when they were not stock traders. This reform also marked the beginning of successive cuts in the corporate tax rate. It was against this background that the STMA created the special regime, discussed in 3.1, of taxing dividends in 2003. Initially a reduced 10 percent tax rate was applied to dividends from listed shares as an incentive for individuals to invest more in shares. Effective from 2014, the tax rate on dividends when taxpayers opt for the special regime has been set at the present rate of 20.315 percent. Unlike the tax reform in 1988, the 2003 reform of STMA did not take corporate/shareholder integration seriously. Rather it was animated by the slogan ‘from savings to investment,’ which meant that Japan’s household portfolio should be more balanced towards investment in shares and in share investment trusts. 3.3

The Concept of Dividends

Some cautionary remarks on the meaning of ‘dividends’ are necessary because the concept is not self-evident as it first seems. Unlike in the U.S., Japan’s ITA does not have a rule to classify distribution of earnings and profits as ‘dividends’ for tax purposes. Rather, the Supreme Court Decision of 7 October 1960 interpreted the concept of dividends for ITA purposes in accordance with the notion generally held in a market, a notion which, according to the court, was also anticipated by the Commercial Code. The Company Act of 2005 substantially changed the commercial law regulation of company distribution to its shareholders. The Company Act liberalized the restriction on the payment of dividends. It was made possible for a company to pay dividends out of capital surplus as well as retained earnings under the same procedure. Accordingly, the 2006 tax reform modified the previous definition of dividend income. The amount of dividends paid out of retained earnings is taxed as dividend income at the shareholder level. With respect to dividends attributable to capital surplus, only a portion of such dividends is taxed as dividend income, while the remaining portion is treated as capital gains (or losses) of the underlying shares. The ITA delegates the calculation method of dividend income to the Cabinet Order, which adopted a pro rata method based on the ratio of the amount of capital within the corporate balance sheet. A bug in the Cabinet Order was found by the Supreme Court Decision of 11 March 2021, which invalidated a part of the Cabinet Order as not in accordance with the ITA. This case involved a distribution from a company organized under the Delaware Limited Liability Company Act. The bug was fixed by the 2022 tax reform.

296  Research handbook on corporate taxation

4.

THE JAPANESE VERSION OF TAX EXPENDITURE ANALYSIS

4.1

The STMA as a Convenient Basket

Japan’s legally defined analogue to tax expenditures is ‘Special Tax Measures.’9 Japan defines its Special Tax Measures by comparison to fundamental tax principles, rather than relative to a benchmark tax system per se. No official guideline has been developed on the substantive criteria to decide whether or not a particular tax rule is a departure from the normative component of income taxation. Japanese policymakers do not rely on the sort of tax expenditure analysis advocated by Stanley S. Surrey, a member of the Shoup Mission, who had a strong intellectual influence on Japan’s academic community. The statutory basis for these Special Tax Measures is the STMA. The STMA has been used by Japan’s legislators as a convenient basket for the collection of miscellaneous exceptions to general tax rules. The STMA was enacted in 1957 and has been amended every year, often several times within the same year. The objective of the STMA is (1) to reduce, exempt, or refund internal taxes such as the Income Tax and the Corporation Tax and (2) to establish special rules as an exception to such general tax statutes as the ITA and the CTA with regard to tax liability, calculation of tax base and tax amount, filing deadline, and collection. The STMA has a history dating back to the 1930s.10 It originated from the 1938 Temporal Tax Measures Act which provided tax incentives for the wartime mobilization. In 1946, the predecessor of the STMA was legislated. Tax incentive measures increased during and immediately after the war. They were drastically curtailed by the 1950 tax reform which implemented the 1949 Shoup Recommendation. Since then, the list of Special Tax Measures expanded again until the end of the 1970s. Greater importance was placed on tax exemptions and credits in the 1950s, while tax deferrals (accelerated depreciation and tax-free reserves) became more significant in the 1960s and 1970s. The total amount of revenue losses due to these measures was 228 billion yen in 1977, doubled to 457 billion yen in 1987, and fell down to 356 billion yen in 1998 in nominal terms. The STMA contains a mixed variety of measures. It certainly gives statutory basis for outright subsidies in the form of tax exemptions, credits, accelerated depreciation, and tax-free reserves. But it also contains tax increase measures including disallowance of deductions for public policy reasons, additional levy to oppress certain transactions, and countermeasure against trafficking in of artificial losses. Importantly, such measures are applied to specific industries or schemes, often accompanied by regulatory oversight by the relevant ministries. The STMA sometimes creates its own special regime as an exception to the ITA and the CTA. The taxation of financial income, which was explained in the previous section, is one example. Another example is the special regime for taxing capital gains in real estate transactions. Moreover, many of the significant rules affecting international transactions are prescribed by the STMA, examples of which rules include transfer pricing legislation, Controlled Foreign Corporation (CFC) legislation, thin-capitalization legislation, and earnings stripping legislation.



9

OECD (2010) 93. Ishi (2001) 189.

10

Corporate taxation in Japan  297 The provisions of the STMA are meant to apply only for the time being. They often have a sunset clause of 2 to 3 years. Such tax measures are destined to expire unless legislators intervene to postpone their deadlines. There is thus an opportunity for a policy review on the effectiveness of the incentives in the tax law-making process. Pressure groups try to intervene and make a lobbying effort to extend these measures. As a result, many tax relief measures survive for a newly extended period. Occasionally taxpayers raise constitutional challenges to the provisions of the STMA on the ground of the equality clause of the Japanese Constitution. However, there is not a single court case which invalidates the STMA provision because the standard of review taken by the Supreme Court is not stringent. Tax legislations generally do not violate the equality principle unless they are proven to be manifestly unreasonable in terms of their objective and measure. 4.2

The Transparency Act

The use of Special Tax Measures has long been criticized. In 1964, the Tax Commission, a governmental body that makes deliberations on tax policy in response to inquiry by the Prime Minister, developed a general policy guidance to control Special Tax Measures. The guidance asks policymakers to consider the following three aspects: (1) reasonableness of the underlying policy objective, (2) effectiveness as a policy measure, and (3) adequate balance between the accompanying costs and benefits of the measure. In 2010, the government legislated the Act concerning the Transparency in the application status of Special Tax Measures (the ‘Transparency Act,’ Law No.8 of 2010). The Transparency Act requires corporate taxpayers to submit a detailed account showing: (1) the content of the Special Tax Measures they seek to apply and (2) the amount of increase or decrease of income or tax due to the application of such measures. Failure to report such information, or false information in the detailed account, results in the non-application of the relevant special tax measure. The scope of the information reporting is limited to the Corporation Tax. The Transparency Act mandates the Ministry of Finance (MOF) to conduct a survey based on the information submitted by corporate taxpayers and to report the result to the Diet every year. The most recent report was produced in January 2022, covering the taxable year ending between 1 April 2020 and 31 March 2021. During that period, 1,369,793 corporations submitted detailed accounts on the total of 81 items of special measures related to the Corporation Tax. The breakdown is as shown in Table 17.1. Table 17.1

Japanese corporate tax data

Special tax rate (e.g., reduced rate for small

Number of

Number of

items

applications

2

992 354

19

145 976

Amount of tax credit: 712.8 billion yen

30

42 685

Depreciation upper limit: 813.4 billion yen

11

3 806

Deductions: 380.6 billion yen

corporations) Tax credit (e.g., R&D credit, special credit for

Amount (different measure used depending on the measure) Applicable amount of income: 3 952.5 billion yen

wage increase) Special depreciation (e.g., accelerated depreciation for specified investment) Special reserves (e.g., reserve for agricultural empowerment)

Source: MOF website, https://​www​.mof​.go​.jp/​tax​_policy/​reference/​stm​_report/​fy2021/​index​.htm.

298  Research handbook on corporate taxation Note that the aggregate number of items reported is less than 81 because some measures did not apply to any of the corporations that submitted the information. By far the biggest number of applications is reported with respect to the reduced rate for small corporations. The Transparency Act was originally introduced under the Administration formed by the union-backed Democratic Party in order to reexamine the necessity of corporate tax incentives. It was for disclosure purposes only. There was no accompanying corporate minimum tax. In 2011, the government reexamined 109 items of special measures on national taxes. As a result, 50 items were either abolished or scaled back. The political tide changed, however, when the coalition between the conservative Liberal Democratic Party and Komeito came back to office in 2012. Since 2013, successive tax legislations expanded various special tax incentives. This experience demonstrates that the Transparency Act may be an indispensable tool for disclosure, but may not be a panacea for countering the proliferation of tax incentive measures. The Transparency Act covers only the corporate tax-related measures. Therefore the annual report produced by the MOF to the Diet does not cover tax incentives in other significant taxes, such as personal income tax, VAT, inheritance tax, and local property tax. In November 2016, the Board of Audit of Japan, a governmental agency set up by the Japanese Constitution, produced an ad hoc report on the status of application regarding special measures on personal income tax. It specifically mentioned the special rules for dividend non-filing and for pension premium deductions. It urged relevant governmental bodies to collect data on their application status and to use such data in their policy evaluation and tax policy formulation.

5.

THE HALF-TERRITORIAL SYSTEM OF TAXING FOREIGN INCOME

5.1

Exemption of Foreign Dividends

In 2009 Japan, which until then had relied solely on a tax credit system in taxing foreign source income, introduced an exemption system for certain foreign dividends, replacing the indirect foreign tax credit.11 The exemption applies to dividends from a foreign subsidiary in which a Japanese resident company holds 25 percent or more of the equity ownership. The exempt amount is 95 percent of the dividends received by the parent company because 5 percent is deemed as a cost for receiving the dividends. The exemption was introduced in order to facilitate the repatriation of foreign profits kept abroad.12 Japan’s corporate tax rate then was 39.5 percent, national and local taxes combined, when the exemption was introduced. The Japanese parent company faced a higher marginal tax rate compared with the underlying corporate tax rate in foreign jurisdictions. The parent company had to pay an additional tax on dividend repatriation even when the indirect foreign tax credit system was fully functional. This made the parent reluctant to receive dividends from its foreign subsidiaries. The exemption of dividends was a solution to remove this bias against repatriation. The business circle welcomed the switch to the exemption system which was simpler to comply with than the former indirect tax system. Ault, Arnold and Cooper (2019) 611. See Masui (2010) and Morotomi (2017).

11 12

Corporate taxation in Japan  299 The reform seems to have produced the intended result. According to one empirical study, foreign affiliates with a large stock of retained earnings were generally more responsive to the reform, and significantly increased dividend payments to their parent firms in response to the dividend exemption system.13 Also, dividend payments by these affiliates became more sensitive to withholding tax rates on dividends levied by host countries under the new exemption system. This finding is consistent with the expected rise in Marginal Reimbursement Rate (MRR) for foreign tax paid by Japan-based multinationals. Readers should be reminded of the higher corporate tax rate when the foreign dividend exemption was introduced in 2009. The rate differential between the Japanese parent and the foreign subsidiary was the essential background to the introduction of the exemption. After 2009 Japan’s corporate tax rate has been reduced several times. A relevant question is whether these rate cuts have made the exemption unnecessary. Apparently the answer is in the negative. As shown in 2.4, the current tax rate is slightly less than 30 percent, national and local taxes combined. It is still higher than the corporate tax rates in most foreign jurisdictions. Therefore the exemption of foreign dividends still functions as a tax neutralizer for dividend repatriation under the current tax rate setting. After 13 years of operation, the dividend exemption seems now entrenched in the taxation of foreign corporate income. 5.2

A Halfway Territorial System

Japan’s 2009 legislation was a halfway territorial method of taxing foreign income, in contrast to the U.K., the system of which moved to a full territorial system around the same period.14 The structural feature of Japan’s 2009 legislation has been kept intact until today. Thus, foreign branch income of a Japanese resident company is fully subject to Japan’s Corporation Tax. Japanese companies are also taxed on the interest and royalties paid by foreign entities as well as dividends repatriated from non-subsidiaries. Moreover, the exclusion does not apply to capital gains/losses arising from the disposition of shares in a subsidiary. As is clear from the foregoing, Japan’s Corporation Tax still holds on the principle of taxing worldwide income, modified only by the targeted exemption of foreign dividends from certain subsidiaries abroad. This chapter makes two related points. The first point concerns the role of CFC legislation after Japan’s CIT went half-territorial. The switch to the dividend exemption system weakened the traditional rationale of anti-deferral. More emphasis was placed on its role as a weapon against profit shifting. In 2010, a new system was introduced to capture certain passive income earned by CFCs.15 Following the Base Erosion Profit Shifting (BEPS) final Recommendation on Action 3, the 2017 reform further remodeled the CFC legislation. The new rule had three legs. (1) It continued to tax the specified items of passive income as income of the resident shareholders who own more than 10 percent shares in the CFC. (2) It taxed the income of those CFCs whose activities are suspected of profit shifting, such as paper companies, corporate cash box, certain insurance companies, and CFCs located in a black-listed jurisdiction, unless the tax burden for the taxable year is 30 percent or more. (3) It taxed the income of those CFCs that fail to meet Hasegawa and Kiyota (2017). Masui (2021) 723. 15 Lokken and Kitamura (2010) observe that effective CFC rules are an essential backstop to a dividend exemption, with three case studies. 13 14

300  Research handbook on corporate taxation any of the economic substance tests (business activity test, asset and active management test, and location/non-related party test) unless the tax burden for the year is 20 percent or more. The second point concerns the boundary between domestic/foreign corporations. If the NTA was able to freely recharacterize the status of a foreign subsidiary as domestic, the whole discussion of taxing foreign income would be overturned, because then the income earned by the subsidiary would be subject to worldwide taxation just as other ordinary resident companies. As a matter of fact, the NTA has not tried to pursue this line of aggressive challenge. The legal background is as follows. Domestic corporation for tax purposes is defined as a corporation having its ‘head office or principal office’ in Japan.16 Significantly, this definition is interpreted rather formally. When a joint stock company is organized under Japan’s Company Act, it must determine the location of its head office by its bylaw and make a registration at the registry office. The company is incorporated by the act of registration at the location of the head office. The location of the head office establishes the exclusive jurisdiction for various forms of company litigation. Therefore, it is impossible to locate the head office outside of Japan’s territory. Accordingly, as long as Japan’s Company Act is the governing law, the head office is always within Japan. The company automatically becomes a domestic corporation for tax purposes. The same applies to the principal office which must be registered by a general corporation organized under the General Corporation Act. This has been an established practice, although there is no court case that explicitly confirms the above interpretation. What comes closest is the Supreme Court Decision of 18 February 2011 which dealt with the residence of an individual for gift tax purposes.17 In that case the Supreme Court refused to depart from the Civil Code definition of residence for individuals. Likewise, the Supreme Court may use a similar reasoning to refer to the Company Act definition, also regarding the interpretation of corporate tax definition of residence.

6. CONCLUSION This chapter reviewed the corporate taxation in Japan. It first outlined its basic structure. It then discussed three topics and made the following points: ● The integration of corporate and shareholder taxes is both imprecise and incomplete. ● Corporate tax expenditures are becoming more transparent. ● The corporate taxation on worldwide income has gone halfway territorial. To finance the huge public debt, the CIT despite its flaws may be indispensable for Japan’s tax mix in the coming years. The survey in this chapter suggests that there is scope for improvements in its structural design.

In 2020, the Tax Commission rejected the policy of adding a ‘place of effective management’ test. See Masui (2015) 508.

16 17

Corporate taxation in Japan  301

REFERENCES Ault, H.J., B.J. Arnold and G.S. Cooper, Comparative Income Taxation (4th edition, Wolters Kluwer, 2019) Brownlee, W.E., E. Ide and Y. Fukagai, eds, The Political Economy of Transnational Tax Reform: The Shoup Mission to Japan in Historical Context (Cambridge University Press, 2013) Hasegawa, M. and K. Kiyota, The Effect of Moving to a Territorial Tax System on Profit Repatriation: Evidence from Japan, Journal of Public Economics, Vol.153, No.1 (2017) 92 Ishi, H., The Japanese Tax System (3rd edition, Oxford University Press, 2001) Kaneko, H., The Reform of the Japanese Tax System in the Latter Half of the Twentieth Century and into the Twenty-First Century, in Daniel H. Foote, ed., Law in Japan: A Turning Point (University of Washington Press, 2007) 564 Kawabata, Y., Corporate Income Taxation in Japan: General Introduction, Bulletin for International Taxation, Vol.61, No.9/10 (2007) 387 Lokken, L. and Y. Kitamura, Credit vs. Exemption: A Comparative Study of Double Tax Relief in the United States and Japan, Northwestern Journal of International Law & Business, Vol.30, No.3 (2010) 621 Masui, Y., Taxation of Partnerships in Japan, Bulletin for International Fiscal Documentation, Vol.54, No.4 (2000) 150 Masui, Y., Transformation of Japan’s Corporation Tax: 1988–2000, Bulletin for International Fiscal Documentation, Vol.55, No.3 (2001) 100 Masui, Y., Taxation of Foreign Subsidiaries: Japan’s Tax Reform 2009/10, Bulletin for International Taxation, Vol.64, No.4 (2010) 242 Masui, Y., The Responsibility of Judges in Interpreting Tax Legislation: Japan’s Experience, Osgoode Hall Law Journal, Vol.52, No.2 (2015) 491 Masui, Y., Japan’s Corporate Income Tax: 1995–2021, Bulletin for International Taxation, Vol.75, No.11/12 (2021) 715 Matsuda, N. and S. Ino, Japan, in IFA, Trends in Company/Shareholder Taxation: Single or Double Taxation?, Cahier de droit fiscal international, Vol.88a (2003) 571 Morotomi, T., Japan’s Shift to Territoriality in 2009 and the Recent Corporate Tax Reform: A JapanUnited States Comparison of Taxing Income from Multinationals, Pittsburg Tax Review, Vol.14, No.2 (2017) 173 Nagato, T., A General Anti-Avoidance Rule (GAAR) and the Rule of Law in Japan, Public Policy Review, Vol.13, No.1 (2017) 35 OECD, Tax Expenditures in OECD Countries (2010) OECD, Corporate Tax Statistics (3rd edition, 2021) Ota, Y., Tax Treatments for Distressed Bank Loans: A Comparative Study of the United States and Japanese Legal Systems, Pacific Rim Law Policy Journal, Vol.10, No.3 (2001) 543 Policy Research Institute of the Ministry of Finance Japan, Tax System Reform: Evidence-Based Policy Recommendations, Public Policy Review, Vol.14, No.2 (2018)

18. Corporate taxation in China Wei Cui

INTRODUCTION In 2021, the Enterprise Income Tax (EIT) in China raised CNY 4.2041 trillion in revenue (equivalent to USD 651.5 billion), making it the world’s largest corporate income tax.1 The EIT has consistently contributed a significant share to total tax revenue in China during the last two decades,2 and is surpassed currently only by general taxes on goods and services and social insurance contributions in importance (see Figure 18.1). Capital taxation in China has become a critical piece in the measurement of global factor income taxation,3 and the EIT clearly constitutes the most substantial component of Chinese capital taxation. Yet scholarly research on the EIT – whether of the legal, economic, or accounting varieties – still forms a small body of literature, and our collective understanding of the EIT’s workings remains limited. There are several relevant explanations. The first is the EIT’s relative youth. Most of the current corporate organizational forms used in China became available only in the early 1990s, when China’s urban sector began its transition to a market economy. A general CIT regulation for domestic firms was adopted only in 1993, and it assumed legislative form only in 2008, when an Enterprise Income Tax Law (EITL) that applies to both domestic and foreign-owned firms was enacted.4 China’s rapid economic transition implies not only that scholarship about the EIT began to accumulate only recently, but also that some of the earlier scholarship quickly became obsolete. Second, during the same early stages of evolution of the CIT in developed countries (in the first half of the 20th century), law played a crucial role in shaping its content. In countries like the U.S. and Canada, legislators debated about and crafted detailed CIT rules, and courts actively interpreted such rules.5 In this setting, both public and scholarly understandings of USD 1 = CNY 6.453 at the average exchange rate in 2021. In comparison, U.S. federal corporate income tax revenue in 2021 was $372 billion, while total state and local corporate income tax collection in the U.S. was $75.754 billion in 2020 (the last year for which data is available). 2 This chapter refers to the ‘CIT’ when discussing the corporate income tax conceptually and comparatively, and to the ‘EIT’ when discussing the CIT’s particular Chinese incarnation in the Enterprise Income Tax. 3 Rising capital taxation in China substantially contributes to rising capital taxation in developing countries. Pierre Bachas, Matthew H. Fisher-Post, Anders Jensen, and Gabriel Zucman, ‘Globalization and Factor Income Taxation,’ NBER Working Paper No. 29819 (2022), Figure 4. 4 Enterprise Income Tax Law (Presidential Decree [2007] No. 63, effective 1 January 2008; amended in 2017 and 2018); Enterprise Income Tax Law Implementation Regulations (State Council, Decree No. 512, 2007) (‘EITLIR’). 5 This was arguably all because the income tax was collected on the basis of self-assessment: large populations of taxpayers had to learn, on their own or through tax advisors, what tax rules applied to them, and they filed tax returns and remitted taxes as a part of their general compliance with the law, with only limited intervention from tax authorities. See Wei Cui, The Administrative Foundations of the Chinese Fiscal State (Cambridge University Press, 2022), Chapter 8. 1

302

Corporate taxation in China  303 the CIT rested on legal foundations. By contrast, the articulation of EIT rules through legal institutions in China is sparse. Statutory language provides limited guidance. Courts are rarely involved in the interpretation and application of EIT rules. Most guidance on the EIT’s application takes the form of informal policy announcements by the Ministry of Finance (MOF) and State Taxation Administration (STA), public knowledge of which used to be patchy, and such national guidance is in any case often lacking in detail.6 The resulting shallowness of common knowledge about the EIT arguably also impedes scholarly research.7

Note: Trends in Chinese tax structure (as % of total revenue), 1999–2020.

Figure 18.1

Composition of tax revenue in China

A third explanation relates to China’s political structure. China’s central government claims exclusive authority in tax lawmaking. Yet it does not engage in tax administration. Instead, tax collection is handled by city-, county-, or even lower-level tax bureaus, which are separated from the central government by at least one (the province) and often more bureaucratic

Id., Chapter 7. It is consequently important for any analysis of the EIT not to stop at the text of the EITL and the EITLIR. This chapter will refer to informal policy announcements by their official document numbers – enough for an interested reader to determine the official basis of rules summarized, but avoiding full title citations that may be excessive for an overview chapter. 7 The lack of such common knowledge is reflected in the underdevelopment of tax curricula in Chinese legal and accounting education: textbooks and treatises about EIT’s details are few and not commonly used. 6

304  Research handbook on corporate taxation tiers. Decentralized tax collection has resulted in considerable friction in upward information transmission. Until recently, most provinces did not have centralized taxpayer databases, and consequently the MOF and STA, which rely on provinces for taxpayer information, lacked access to taxpayer data. Few EIT statistics are publicly available, and national policy discussions often generate little information regarding policy impacts. Data available for economic analyses is scant: to date, most empirical studies of the EIT are based on highly aggregated statistics, financial disclosures of large listed companies, surveys of industrial firms conducted by statistical agencies, or, at best, taxpayer surveys (but not tax returns) of larger firms.8 Besides these general institutional backgrounds, a critical legal background to understanding the Chinese EIT is that the Chinese personal income tax (PIT) remains quite underdeveloped.9 In addition to its relatively meagre revenue intake (Figure 18.1), the PIT’s arrested development is manifest also in its excessive simplicity. In U.S. tax law lingo, there are few ‘above-the-line’ deductions permitted to arrive at accurate depictions of income earned.10 This is important for the EIT for two reasons. First, it means that EIT rules are the most important area in which income tax norms are elaborated. One cannot assume that income tax accounting applies similarly to individual and corporate taxpayers, and that, in discussing the CIT, only rules special to corporate level taxation or those governing transactions among corporations and shareholders require consideration. Second, the tax consequences of corporate transactions with individual shareholders become much simpler. There is, for example, no such thing as ‘capital loss’ for individual shareholders, because the PIT has no place for the deduction of losses from investments (against either capital gains or other types of income). Also, few shareholders would have ordinary (i.e. non-capital) gains or losses from shareholding, because trading activities are not treated as a type of ‘business’ that would give rise to taxable sole-proprietor business income. The income tax consequences of individuals’ shareholding are therefore limited to the receipt of dividends or capital gains from the sale of shares, both of which are generally taxed at 20 percent. Section I in this overview discusses the EIT’s personal scope, thereby identifying the (in) significance of the pass-through and the tax-exempt sectors. Section II discusses a range of determinants of the effective tax burden for corporate taxpayers, including the graduated rate structure, tax exemptions and rate reductions, local tax rebates, policy-based modifications of the income tax base, and income tax accounting rules. Section III considers key rules governing transactions between a corporation and its shareholders, as well as rules concerning corporate reorganizations and group consolidation, topics that generate some of the greatest

Cui, supra note 5, Chapter 6. The Chinese PIT collects a small share of total income tax revenue even compared to other countries with similar or lower levels of income per capita. Zhao Chen, Yuxuan He, Zhikuo Liu, Juan Carlos Suárez Serrato, and Daniel Yi Xu, ‘The Structure of Business Taxation in China,’ 35 Tax Policy and the Economy 131 (2021), 149–50. The PIT’s stagnation needs to be explained not by the lack of state capacity common to developing countries, but by specific and deliberate policy decisions made by China’s political leaders. See Cui, supra note 5, 180–85. 10 In 2018, China introduced several PIT deductions that favored high-income households that correspond to what U.S. tax specialists would call ‘below-the-line’ deductions. These deductions did little to strengthen principles regarding income measurement. See, P. Zhan, S. Li, and X. Xu, ‘Personal Income Tax Reform in China in 2018 and Its Impact on Income Distribution,’ 27 China & World Economy 25 (2019). 8 9

Corporate taxation in China  305 complexity in CIT regimes in other countries. The Conclusion finally highlights several questions the EIT poses for theories of the CIT. While this chapter explores the Chinese EIT primarily from a legal perspective, it also refers to economic and accounting research and supplies some EIT statistics based on such research. The chapter focuses on the purely domestic dimensions of the Chinese EIT, and does not consider the EIT’s application to cross-border transactions.11

I.

THE TAXABLE CORPORATE SECTOR

The EIT’s personal scope is extremely broad: subject to two explicit exceptions, it is applicable not only to all ‘enterprises’ – that is, entities organized to pursue profit – regardless of whether they have limited or unlimited liability, but also to government-affiliated institutions that are not government agencies (e.g. public schools, universities, hospitals), social organizations or ‘any other organization earning income.’12 This means, for example, that there is no general exemption from the EIT for government-owned or government-operated entities. Many such entities may still have no EIT liability, if their only sources of revenue are government budgetary appropriations, authorized fees collected from the provision of public services, charges collected on behalf of government authorities, or other types of ‘non-taxable income’ that have specific government-designated uses.13 But as long as such organizations receive other types of income, they are subject to the EIT. The two explicit exceptions from the personal scope of the EIT are ‘partnership enterprises’ and ‘individual proprietorship enterprises’ formed pursuant to specific organizational statutes.14 Partnership enterprises are subject to an underdeveloped set of rules whereby income from a partnership is taxed at the partner level, but the character of income is not necessarily preserved and losses and deductions do not flow through.15 ‘Individual proprietorship enterprises’ are taxed like other types of sole proprietorships under the PIT. The types of firms subject to flow-through taxation are few. The actual use of ‘partnership enterprises’ and ‘individual proprietorship enterprises’ is surprisingly even more limited. In a 2016 sample of the universe of firms from a large province used in a number of studies discussed below, out of over 2 million registered entities, less than 1 percent are partnerships, and only about 7 percent are ‘individual proprietorship enterprises.’

Perhaps not surprisingly, scholarly publications in English on Chinese international taxation are more voluminous than such publications on the EIT’s domestic aspects. For earlier treatments of Chinese international taxation, see Fuli Cao, Corporate Income Tax Law and Practice in the People’s Republic of China (Oxford University Press, 2011); Jinyan Li, International Taxation in China: A Contextual Analysis (IBFD, 2016). 12 EITLIR Art. 3. 13 EITL Art. 7 and EITLIR Art. 26. 14 Chinese civil law recognizes non-statutory partnerships, but such ‘civil law partnerships’ are not explicitly carved out of the EITL’s scope. Similarly, ‘individual proprietorship enterprises’ are to be distinguished both from the vast population of sole proprietors that are not viewed as organizations (and therefore outside the scope of the EIT) and from limited liability companies with single owners and subject to the EIT. 15 Wei Cui, ‘The Prospect of New Partnership Taxation in China,’ 46 Tax Notes Int’l 625 (2007). 11

306  Research handbook on corporate taxation Besides partnership and individual proprietorship enterprises, there are no exempt organizations per se under the EIT. The EITL does provide that the income of ‘qualified non-profit organizations’ (QNPOs) may be exempt from taxation.16 The EITL’s implementational regulations (EITLIR) specify the eligibility criteria for QNPOs, and provide that exempt income received by QNPOs does not include income derived from for-profit activities, unless the MOF and STA prescribe otherwise.17 However, the MOF and STA subsequently ruled that, even for QNPOs, income exempt from the EIT only includes donations received,18 government subsidies (not including compensation for services rendered to the government), membership dues made mandatory by government agencies, and bank deposit interest derived from these previous ‘income’ sources.19 No income from the provision of goods or services or from investment (even through non-profit activities) is ever exempt. QNPOs’ exempt status thus currently carries little interest from the perspective of income taxation.20 The vast majority of EIT taxpayers are ‘limited liability companies’ governed by the Company Law. A second corporate form governed by extensive rules in the Company Law is the joint stock company: it is a required form for listed companies, and extensively studied by Chinese corporate law scholars. But it is used by less than 0.5 percent of corporate taxpayers.21

II.

RATE AND BASE DETERMINANTS OF EFFECTIVE TAX RATE

1.

Graduated Average Rates

The EIT deploys a graduated rate structure – and to an extent that cannot be inferred from the statutory language alone. The regular and most often-cited EIT rate is 25 percent. But in the past decade, only a small portion of Chinese corporate taxpayers were subject to this rate, thanks to an extra-statutory regime for ‘small and micro-profit enterprises’ (SMPEs). The EITL (Art. 28) provides that an SMPE is entitled to a reduced 20 percent rate. To specify the scope of the reduced rate’s application, the EITLIR (Art. 92) defined SMPEs in terms of certain employee (80), asset (CNY 10 million), and annual taxable income (CNY 300,000) thresholds. However, in 2009, the MOF and STA announced that firms that satisfied the SMPE asset and employee criteria under the EITLIR and that earned less than CNY 30,000 in taxable income may include only half of such income when calculating their EIT liabilities in 2010. Eligible firms in effect faced a 10 percent EIT rate. In a series of subsequent tax cuts, the MOF and STA not only extended the half-income-inclusion rule for additional years, but also gradually lifted the taxable income

EITL Art. 26. EITLIR Arts. 84 and 85. 18 Under regular EIT rules, donations/gifts represent income to the recipient: EITL Art. 6(8). 19 Caishui [2009] 122. 20 In any case, the number of registered non-business social organizations in China appears to remain small. In the provincial taxpayer database cited above, they represent less than 1 percent of registered entities. 21 However, the U.S. Treasury treats the joint stock company as the only form of per se corporation in China and all limited liability companies are eligible for ‘checking the box.’ 16 17

Corporate taxation in China  307 eligibility threshold.22 By 2016, all businesses describable as SMPEs under the EITLIR’s definition had become entitled for the half-income-inclusion rule. In other words, no Chinese firm was supposed to be paying the 20 percent tax rate at that point. This graduated structure (under both the statutory SMPE regime and its administrative extension) describes average, not marginal, tax rates: a firm above the taxable income threshold would be subject to a higher rate on all of its income.23 In 2017, the State Council wished to extend the SMPE tax cut to more firms. Instead of doing so by amending legislation or even its own administrative statute (the EITLIR), it authorized the MOF and STA to announce, in an informal policy circular, that ‘SMPEs’ with annual income up to CNY 500,000 could claim a 20 percent tax rate and half income inclusion. This directly contradicted the EITLIR definition of SMPEs, according to which a firm with more than CNY 300,000 of taxable income could not be an SMPE. Consequently, the STA, in providing further guidance under this new policy, stated that ‘SMPE’ meant either firms defined under EITLIR Art. 92 or those described in the 2017 informal circular.24 This extra-statutory SMPE regime further expanded when the MOF and STA, again acting at the direction of the State Council, increased the ‘SMPE’ income threshold to CNY 1 million in 2018. And in 2019, they lifted the employee and asset thresholds for applying the rate cuts: firms with fewer than 300 employees and less than RMB 50 million in assets could qualify as ‘SMPEs.’ Moreover, further rate graduation is introduced: firms with less than CNY 3 million in taxable income are entitled to half income inclusion, while firms earning less than CNY 1 million of taxable income a year only had to include a quarter of their income, implying a 5 percent tax rate.25 The MOF claimed that this tax cut delivered benefits to 95 percent of all Chinese firms.26 The ‘SMPE’ term became completely unanchored from statutory law. EIT rate cuts are a favored policy instrument in China, and the expanded SMPE regime continues to evolve. In 2022, the tax rate for ‘SMPEs’ earning less than CNY 1 million of taxable income was again reduced by virtue of a new 1/8 income inclusion rule, while those earning CNY 1–3 million of taxable income became eligible for 1/4 income inclusion. The new benefits are available until the end of 2024. Although all SMPE tax rates below 20 percent have been announced as temporary, such rates have been in place for 13 out of the 15 years in which the EITL legal regime has been in place.27

Wei Cui, Mengying Wei, Weisi Xie, and Jing Xing, ‘Corporate Tax Cuts for Small Firms: What Do Firms Do?’ CESifo Working Paper No. 9389 (2021). 23 The resulting ‘notches’ in rates predictably led to bunching in taxable income reporting around the income thresholds, but, interestingly, not the asset threshold. Id. 24 For further discussions of this alternative, extra-statutory SMPE regime, see Cui, supra note 5, 215–18. 25 Caishui [2019] 13. 26 Using 2011 data on primarily large- and medium-sized firms, Chen et al, supra note 9, report that the most prevalent (modal) tax rate among firms with positive income was 25 percent. In our 2016 sample of the universe of firms from a large province, the modal rate has become 10 percent. 27 Cui et al, supra note 22, find suggestive evidence that at least before 2016, firms treat the SMPE tax cuts as temporary: manufacturing firms demonstrated positive investment responses depending on the size of the cash flow effect from the tax cut. 22

308  Research handbook on corporate taxation 2.

Preferential Tax Exemptions and Rate Reductions

In addition to rate differentiation by firm size, the EITL also offers sector-based preferential rates. For instance, income from much agricultural, forestry, and fisheries business is exempt from the EIT, while other agricultural and fisheries activities are taxed at half the regular applicable rate.28 Infrastructure and environmental protection projects enjoy tax holidays (3 years of exemption, 3 years of taxation at half the regular applicable rate).29 Income from the transfer of technology is exempt to the extent of CNY 5 million and amounts in excess of CNY 5 million are taxed at half the normal rate.30 Perhaps the best-known EIT preferential rate (aside from the ‘temporary’ tax cuts for SMPEs) is the 15 percent rate available to ‘high and new technology enterprises’ (HNTEs).31 China’s HNTE regime has attracted extensive scholarly attention.32 To qualify, a firm must submit extensive documentation regarding its business and technological profile and demonstrate that it satisfied a range of criteria including the proportion of personnel engaged in research and development (R&D) (no less than 10 percent), the proportion of revenue from the sale of high tech products and services (no less than 60 percent), and R&D intensity, measured by the ratio of R&D expenditures to sales.33 The R&D intensity requirement is size-dependent and higher for firms with lower revenue. A study based on taxpayer survey data for 2008–11 shows that firms’ observed R&D intensities bunch at the size-dependent thresholds, consistent with the fact that HNTE qualification lowers the average tax rate for all income of a firm (instead of incentivizing marginal spending).34 Moreover, firms clearly engage in ‘re-labelling’ and report other administrative expenses as R&D, despite the relatively close scrutiny they are subject to. Using a complex economic model, the authors of the study estimate that, on average, 24 percent of ‘R&D investments’ result from mis-labelling. Given firms’ propensity to mis-label, however, they argue that a preferential regime offering carefully selected firms a lower average tax rate (i.e. 15 percent) is superior to tax policy that offers marginal incentives for R&D spending to all firms.35 Moreover, they argue that even though mis-labelling results in lost revenue and the notching of average tax rates distort behavior, the HNTE program may be welfare-enhancing overall, based on reasonable assumptions about the positive spillover effects of R&D on the productivity of other firms.36

EITL Art. 27(1), EITLIR Art. 86. EITL Art. 27(2)–(3), EITLIR Arts. 87–88. 30 EITL Art. 27(4), EITLIR Arts. 87–88. 31 EITL Art. 28(2), EITLIR Art. 93. 32 See, e.g. Z. Chen, Z. Liu, J.C. Suárez Serrato, and D.Y. Xu, ‘Notching R&D Investment with Corporate Income Tax Cuts in China’, 111 American Economic Review 2065 (2021); M. Koenig, Z. Song, K. Storesletten, and F. Zilibotti, ‘From Imitation to Innovation: Where Is All that Chinese R&D Going?’ forthcoming in Econometrica (2022). 33 For the most recent version of these requirements, see Guokefahuo 2016 [32]. 34 Chen et al, supra note 32, 2069–74. 35 In reality, the EIT does offer marginal incentives to all firms for R&D spending, through the ‘super-deduction’ for such expenditures discussed below. 36 It has also been suggested that the Chinese HNTE policy is relatively unique – and effective – in requiring at least 60 percent of the R&D activity to be conducted within China. Annette Alstadsæter, Salvador Barrios, Gaetan Nicodeme, Agnieszka Skonieczna, and Antonio Vezzani, ‘Patent Boxes Design, Patents Location, and Local R&D,’ 33 Economic Policy 131 (2018). 28 29

Corporate taxation in China  309 If one only examined the EIT statute and formal regulations to identify tax exemptions and rate reductions, one would miss the vast majority of national preferential policies – and be under the serious mis-impression that the Chinese EIT is much more uniform in its treatment of firms from different regions and industries than CIT regimes in other countries. In reality, most national preferential EIT policies are adopted by the MOF and STA without specific statutory authorization, through informal policy announcements.37 The 15 percent reduced rate, for example, is available not only to HNTEs but also to ‘technologically advanced service firms’ that export a substantial portion of their services, firms operating in encouraged industries and designated western China regions, and firms in an ever-growing set of free-trade zones and special economic zones. The list of tax exemptions, holidays, and reductions offered over the years is much longer.38 An examination of such a list would show that rate cuts, as opposed to modifications of the tax base, represent the dominant type of tax preference. 3.

Local Tax Rebates as Rate Reductions

Chinese local governments are notorious for offering tax cuts to attract business investment.39 While there is only one EIT in China – there are no subnational income taxes per se – 40 percent of EIT revenue is allocated among provincial and sub-provincial governments.40 And local governments, especially at the county, district, and sometimes even lower (e.g. township) levels, are known for the practice of extending rebates of their share of EIT revenue to persuade businesses to locate in their jurisdictions. Because the national government disfavors such rebates, they are usually offered in secret during individual negotiations between local governments and businesses and as fiscal subsidies rather than tax cuts.41 But such rebates effectively reduce the applicable EIT rate, and reinforce the practice of offering tax incentives through rate reductions instead of base modifications.

37 EITL Art. 36 provides that ‘where the national economic and social development so requires, or the business operations of enterprises have been seriously affected by emergencies and other factors, the State Council may formulate special preferential policies concerning the EIT and submit them to the Standing Committee of the National People’s Congress for archival purposes.’ 38 An official compilation of pre-2019 policies is found at http://​www​.chinatax​.gov​.cn/​download/​ pdf/​bszn/​44​.pdf, accessed 19 March 2023. 39 See Wei Cui, ‘Fiscal Federalism in Chinese Taxation,’ 3 World Tax Journal 455 (2011). For spatial-econometric evidence on income tax competition at the city level, see Jing Xing, Wei Cui, and Xi Qu, ‘Local Tax Incentives and Behavior of Foreign Enterprises: Evidence from a Large Developing Country,’ Singapore Management University School of Accountancy Research Paper No. 2018-S-71. 40 In a tax sharing arrangement dating back to 2002, the central government claims 60 percent of the EIT revenue collected, while provincial governments split the remaining 40 percent with sub-provincial jurisdictions. Intra-provincial EIT revenue sharing arrangements vary from province to province. 41 It is generally believed that local governments offer such tax incentives because economic growth features prominently in the performance metrics of Chinese politicians, who engage in tournament competitions for promotion. For a recent study that offers purported causal evidence, see Z. Li and A.Z. Yu, ‘The Last Strike: Age, Career Incentives and Taxation in China,’ 58 St Comp Int Dev 55 (2022). Provincial- and city-level political leaders are less likely to liberally offer businesses tax rebates both because they face less specific pressure to promote economic growth and because they are more sensitive to national government directives, which disfavor local tax competition.

310  Research handbook on corporate taxation 4.

Modifications of the Income Tax Base

The Chinese government’s propensity to offer tax incentives through exemptions and rate cuts can be contrasted with the more sparing use of tax base modifications. Consider the depreciation of tangible assets. The EITL’s basic depreciation rules are quite simple and provide only for straight-line depreciation and five fixed asset classes, with asset lives ranging from 3 to 20 years. The statute contemplates accelerated depreciation (AD) only to correct serious errors in the classification of assets for economic depreciation. In comparison, Chinese accounting rules allow both double declining balance (DDB) and sum-of-the-year’s-digits (SYD) depreciation. In 2014, the MOF and STA introduced AD for large populations of taxpayers for the first time. Effective from 1 January 2014, all firms could immediately expense newly purchased fixed assets with unit value under CNY 5,000, as well as newly purchased instruments and machinery with unit value under CNY 1 million used exclusively for R&D. For purchases with unit values greater than CNY 1 million and used exclusively for R&D, firms could also claim AD, understood as a choice of either using 60 percent of the statutory asset life for straight-line depreciation, or using DDB or SYD depreciation. In addition, firms in six manufacturing industries could apply AD to any newly purchased fixed assets, regardless of the size and purpose of the investment.42 In 2015, these investment incentives were extended to four additional manufacturing industries. All AD policies in 2014 and 2015 were introduced as permanent measures. In 2019, the Chinese government extended the incentives to all manufacturing industries, also on a permanent basis. However, initial take-up of AD benefits was very low. A study based on EIT return data from one province found that during 2014–16, firms failed to claim AD benefits on over 80 percent of eligible investments.43 One explanation is that widespread losses reduce the value of AD. An additional explanation is that, due to poor policy publicity and a lack of prior exposure, many firms are unaware or fail to grasp the policy’s benefits. Consistent with this idea, the study found that larger firms and HNTEs (which have more tax expertise because of HNTE qualification requirements) were more likely to claim AD. There is also evidence that greater local tax administration resources increase benefit take-up: both proximity to tax bureaus and a higher local tax-administrator-to-taxpayer ratio increase take-up. An important question about tax incentives is whether they mainly subsidize infra-marginal investments. The study of firm response to AD finds that the largest 5 percent of firms both are more likely to claim AD than the rest of the sample and displayed a significant investment response. However, in the rest of the sample, proxies for awareness of the AD policy do not predict greater investment, suggesting that many better-informed firms did not increase investment because of AD, but simply claimed advantageous deductions ex post. A number of other notable investment and employment incentives under the EIT modify the tax base. For all firms (i.e. not just HNTEs), there is a ‘super-deduction’ for R&D expenses: firms can either deduct 150 percent of the actual expenses, or if the expenses are required to be capitalized and amortized over time, they can claim 150 percent of the normally available

42 SMPEs in the six industries could immediately expense investments on instruments and machinery partially used for R&D and with unit values under CNY 1 million. 43 W. Cui, J. Hicks, and J. Xing, ‘Cash on the Table? Imperfect Take-up of Tax Incentives and Firm Investment Behavior,’ 208 Journal of Public Economics 104632 (2022).

Corporate taxation in China  311 amortization deductions.44 In 2017, the MOF and STA further enhanced the deduction to 175 percent for ‘technology-type medium and small enterprises’ for three years. In 2018, the 175 percent super-deduction became available to all firms until the end of 2020, and this incentive has since been extended to the end of 2023.45 In 2021 and 2022, the government separately made a 200 percent super-deduction permanently available for all manufacturing firms and ‘technology-type medium and small enterprises.’46 In terms of employment incentives, the EITLIR provides for a 200 percent super-deduction for wages paid to disabled individuals that a firm employs.47 Although the EITL also authorized the State Council to adopt other similar wage super-deductions to encourage other types of employment, no such incentive appears to have been adopted.48 Investment tax credits are also available under the EIT, but are more limited compared to deductions: 10 percent of the cost of purchase of specialized equipment used for environmental protection, energy or water saving, or production safety can be used to offset current year EIT liabilities; unused credits can be carried forward for 5 years.49 5.

Loss Carryovers

An important limitation of the EIT is that losses can be carried forward generally only for 5 years (there is no loss carryback).50 This not only results in the mismeasurement of firm income over time but also diminishes the attraction of the incentives offered by various deductions. A study based on a 2011 national sample of firms (biased towards large and medium firms) found that 40 percent of firms had non-positive profits.51 Another study based on a sample of all firms from a large province showed that the percentage of loss-making firms each year is even higher among smaller firms (ranging from 54 percent to 70 percent during 2010–16), and that the stock of accumulated tax losses represented on average 12–15 percent of the revenue of such firms.52 The presence of losses has been found to completely eliminate the effect of the tax cut for SMPEs, and also sharply reduce the claim of AD benefits.53

EITL Art. 30(1), EITLIR Art. 95. Firms in numerous industries (e.g. wholesale and retail, hospitality and restaurants, entertainment, real estate, and rental and commercial services) are precluded from taking R&D super-deductions (Caishui [2015] 119). Starting in 2018, expenses from R&D performed outside of China are eligible for the super-deduction, but (i) only 80 percent of the actual amount of such expenses are considered and (ii) only if expenses from R&D performed outside of China do not exceed 2/3 of total R&D expenses. Caishui [2018] 64. 45 Caishui [2018] 99 and MOF/STA Bulletin [2021] No. 6. 46 MOF/STA Bulletin [2021] No. 13; MOF, STA and Ministry of Science and Technology Bulletin [2022] No. 16. 47 EITL Art. 30(2) and EITLIR Art. 96. 48 Limited per worker tax credits have been made available, but usually such tax credits are used first against liabilities for taxes other than the EIT (such as the value added tax). 49 EITL Art. 34, EITLIR Art. 100. The purchased equipment must also be held and used for 5 years; the transfer or loss of such equipment within 5 years leads to the claw back of the credits. 50 EITL Art. 18. 51 Chen et al, supra note 9. 52 Cui et al, supra note 22. 53 Id. (loss firms show no response to SMPE tax cuts); Cui et al, supra note 43 (loss firms fail to take up AD benefits). 44

312  Research handbook on corporate taxation In 2018, the MOF and STA permanently extended the duration of permitted loss carryover from 5 to 10 years – but only for HNTEs and ‘technology-type medium and small enterprises.’54 Since AD and R&D super-deductions are now generally available to all manufacturing firms, the expansion of favorable loss carryover treatment still lags the expansion of tax incentives based on base modification. 6.

Income Tax Accounting

As mentioned in the Introduction, the elaboration of income tax norms in China primarily takes place in the EIT context. Many features of the EIT require taxpayers to account for income or losses in ways that are substantially different from financial accounting rules. Two examples that may especially resonate with tax scholars elsewhere are the taxation of gift transactions and income from the cancellation of debt (CODI). The receipt of donations by an EIT taxpayer gives rise to taxable income,55 but gratuitous giving in the form of sponsorships – which are distinct from contributions to recognized charities and from advertising expenses – are not deductible to the donor,56 illustrating that rare pairing of inclusion by the donee and non-deductibility by the donor that is discussed only as a theoretical possibility in other tax systems. In terms of CODI, the EIT explicitly requires taxpayers to recognize income when payable amounts are determined to be unpayable, and when debt liabilities are reduced as a result of debt restructuring.57 Though the pursuit of a business is likely to be in the background for both occasions of CODI recognition, neither is required under accounting rules. There are many other instances of EIT rules overriding accounting principles. Entertainment expenses, for example, are not fully deductible: only 60 percent of the amount of actual expenses are allowable as deductions, and each taxpayer’s total annual entertainment expenses cannot exceed 0.5 percent of business revenue.58 Advertising expenses in excess of 15 percent of annual sales revenue cannot be immediately deducted, but can be carried over to future years.59 And deductions for charitable contributions each year cannot exceed 12 percent of total accounting profits.60 Indeed, the EITL explicitly provides that in the computation of taxable income, whenever accounting rules conflict with tax rules set out in statutes and regulations, tax rules prevail.61 However, one might still be justified in taking the view that accounting rules serve a default role in the determination of EIT liabilities: on the annual EIT return, taxpayers are required to report a set of book-tax adjustments after reporting income and expenses, indicating that the initial computation of income and expenses are based on accounting principles. Still, there is no legal authority, especially in the complete absence of any EIT jurisprudence, for the inference that, when tax rules are silent, taxpayers are entitled to tax consequences that flow from applicable accounting rules.

56 57 58 59 60 61 54 55

Caishui [2018] 76. EITL Art. 6(8). EITL Art. 10(6) and EITLIR Art. 54. EITLIR Art. 22. EITLIR Art. 43. EITLIR Art. 44. EITLIR Art. 53. Excess contributions can be carried over for 3 years (EITL Art. 9). EITL Art. 21.

Corporate taxation in China  313 Importantly, for Chinese corporate taxpayers, there is no distinction between capital and ordinary (business) income and losses. And because this distinction is also absent from the PIT, extensive rules regarding the character of income and losses are not needed. This implies, for example, there are no rules for ‘recapturing income’ from the disposition of depreciated property, since none of the gain from such disposition receives favorable ‘capital gain’ treatment.

III.

TRANSACTIONS BETWEEN CORPORATION AND SHAREHOLDERS

Under China’s PIT, labor and business income faces higher marginal tax rates than the highest EIT rate of 25 percent: the highest marginal rate on wages is 45 percent, on non-wage labor compensation 36 percent, and on self-employed or sole-proprietor income 35 percent. Because the applicable EIT rate is often much lower (per Section II.1–2 above), and because the EIT allows a much larger range of deductions than the PIT, incentives for individual entrepreneurs to earn labor or business income through corporations would appear to be substantial. This is consistent with empirical evidence. In the dataset on the universe of firms from a large province cited above, companies owned by a single individual investor represented almost 40 percent of all companies formed in recent years.62 Moreover, companies majority-owned by individuals represent more than 85 percent of all companies, whereas those majority-owned by other companies represent less than 6 percent (and companies that are wholly owned by another company only 3 percent). However, it is also worth noting that under the PIT, the investment income (e.g. dividends, interest, and capital gains) of individuals are generally subject to a flat 20 percent rate. This relatively lower, non-progressive tax on individual investment income somewhat mitigates incentives to earn investment income through closely-held corporations. Moreover, publicly traded equity is already lightly taxed to individual shareholders. For shares traded on the Shanghai and Shenzhen stock exchanges, the MOF and STA have exempted individual investors’ capital gain from the on-exchange sale of shares from the PIT since 1997. Since 2013, the tax rate on dividends paid on shares purchased on the stock exchanges has depended on the investor’s holding period: for shares held for more than a year, the rate is only 5 percent; for shares held for between a year and a month, the rate is 10 percent; only dividends on shares held for a month or less are subject to the full 20 percent rate.63 The use of closely-held corporations for making financial investments therefore may be limited.64

62 Wei Cui and Mengying Wei, ‘Unleashing Mass Entrepreneurship: Firm-Level Evidence on the Impact of China’s Registered Capital Reform,’ working paper, available at https://​papers​.ssrn​.com/​sol3/​ papers​.cfm​?abstract​_id​=​3914483, accessed 17 April 2023. This proportion especially increased after a legislative change in 2014 that reduced the equity contribution requirement for new companies. 63 O. Li, H. Liu, C. Ni and K. Ye, ‘Individual Investors’ Dividend Taxes and Corporate Payout Policies’, 52 Journal of Financial and Quantitative Analysis 963 (2017). This study reports that share repurchases by listed companies have been uncommon in the past. 64 However, at least in theory, because investment losses can be deducted by a business entity (corporate or non-corporate) but not by an individual, an entity can facilitate the offset of investment loss against investment gain.

314  Research handbook on corporate taxation 1.

Shareholder Benefits and Loans

Unsurprisingly, there are many anecdotal reports that in China’s vast population of small and closely-held companies, corporate funds are often used to pay for personal expenses. The government has long taken the stand that corporate payments for shareholders’ personal consumption expenses and purchases of consumption goods are non-deductible and moreover taxable under the PIT as dividends to shareholders.65 Moreover, funds loaned by companies to shareholders, if not repaid within the same year the loan is made and not used by the shareholders for ‘enterprise operations,’ will be treated as dividends.66 Failures to keep personal and corporate funds separate also go the other way: shareholders may lend funds to their companies for business operations. Because the applicable EIT rate is often lower than the 20 percent PIT rate that interest income is subject to in the hands of an individual, interest payments on loans from shareholders would not normally serve as a tax planning device. Perhaps because of this, the MOF and STA have allowed interest payments to shareholders and other individuals to be deducted in computing corporate taxable income, even though the law (likely out of neglect) does not provide for such deductions.67 The deductions are subject to generally applicable limitations on related parties’ loans regarding the interest rate and thin capitalization.68 2.

Contributions, Distributions and Reorganizations

Generally, shareholder contributions of assets to corporations (whether during incorporation or subsequently) are taxable events under the EIT.69 The making of in-kind contributions to a company thus triggers the recognition of either income or losses to the transferor.70 For individual shareholders, the amount realized in an exchange of assets for shares is determined by subtracting the basis of the asset from the value of the assets relinquished.71 Such valuation of assets contributed (rather than the value of shares received) will in turn determine the shareholder’s basis in the shares received. Moreover, individual shareholders can pay the tax liability from gains realized on the exchange over up to 5 years.72 Similar rules apply when the shareholder is a company, and both

This position, however, does not consider whether the company has sufficient profits to make dividend distributions, and whether, in the common case that the company has losses, the expenditure/ distribution should be treated as a return of capital instead. 66 Caishui [2003] 158 and Caishui [2008] 83. 67 Guoshuihan [2009] 777. EITLIR Art. 38 only provides for deductions for interests paid to non-individual lenders. 68 Caishui [2008] 121. Under China’s thin cap rules, interest on loans from related parties that exceed two times the equity capital of the borrower is not deductible. 69 Caishui [2015] 41 (PIT treatment of individual shareholders); EITLIR Art. 25 (treatment of corporate shareholders). 70 Neither the PIT nor EIT regime in China contains rules generally denying losses from related party transactions that are analogous to the United States Internal Revenue Code Section 267. 71 Caishui [2015] 41, par. 2. Moreover, if the contributed assets are shares of another company, the valuation of such shares upon contribution is governed by a separate set of rules focused on preventing the under-valuation of shares. STA Bulletin [2014] No. 67. 72 Cash considerations received from asset contributions and from the (partial) disposition of the shares received are required to be used to pay down such tax liability. STA Bulletin [2015] No. 50. 65

Corporate taxation in China  315 the transferor and transferee companies are residents in China.73 In other cases (i.e. where the transferor or transferee is non-resident), the shareholder’s basis in the shares received is determined by the shares’ fair market value, which presumably means that the amount received on the exchange is also determined by the shares’ fair market value and not the value of the assets contributed.74 There is also no deferral of payment of the tax liability on gains.75 Regardless of the nature of the contributing shareholder, the company takes fair market value basis in the assets received.76 Corporate liquidations are also generally realization events, including the complete liquidation of a subsidiary into a parent corporation. A liquidating company must pay EIT on its ‘liquidation income,’ computed as the difference between the cash or fair market value of the total assets available to shareholders for distribution minus the adjusted basis of the assets. All assets distributed (after the payment of EIT on liquidation income) are treated as dividends to the extent of undistributed earnings, and any remaining amount would give rise to a gain or loss to the extent it exceeds (or falls short of) the cost of the shares.77 That asset contributions to and distributions from corporations are generally taxable invites the question of whether and when deferral (non-recognition, ‘rollover’) treatments are available. Similarly to the U.S., the tax treatment of corporation reorganizations was a prominent topic during the early evolution of the CIT in China. This was because the CIT’s introduction in the early 1990s was fundamentally motivated by China’s transition to a market economy, and large-scale asset sales and reorganizations involving state-owned enterprises (SOEs) were integral to such transition.78 However, by 2009, when the MOF and STA put in place a new set of rules governing reorganizations, such society-wide asset reallocations originating from the state-owned sector was already over. Under the 2009 rules (as subsequently modified),79 the following transactions are treated eligible for ‘special treatments’ including the deferral of gain/loss recognition and carryover of basis: ● Debt-to-equity recapitalizations in the context of debt restructurings;80 ● ‘Share acquisitions’ where the acquiring company acquires at least 50 percent of all the shares of the target company, and uses its own shares or the shares of controlled subsidiaries as at least 85 percent of the consideration;81

Caishui [2014] 116. EITLIR Art. 71(2). 75 STA Bulletin [2010] No. 19. 76 EITLIR Arts. 58(5). 77 EITL Art. 55; EITLIR Art. 11; Caishui [2009] 60. 78 Wei Cui and Richard Krever, ‘The Tax Consequences of Corporate Reorganisations in China’ 3 British Tax Review 340 (2011). 79 Caishui [2009] 59; STA Bulletin [2015] No. 48. 80 Debt restructurings are, by definition under Caishui [2009] 59, situations in which the debtor faces financial difficulties and is released from some repayment obligations (and therefore has CODI). 81 Initially, a share acquisition was eligible for special treatment only if 75 percent or more of the shares of the target is acquired. This requirement was lowered in 2014 to 50 percent pursuant to a State Council initiative to promote reorganizations and reallocation of assets. Caishui [2014] 109. 73 74

316  Research handbook on corporate taxation ● ‘Asset acquisitions’ where a target company transfers at least 50 percent of its total assets to an acquiring company,82 and the acquiror pays consideration no less than 85 percent of which comprises the shares of the acquiror or of controlled subsidiaries; ● ‘Divisions’ where the shareholders of a company being divided receive pro rata the shares of the company spun off, where both the divided and spun-off companies continue previous operations, and where share considerations represent no less than 85 percent of the consideration received by shareholders of a company divided. In addition to these formal requirements, the above reorganization transactions are eligible for special (i.e. deferral) treatment only if additional requirements regarding reasonable business purpose, continuity of business (for 12 months), and continuity of interest (major shareholders of the previous target, absorbed, or divided company must retain shares received for at least 12 months). In characterizing transactions as eligible or ineligible reorganization, account may also be taken of transactions during the 12 months both before and after the reorganization transactions according to the principle of substance over form. China’s ‘special reorganization’ rules were deliberately modeled on the U.S. federal income tax treatment of corporate reorganization, although resemblance is only partial. A number of other special treatments of corporate reorganizations have more native origins. For example (as discussed below), China does not have a consolidated returns regime, but an MOF-STA policy announcement in 2014 provided that among resident companies that bear 100 percent control relationships, transfers of assets or shares for no consideration (which are called huazhuan or reallocations) that are recorded by both the transferor and the transferee at book value are treated as non-recognition transactions.83 Because such transfers are legally defined only for SOEs, this rule appears only to accommodate SOEs that are (still) unable to accomplish the same reallocations pursuant to normal contractual practices. Another type of unusual tax treatment of reorganizations involves taxable transactions that SOEs engage in that do not qualify for deferral treatment under general rules, but where the SOEs obtain special income tax exemptions by obtaining individual rulings. While no tax is collected from the transactions, the new owners of assets or shares after the reorganizations obtain stepped-up basis.84 3.

‘De-Consolidation’ among Group Members and Branches

Inter-corporate dividends are exempt from EIT for the recipient company, unless the shares on which dividends are paid are listed shares held for less than 12 months.85 Aside from this basic rule for relieving multiple layers of entity-level taxation, the EIT does almost nothing by way of special treatment of intra-group transactions. Before 2009, a select set of SOE groups were eligible for consolidation treatment, whereby losses of some group members can be used to

The 50 percent asset transfer requirement was also the result of a 2014 relaxation of previous requirements, under which 75 percent or more of all assets must be transferred by the target. 83 Caishui [2014] 109, par. 3. 84 Wei Cui, ‘Taxation of State-Owned Enterprises: A Review of Empirical Evidence from China,’ in Benjamin Liebman and Curtis Milhaupt (eds), Regulating the Visible Hand? The Institutional Implications of Chinese State Capitalism (Oxford University Press, 2015), 120–22. 85 EITL Art. 26(2) and EITLIR Art. 83. 82

Corporate taxation in China  317 offset income of others. This treatment was repealed in 2009 because of its revenue cost and has not been revived.86 Intra-group transactions are generally given full effect. While the EIT generally disregards transactions among domestic branches of the same corporate legal person, an elaborate formulary apportionment system is used to compute EIT liabilities payable by branches in different provinces.87 The reason is that while the EIT itself is a single (nationally imposed) tax, EIT revenue is split 60/40 between the central and provincial governments: where a corporation has operations in different provinces, it cannot pay tax just to the headquarter (HQ) jurisdiction. Instead, 50 percent of its tax liabilities is allocated to the HQ jurisdiction, with the remaining 50 percent allocated among the jurisdictions of the branches.88 The branch allocation formula uses the factors of revenue, payroll, and total assets with weights of 35 percent, 35 percent, and 30 percent for each. Interestingly, if different branches are entitled to different EIT rates thanks to regional tax differentials, the computation of the total EIT liability of the company depends on the allocation of income to different branches. The allocation of EIT liabilities holds for both monthly or quarterly advance payments and for the settling of tax liabilities after annual filing.89 Tax bureaus in each jurisdiction have the authority to audit the local branches, and any outstanding tax liability discovered would be shared 50/50 between the auditing and HQ jurisdictions – but not with other branch jurisdictions.

CONCLUSION Many of the off-the-shelf theories of the CIT present an awkward fit for the Chinese EIT. For example, the textbook idea of the CIT as a backstop to personal income taxation – that is, as a complement to the PIT – seems highly incongruous, both because the Chinese government shows no commitment to a robust PIT, and because effective tax rates under the EIT are sufficiently low that individuals often have clear incentives to earn business income through corporations. As a self-standing tax on entities, however, the EIT is characterized by two contrasting sets of features. On the one hand, smaller firms are subject to lower tax rates, especially after the last decade of SMPE tax cuts. Together with the fact that smaller firms are also more likely to report losses, this implies that the EIT probably imposes a relatively small cost on small firm operations.90 Aside from compliance costs, the EIT is unlikely to present a barrier to business formation. Conversely, it is unlikely to be effective as a screen against unproductive firms. Little would be lost, it seems, if many small firms already enjoying de facto exemption from the EIT are nominally made exempt as well. Cui, supra note 84, 119–20. STA Bulletin [2012] No. 57. 88 A branch for EIT allocation purposes must either be an operation that has an independent business license but over the personnel, operation, and finances of which the HQ exercises direct control, or an operation that has separate financial accounting. 89 EIT taxpayers are generally required to make monthly or quarterly pre-payments, with the frequency determined by the local tax bureau to which they are assigned. 90 This stands in contrast to the regressivity of some other taxes paid by Chinese businesses, e.g. the employer’s portion of social insurance contributions. This difference between tax types may be hidden by the fact that, for most taxes, the vast majority of revenue is generated from the top decile of firms. 86 87

318  Research handbook on corporate taxation On the other hand, the EIT also does not appear to be well-suited for large firms. This is seen, for example, through the relative simplicity of EIT rules, and the fact that tax incentives are given mostly through rate reductions instead of base modifications. And many aspects of the design of the EIT, for example, the serious limitation on loss carryovers, at least look inefficient and poised to induce substantial distortions for the large firms affected by the EIT. Yet how much the EIT actually distorts Chinese firms’ behavior remains little investigated.91 If the EIT’s main effects are not on individual savers or entrepreneurs in small businesses, but on large firms, how are these effects best described? For scholars interested in developing positive theories of the CIT – in the sense of theories that match, explain, and predict CITs in the real world – the Chinese EIT raises significant and interesting questions.

91 Chen et al, supra note 9, report no significant sign of capital misallocation induced by the dispersion in effective EIT rates.

19. Corporate taxation in India Arvind P. Datar1

I. INTRODUCTION Constitutional Scheme The constitutional scheme in India broadly provides for a federal structure with various legislative powers – including powers relating to taxation – being distributed between the Union and the States (i.e. the various units in the federation). The power to tax income (as well as capital) vests exclusively with the Union, that is, the Central Government; consequently, there is a single central income tax in India, and there are no separate income taxes at the state level.2 Outline of the Legislative Scheme Under Indian law, as with most other legal systems, a company is treated as a legal person distinct from its shareholders. Indian tax law reflects this position as well, and considers a company as being a separate taxable unit.3 In principle, the profits and gains of the company are distinct from the income which may be derived from the company by the shareholder. Companies resident in India are taxed on their worldwide income, while companies which are not resident in India are taxed on Indian-sourced income.4 The Income Tax Act, 1961 remains the basis on which corporate profits are taxed: unlike other jurisdictions which may have a separate code for corporate taxation. Broadly, income is charged under five heads viz.: ‘profits and gains of business or profession’, ‘income from house property’, ‘salaries’, ‘capital gains’ and ‘income from other sources’. The last category is residuary, and income which does not fall under the first four categories will fall under this head. Tax and Accounting In determining the taxable profits of companies, the financial/accounting profits under the Companies Act, 2013 are the starting point. This is made clear from section 145 of the Act, which notes that income chargeable under the head of ‘profits and gains of business’ is to be computed in accordance with the system of accounting regularly employed by the taxpayer. The author gratefully acknowledges the assistance of Mihir Naniwadekar, Advocate, Bombay High Court in the preparation of this chapter. 2 Article 246 read with Entries 82 and 86, List I, Schedule VII, Constitution of India 1950. Entry 85 of the same list provides the Centre with the legislative competence in respect of ‘corporation tax’. 3 See: s 2(31)(iii), Income Tax Act, 1961. 4 Ss 5 and 9, Income Tax Act, 1961. This general position is subject to any tax treaties and so on. A company is treated as resident in India under s 6 of the Act when it is incorporated in India or has its place of effective management in India: s 6(3). ‘Income’ has a broad meaning under s 2(24), and includes gains on the transfer of a capital asset. 1

319

320  Research handbook on corporate taxation The Central Government has also notified Income Computation and Disclosure Standards (ICDS) for determining taxable profits.5 It has been held by the Delhi High Court that the standards notified by the Central Government cannot override either the provisions of the statute or even binding judicial precedents,6 but shortly after the decision, several legislative amendments were introduced in order to provide statutory backing for various aspects covered by the ICDS.7 It is, however, recognised in Indian law that accounting entries are not determinative as a matter of tax law.8 Minimum Alternate Tax (MAT) The levy of minimum alternate tax, or MAT, as it is popularly called, is perhaps a unique feature of Indian corporate taxation. There are several incentives given to companies under the Act which make higher capital investment. These incentives are by way of accelerated depreciation and special investment allowances that are granted as deductions while calculating taxable income. Thus, typically well-managed companies and companies which pursue an aggressive growth strategy are able to get substantial deductions. This can lead to nil taxable income under the Act and such companies are called zero-tax companies. At the same time, under the Companies Act, 2013, these companies may have substantial book profits as the deductions granted for tax purposes do not reduce book profits. MAT is levied on the book profits on the basis of an elaborate computation mechanism. The net result is that zero-tax companies are then faced with a MAT liability on their book profits. This provision has been criticised as penalising development and expansion and productive investment. Nevertheless, MAT has come to stay for companies. With this brief overview, certain specific issues of importance in the taxation of corporate income are considered below. An examination of these issues would reveal that the law as it stands today has developed in response to pulls and pushes from different directions and different provisions appear to have been drafted with different objectives in mind. The result is that the law of corporate taxation in India is hard to understand on the basis of a coherent ordering framework: it is, instead, an eclectic jumble of provisions which serve divergent policy objectives.

Chamber of Tax Consultants v. Union of India 400 ITR 178 (Del). See: Kamal Abrol and Manish Bhatia, ‘Another Twist in the ICDS Tale’ [2018] 90 taxmann.com 152 (Art). 7 Kedarnath Jute Manufacturing Co. v. CIT 82 ITR 363 (SC). 8 For an argument that tax treatment generally favours debt over equity, see: Sonu Jain and Sunita Jain, ‘A Study of Corporate Taxation in India’ (2017) 8 (4) IOSR Journal of Economics and Finance 68. 5 6

Corporate taxation in India  321

II.

RAISING OF FINANCING AND TAXATION OF DISTRIBUTIONS

Debt versus Equity Companies can raise finances in multiple ways: either by equity contributions or by borrowings.9 If funds are raised by borrowings, interest may be payable in respect of those borrowings.10 As long as the borrowings are used for the purposes of business, interest expenses on the borrowings would in principle be deductible in the computation of the company’s income.11 In general,12 the mere fact that a company chooses to raise funds through borrowings rather than equity capital should not be a reason to disallow the interest on the borrowings. Indian law accepts that it is for the businessperson to decide the manner of carrying on business: as long as revenue expenses are incurred wholly and exclusively for the purposes of business, it is not open to the Revenue to substitute the commercial judgement of the taxpayer. It may often be the case that a company borrows moneys on which it pays interest, and in turn lends money to associate concerns.13 Even in such cases, unless it can be shown that there is a diversion of funds in breach of commercial expediency,14 the interest payments ought to be allowable.15 In an important decision,16 the Supreme Court considered a situation where the taxpayer company borrowed funds from a bank and in turn advanced those funds to an associated entity. The Supreme Court laid down the test to be applied in such situations in the following terms: once it is established that there was nexus between the expenditure and the purpose of the business (which need not necessarily be the business of the assessee itself), the Revenue cannot justifiably claim to put itself in the arm-chair of the businessman or in the position of the board of directors and assume the role to decide how much is reasonable expenditure having regard to the circumstances of the case. No businessman can be compelled to maximize its profit. The income tax authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act. The authorities must not look at the matter from their own view point but that of a prudent businessman. As already stated above, we have to see the transfer of the borrowed funds to a sister concern from the point of view of commercial expediency and not from the point of view whether the amount was advanced for earning profits … We wish to make it clear that it is not our opinion that in every case interest on borrowed loan has to be allowed if the assessee advances it to a sister concern. It all depends on the facts and circumstances of the respective case. For instance, if the Directors of the sister concern utilize the amount advanced to it by the assessee for their personal benefit, obviously it cannot be said that such money was advanced as a measure of commercial expediency. However, An interesting question arises in the case of convertible instruments: whether such instruments are to be regarded as debt or as equity. See for instance: Kamlesh Chainani and Urmi Rambhia, ‘Compulsorily Convertible Debentures: Debt or Equity?’ [2019] 109 taxmann.com 34 (Art). 10 S 36(1)(iii). 11 Subject to thin capitalisation provisions or to transfer pricing issues in cases of transactions between related enterprises. 12 See: R. Kalidas, ‘Inter-Corporate Loans and Investments’ [2007] 80 SCL 25 (Mag). 13 T.N. Pandey, ‘Interest on Borrowed Capital’ [2007] 159 Taxman 61 (Art). 14 See: SA Builders v. CIT 288 ITR 1 (SC). 15 SA Builders v. CIT 288 ITR 1 (SC). However, this decision is presently under reconsideration by a larger Bench of the Supreme Court: see Addl.CIT v. Tulip Star Hotels Ltd. [SLP (C) No. 14729 of 2012, dated 7 February 2019]. 16 See s 68. 9

322  Research handbook on corporate taxation money can be said to be advanced to a sister concern for commercial expediency in many other circumstances (which need not be enumerated here). However, where it is obvious that a holding company has a deep interest in its subsidiary, and hence if the holding company advances borrowed money to a subsidiary and the same is used by the subsidiary for some business purposes, the assessee would, in our opinion, ordinarily be entitled to deduction of interest on its borrowed loans … (Emphasis added)

Thin Capitalisation Rule Section 94B was introduced in 2017 to give effect to Action Plan 4 of the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) project. The section places a limit on how much interest can be allowed to be paid for loans given by associated enterprises. The definition of ‘associated enterprise’ for the thin capitalisation rule is the same as applicable in case of transfer pricing. Section 36 allows deduction of interest if the amounts are borrowed for business purposes provided the loan is not spent in connection with earning of the exempt income. Section 94B restricts the interest payable by an Indian company to its non-resident associated enterprise. The purpose of introducing section 94B was to check the possibility of a non-resident associated enterprise issuing loans to the Indian entity by keeping the equity investment lower and the debt component higher. This can enable the Indian company to pay interest which is allowed as a deduction thereby reducing the Indian company’s tax liabilities and the interest is paid in a jurisdiction where it is either not taxable or is subject to a very low rate of tax. An exception could have been made if the interest paid to the non-resident associated enterprise is equivalent to the market rate of interest. Further, in large infrastructure projects, the debt is always the higher component because the Indian subsidiary is usually formed for a specific project and it does not make business sense to have a high equity component. Share Issues If a company chooses to raise funds through equity, there may often be questions of whether the share issue (to generate the equity capital) gives rise to taxable income in the company’s hands. In general, share capital would be a pure capital receipt and not in the nature of income. The raising of funds through the issue of shares does not give rise to a charge of capital gains, as there is no element of ‘transfer’ in such transactions. When a company issues shares, that does not amount to a ‘transfer’ of shares.17 Thus, while there are some statutory inroads introduced to tackle the perceived abuse of unaccounted money being routed through unexplained ‘share premium’,18 the issue of shares at a premium ought not in principle to be considered as the income of the company. Correspondingly, in general, the expenditure incurred on issuance

Brooke Bond v. CIT 225 ITR 798 (SC). Vodafone India Services v. Union of India 368 ITR 1. The UK Upper Tier Tribunal has considered that the principle in Vodafone is confined to the specific Indian transfer pricing provisions, and cannot be extended to a general rule that capital transactions such as the issue of shares must necessarily be outside the scope of transfer pricing provisions. See: Union Castle Mail Steamship v. HMRC [2018] UKUT 316 (TCC). 17 18

Corporate taxation in India  323 of shares would also not be considered as a revenue expenditure but would be treated as an expenditure on the capital account.19 The Revenue had attempted to tax the premium on the issuance of shares under the transfer pricing provisions or under other residuary provisions. However, this attempt was negated by the Bombay High Court, which held that, once the receipt of share capital is not chargeable as income, there can be no question of invoking transfer pricing provisions.20 However, the Revenue continues to seek to tax such receipts under the provisions of section 68 of the Act, especially when the premium is considered ‘excessive’. Section 68 treats unexplained credits in books of accounts as the income of the assessee. A company can avoid the rigours of section 68 by establishing that the investors, particularly the large ones, had adequate sources of funds to make the investment in the share issue.21 Dividends As noted above, given that the law regards the profits of a company as distinct from the profits of the shareholders, it is permissible, in principle, to tax corporate distributions at the shareholder level in addition to taxing corporate profits at the company level. While this might in certain situations amount to economic double taxation,22 this flows from regarding the company and the shareholders as separate entities. Under Indian law, until recently, dividends were not taxed in the shareholders hands,23 but a separate ‘dividend distribution tax’ was levied at the company level on the distributed profits of the company.24 While this might seem beneficial to shareholders, it meant that expenses incurred by shareholders for earning the dividend income was not allowable. Under section 14A of Income Tax Act, expenses incurred in relation to exempt income is not allowable and the Supreme Court held that, even though dividends are taxed at the company level (in the form of not just taxing the profits of the company, but by levying a dividend distribution tax on the distributed profits), they are ‘exempt’ in the hands of the shareholders. Consequently, the expenses incurred in relation to earning the dividend income are not deductible.25 This decision hurts corporate groups where interest expense is incurred in order to make investments in subsidiaries. The earlier system of taxation was reintroduced by the Finance Act, 2020, where dividends are once again taxable in the hands of shareholders and dividend distribution tax at the company level is abolished. In addition to regular dividends, Indian law contains a wide legal fiction deeming certain payments to be dividends.26 This fiction is applicable to certain types of payments made by

19 See generally: V.K. Subramani, ‘Taxation Issues for Closely-Held Companies for Share Premium Amounts Received’ [2022] 140 taxmann.com 399 (Art). 20 For an academic study of where the economic incidence of corporate tax falls in the Indian context, see: Samiksha Agarwal and Lekha Chakraborty, ‘Corporate Tax Incidence in India’ Levy Economics Institute Working Paper No. 88 (2017). 21 S 10(34). 22 S 115-O. 23 Godrej & Boyce Manufacturing v. DCIT 394 ITR 449 (SC). 24 S 2(22). 25 T.N. Pandey, ‘An Insight into Controversial Provisions of Deemed Dividends’ [2017] 79 taxmann. com 57 (Art). 26 S 2(22)(e).

324  Research handbook on corporate taxation closely held companies.27 Amongst other transactions, a loan or advance given to shareholders can fall within the scope of the deeming fiction.28 Such loans or advances are treated as ‘deemed dividend’ and then taxed in the hands of the shareholder. The idea appears to be to bring to tax transactions which have the effect of distributing the profits or reserves as loans to shareholders and avoiding distribution as dividends.29

III.

CORPORATE GROUPS

Judicial Inroads to Separate Personality: Lifting the Veil in Tax Matters Indian law recognises that each company within a corporate group has its own separate and distinct legal personality. As in most countries, the judicial principles of lifting the corporate veil may be applicable in cases of fraud or evasion.30 The Supreme Court of India has discussed issues in connection with lifting of the corporate veil between holding and subsidiary companies in some detail in the landmark Vodafone judgment.31 It recognised that a corporate group may decide to conduct its operations through multiple subsidiaries and the mere fact that the shareholding is ultimately controlled by the parent is of no consequence in deciding whether the subsidiaries could be ignored. Laying down the tests for a judicial substance-over-form approach, the Court finally held: at the threshold, the burden is on the Revenue to allege and establish abuse, in the sense of tax avoidance in the creation and/or use of such structure(s). In the application of a judicial anti-avoidance rule, the Revenue may invoke the ‘substance over form’ principle or ‘piercing the corporate veil’ test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant … It is the task of the Revenue/Court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach. The Revenue cannot start with the question as to whether the impugned transaction is a tax deferment/saving device but that it should apply the ‘look at’ test to ascertain its true legal nature … the onus will be on the Revenue to identify the scheme and its dominant purpose … The corporate business purpose of a transaction is evidence of the fact that the impugned transaction is not undertaken as a colourable or artificial device. The stronger the evidence of a device, the stronger the corporate business purpose must exist to overcome the evidence of a device …

Thus, in principle, the Supreme Court recognised that there was nothing inherently wrong in carrying on activities through subsidiary companies. But it is open to the Revenue to ‘see through’ such subsidiaries only in limited cases where these are created as a colourable device

V.K. Subramani, ‘Deemed Dividend and Tax Issues’ [2006] 156 Taxman 29 (Art). Vodafone International Holdings v. Union of India [2012] 341 ITR 1 (SC). 29 As pointed out later, the GAAR provisions, inter alia, define ‘impermissible avoidance arrangements’. 30 S 179. 31 Ajay Patel v. DCIT 394 ITR 321 (Guj). For a comment on this aspect, see: S. Anand, ‘Vicarious Liability of Directors of a Public Company/S 179 of the Income Tax Act, 1961’ [2017] 79 taxmann.com 319 (Art). 27 28

Corporate taxation in India  325 or for impermissible tax avoidance schemes. This judicial approach is now supplanted by the General Anti-Avoidance Rule (GAAR) as well.32 Statutory Inroads to Separate Personality Even leaving aside the judicially crafted exceptions, there are a few statutory inroads into the principle of separate legal personality. Thus, there is a provision under the Act which permits the directors of a private limited company to be made liable for the tax dues of the company; and this provision33 has been stretched by judicial interpretation to apply even to public companies when there is some evidence that a company is run as a public company only to defraud the Revenue.34 There are also several provisions which put a heavier onus on ‘related party’ transactions as opposed to transactions with third parties.35 Tax Neutrality in Intra-Group Transactions and in Corporate Restructurings There are also some situations where taxpayers may benefit if the principle of a separate legal personality is discarded to a limited extent, and several tax systems recognise this reality of the commercial world. Indian law does so too: but to a very limited extent. There is no general principle in Indian law that transfers inter se within a group will automatically be considered as exempt. However, there are some exemptions in respect of inter-group transfers of assets:36 a transfer of an asset by a parent company to a subsidiary will (subject to certain conditions) not be considered as a transfer. There is thus no chargeable capital gains, although the transferee will continue holding the asset at the historical cost in the hands of the transferor. At the same time, these provisions do not provide for complete group consolidation. Thus, the transfers within a group would result in exemptions in the case of transfers by a parent to a subsidiary but not to other transfers within the group;37 and further, the conditions for exemption can also be strict. More importantly, while there is this limited notion of relieving intra-group transactions, a ‘group relief’ mechanism for corporate losses is conspicuous by its absence. Mergers and Demergers The corporate tax regime in India also provides options for certain restructurings such as mergers and demergers to be ‘tax neutral’: if certain conditions are satisfied, then the demerger is not considered to be a chargeable transfer, and the acquirer acquires the unit at the historical cost, while the tax breaks that were available to the transferor unit are now available in the assessment of the acquirer. The key to achieving tax neutrality is that the transfer must be of 32 Examples include s 40A on related-party transactions; and the transfer pricing provisions which extend not just to international transactions but also to specified domestic transactions. 33 S 47(iv). 34 S 47. 35 Rustom Cavasjee Cooper v. Union of India (1970) 40 Com Cases 325. 36 Madras Gymkhana Club Employees Union v. Management of the Gymkhana Club AIR 1968 SC 54, 543. 37 In Re., Indo Rama Textile Ltd. 212 Taxman 462 (Del).

326  Research handbook on corporate taxation an ‘undertaking’: a term which has effectively become a term of art in Indian tax law. The relevant definition of ‘undertaking’ is found in Explanation I to section 2(19AA), which defines undertaking to include ‘any part of an undertaking, or a unit or division of an undertaking, or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity’. Thus, undertaking includes ‘part’ of an undertaking; but does not include assets/liabilities which do not constitute a business activity. It will be noted that the definition is an inclusive definition. An activity can be considered to be an undertaking if it is: 1. 2. 3. 4.

An undertaking, as is generally understood; or A part of an undertaking; or A unit of an undertaking; or A division of an undertaking.

The Supreme Court has held38 that an ‘undertaking’ means a business unit or enterprise which is engaged in gainful occupation. For example, each one of several factories or manufacturing plants of a company is considered an ‘undertaking’ from a business point of view. It does not consist of mere assets or property. It is a productive organism, so to speak, and signifies a going concern engaged in the production, distribution and so on of goods or services: sometimes it means also the entire business or organisation of a company.39 The Delhi High Court has held40 that, to satisfy the definition of undertaking under section 2(19AA), the undertaking that is being demerged as a going concern must constitute a business activity capable of being run independently for a foreseeable future. It also held that, to ensure that it is a going concern, the Court can examine whether essential and integral assets like plant, machinery and manpower, without which it would not be able to run as an independent unit, have been transferred to the demerged company.

IV.

ANTI-ABUSE PROVISIONS AND INTERNATIONAL ASPECTS

Residential Status on the Basis of ‘Place of Effective Management’ (POEM) Until 2015, a foreign company would be treated as resident in India in any previous year only if the control and management of its affairs was situated wholly in India. The courts had held that even if part of the control and management was abroad, the foreign company would not be treated as resident. Once the company is resident, then it is liable to tax on its global income under section 5(1) of the Act. Thus, the meaning of the expression ‘place of effective management’ now becomes critical and has been defined to mean the place where key management and commercial decisions that are necessary for the conduct of business of an entity as a whole

Circular No.3 of 2017, 20 January 2017 – 391 ITR (ST) 253, 269–71. For a historical survey, see: S. Ambirajan, The Taxation of Corporate Income in India (1964, Asia Publishing House: Bombay). 40 In Re., Indo Rama Textile Ltd. 212 Taxman 462 (Del). 38 39

Corporate taxation in India  327 or, in substance, are made. The Central Board of Direct Taxes has issued Circular No.3 of 2017 that expands the ambit and scope of this expression.41 Significant Economic Presence Section 9 creates a deeming fiction and treats several incomes of non-residents as deemed to accrue or arise in India. Section 9(1)(i) deals with four categories of income: 1. All income accruing or arising whether directly or indirectly through or from any business connection in India; 2. Or through or from any property in India; 3. Or through or from any asset or source of income in India; and 4. Or through the transfer of a capital asset situate in India. The meaning of the expression ‘business connection’ has always been subject to controversy and litigation. This expression is now sought to be expanded by including the concept of ‘significant economic presence’ (SEP). This was introduced in 2020 and is based on BEPS Action Plan 1. Currently, the income of all non-residents which is deemed to accrue or arise in India is only that part which is reasonably attributable to operations carried out in India. With the expansion of the meaning of ‘business connection’ to include ‘significant economic presence’ of a non-resident in India, it is no longer necessary for the income to be attributable to operations carried out in India. Now, the fact that the non-resident has transactions in goods or services above a certain threshold or is engaged in interactions with users in India will signify SEP. Rule 11UD has specified the threshold limits that will trigger the existence of SEP. For transactions of goods, services or property carried out by a non-resident with any person in India in excess of Rs.20 million (equivalent to approximately USD 2,400,000), the non-resident will be treated as having a SEP. Similarly, if the number of users with whom there is interaction exceeds 300,000 in a year, the non-resident will be once again treated as having SEP. General Anti-Avoidance Rule (GAAR) Chapter X-A of the Income Tax Act, 1961 sets out statutory provisions for GAAR. Section 96 defines what constitutes an ‘impermissible avoidance arrangement’ and other statutory provisions in the chapter set out circumstances when an arrangement lacks commercial substance and the attendant consequences that can follow. The provision enables the recharacterisation of a contract and confers wide powers on statutory authorities. The definition of ‘tax benefit’ is also very wide. The provisions of GAAR remained inoperational until recently because the Approving Panel had to be constituted. This has been done recently and it will be interesting to see the implementation of GAAR by Indian tax authorities.

41

See: s 2(31)(iii), Income Tax Act, 1961.

328  Research handbook on corporate taxation

V.

EQUALISATION LEVY

This levy was first introduced in 2016 and was initially confined to certain digital services. In 2020, it was expanded to cover e-commerce supply of goods or services. The levy is on an e-commerce operator who owns, operates or manages a digital or electronic facility or platform for online sale of goods or online provision of services. Section 165A contemplates an equalisation levy at the rate of 2 per cent of the consideration that is received by such e-commerce operator from persons residing in India or from specified non-residents. This will also extend to persons who buy electronic goods using an internet protocol address located in India. Interestingly, this levy is not part of the Income Tax Act, 1961, but is levied through the Finance Act even though it is in the nature of a direct tax. If an e-commerce supply of goods or services is subject to equalisation levy, it will not be subject to income tax. This is a helpful and salutary provision. The initial controversy of whether equalisation levy will apply to all imported goods was resolved and it is now accepted that this levy is only on the online sale of digital goods or digital services. Supply of physical goods will be subject to existing import duties under the Customs Act, or any other applicable law.

VI. CONCLUSION A survey of the provisions of the Act indicates that it is hard to arrive at a single theory coherently explaining the entirety of the corporate tax framework in India. This is unsurprising: the provisions pertaining to corporate tax have evolved from the Income Tax Act, 1922 and are now contained in the Income Tax Act, 1961.42 However, the Act has been amended (often, earlier, with retrospective effect) practically every year by the annual Finance Act. Each annual Finance Act reflects the priorities and politics of the individual government. Therefore, the current corporate tax framework is a patchwork of different sections that are not part of a single coherent framework. The Act would be greatly helped by a serious attempt at rationalisation. This can be done by reducing the number of deductions, allowances and incentives. The unfortunate practice of nullifying the effect of several judgments that are in favour of assessees by amendments to the Act has also made the provisions relating to corporate tax quite complex apart from resulting in uncertainty. What is needed in the near future is to design a corporate tax system that focuses on growth maximisation, rather than revenue maximisation. Taxes must always be regarded as a by-product of economic growth.

42 Sections 5 and 9, Income Tax Act, 1961. This general position is subject to any tax treaties and so on. A company is treated as resident in India under s 6 of the Act when it is incorporated in India or has its place of effective management in India: s 6(3). ‘Income’ has a broad meaning under s 2(24), and includes gains on the transfer of a capital asset.

20. Corporate taxation in Brazil Luís Eduardo Schoueri and Guilherme Galdino

1. INTRODUCTION On 31 December 2022, the Brazilian Income Tax celebrates its 100th anniversary. Until the enactment of Law No. 4,625/1922, Brazil had only had taxes on one or another earnings.1 The creation of the Brazilian Income Tax by this law was important to impose a general taxation on income obtained by both individuals and legal entities. Income taxation in Brazil comprises different rules for individuals and for legal entities. The latter is called Imposto de Renda Pessoas Jurídicas (IRPJ) and comprises a corporation, partnership or even an entity with no legal personality. Furthermore, Law No. 7,689/1988 created a Social Contribution on Profits (Contribuição Social sobre o Lucro – CSL), which effectively substituted part of the pre-existing IRPJ. Thus, this chapter addresses both IRPJ and CSL – hereafter jointly referred to as Corporate Income Tax (CIT). Section 2 of this Chapter addresses the notion of income as prescribed by the Brazilian National Tax Code (Código Tributário Nacional – CTN). Section 3 deals with the integration between the taxation on the income of shareholders and the taxation on the income of legal entities, as well as the notion of legal entity for CIT. Section 4 reports the regimes for CIT. Subsequently, section 5 addresses the Brazilian Worldwide Taxation rules. Finally, section 6 summarizes selected issues for companies subject to the actual profit regime: the deductibility rules, the tax losses treatment, the interest on net equity payments, transfer pricing and thin cap rules.

2.

THE NOTION OF INCOME FOR THE BRAZILIAN CIT

Under Article 43 of the CTN, the notion of income for IRPJ relies on both theories: the source theory and the net accretion theory (see section 2.1). Although CSL is a different tax from IRPJ under the Brazilian tax system, the same regime of IRPJ is applicable to CSL (see section 2.2). 2.1

The Notion of Income for the IRPJ

There are two main theories that intend to explain the notion of income: the source theory; and the net accretion theory. On the one hand, the source theory sees income as recurring fruits from a permanent source. This theory encompasses any product of capital (e.g., dividends and interests) and any product of labor (e.g., wages). Nevertheless, this theory excludes, for example, capital gains, since they

1 See Article 23 of Law No. 317/1843; Article 22 of Law No. 1,507/1867; Article 1, item 29, of Law No. 2,321/1910; and Article 2, item VII, of Law No. 2,919/1914.

329

330  Research handbook on corporate taxation are not recurrent. For instance, the rent (fruit) of a house (source) is an income, but when the owner sells the house (the source itself), no income would arise, even if the acquisition cost of the house were lower than the sale price.2 Also, windfall gains would not be taxed, since they would not be recurring. On the other hand, the net accretion theory defines income as the positive difference on one’s economic power in a given period. The foundation concept of income is based on the Schanz-Haig-Simons model, which relies on satisfactions from all economic events between two points of time.3 The reasoning is quite simple: if government shall take resources from society, it should choose to tax those who have more well-being. If one taxes people that do not reveal satisfactions, then the tax will only worsen their situation. On the contrary, those who are comfortable shall be taxed because they could produce more wealth. The practical measurement of these satisfactions can be defined as net increases in wealth plus consumption expenditure. The net accretion theory cannot comprehend, however, the taxation of non-residents, since one may not ascertain whether a non-resident has actually accrued income when rendering services for residents. Accordingly, non-residents ordinarily do not file tax returns and thus their net accretion cannot be measured. On the other side, this theory encompasses the capital gains taxation, which will measure the difference between the sale price and the acquisition cost of the house, for instance. If the sale price is higher than the acquisition cost, then there is a capital gain that is taxed by income tax; otherwise, if no net accretion is verified, no tax is due. Normally, the capital gains taxation is related to the income taxation under the net accretion theory, that is, the income taxation comprises capital gains taxation. However, in some jurisdictions such as the United Kingdom the taxation of capital gains has a different regime from income taxation.4 Instead of choosing one of these two theories, the Brazilian legal system has adopted both. As per Article 153, III, of the Brazilian Federal Constitution, only the Union (Federal Government) has the power to tax income. In order to define what is the taxable event of any taxes, including the Income Tax, the Brazilian legal system has adopted a special category of statute, so-called ‘complementary law’ (lei complementar). Although complementary laws do not amend the Constitution, they represent an important instrument for the interpretation of the latter, since, as set by the Constitution, complementary laws shall establish general tax rules such as the definition of the taxable event of the Income Tax.5 Therefore, the ordinary law shall prescribe the taxation on income respecting the definition of its taxable event under the complementary law. Concerning the Income Tax, the CTN has the status of complementary law defining its taxable event. According to Article 43 of this Code, the Income Tax may be imposed on the income ‘understood as the product of capital, labor or a combination of both’ (source theory)

2 See Joachim Lang, ‘The influence of tax principles on the taxation of income from capital’, in Peter Essers and Arie Rijkers (eds), The notion of income from capital (IBFD 2005) 18–21. 3 See Kevin Holmes, The concept of income: A multi-disciplinary analysis (IBFD 2000) Chapter 2. 4 See Judith Freedman, ‘Treatment of capital gains and losses’, in Peter Essers and Arie Rijkers (eds), The notion of income from capital (IBFD 2005) 191 ff. 5 See Luís Eduardo Schoueri, ‘Legal interpretation of tax law: Brazil’, in Robert F. van Brederode and R. Krever (eds), Legal interpretation of tax law (Series on International Taxation, vol 46, Wolters Kluwer 2014) 47–51.

Corporate taxation in Brazil  331 or on ‘income of any nature’, which comprehends the ‘net accretion not included’ in the previous provision (net accretion theory). Irrespective of the type of income, whether following the source theory or the net accretion one, Article 43 establishes that the taxable event of the Income Tax shall depend on the acquisition of economic or juridical availability of the income. For instance, capital gains shall only be taxed from the moment they are available to the taxpayer. The issue on this matter is to ascertain what economic or juridical availability of the income is. Many Brazilian scholars have already tried to distinguish economic availability from the juridical one, for example, considering the effective inflow of resources6 or the lawfulness of the activity that generated the income.7 In any case, economic or juridical, what matters for this provision is the availability of income.8 This is called the Realization Principle. In short: the taxable event of the Brazilian Income Tax relies both on source and on net accretion theories (e.g., capital gains), but as long as the income is available for the taxpayer (Realization Principle). Thus, IRPJ may be imposed under both source and net accretion theories, as long as the income is available for the taxpayer. 2.2

The Rise of the CSL

Immediately after the enactment of the Brazilian 1988 Federal Constitution, Law No. 7,689/1988 imposed, for the first time, the CSL. When one compares CSL to the pre-existing IRPJ, the similarity is immediate. The respective taxable events and tax basis are very similar. As a matter of fact, CSL was created to substitute part of the pre-existing IRPJ. This can be evidenced by the fact that, at that time, IRPJ used to reach the maximum rate of 33 percent. This rate was reduced to 25 percent but simultaneously CSL charged 8 percent of the profits. Thus, from a taxpayer’s perspective nothing changed: instead of paying 33 percent of IRPJ, it would pay 25 percent of IRPJ plus 8 percent of CSL. The only effect would be in the balance between the Union, States and Municipalities in Brazil: while IRPJ is a tax collected by the Union, the revenue of which must be shared with States and Municipalities, CSL is earmarked because it is collected by the Union in order to fund the social security system, that is, it is not shared with other entities. In such sense, the creation of CSL had an enormous effect on the distribution of revenues among public entities, but no effect for taxpayers. The tax base of the CSL is the annual net profits of the entity.9 In order to calculate this tax base, several provisions dealing with the calculation of the IRPJ tax base are applicable.10 Besides the tax base, all the provisions of the IRPJ legislation referring to administration, tax assessment, advance rulings, tax collection, penalties, guarantees and the administrative

See José Luiz Bulhões Pedreira, Imposto sobre a Renda – pessoas jurídicas, vol 1 (Justec 1979) 195–200. 7 See Gilberto de Ulhôa Canto, ‘A aquisição de disponibilidade e o acréscimo patrimonial no Imposto sobre a Renda’, in Ives Gandra da Silva Martins (ed.), Estudos sobre o Imposto de Renda (em memória de Henry Tilbery) (Resenha Tributária 1994) 38; Ricardo Mariz de Oliveira, Fundamentos do Imposto de Renda (Quartier Latin 2008) 301. 8 See Luís Eduardo Schoueri, ‘O conceito de renda e o artigo 43 do Código Tributário Nacional: entre a disponibilidade econômica e a disponibilidade jurídica’, 3 Revista da Academia Paulista de Direito 61–78 (2012). 9 See Article 2 of Law No. 7,689/1988. 10 See Article 28 of Law No. 9,430/1996. 6

332  Research handbook on corporate taxation process are applicable to CSL, unless otherwise specified.11 Thus, it is clear-cut that the CSL is a tax in addition to IRPJ. The existence of one or other difference between the CSL and the IRPJ regimes actually proves the high similarity among these taxes. To understand the Brazilian CIT taxation and their regimes, one should, previously, consider the notion of integration as well as of taxpayer for CIT.

3.

FROM INTEGRATION TO THE NOTION OF TAXPAYER FOR CIT

Regarding integration between the taxation on the income of shareholders and the taxation on the income of legal entities, the current Brazilian legislation adopts the exclusion dividends method (see section 3.1). The focus on the taxation of the income of legal entities makes the notion of taxpayer for CIT even more important (see section 3.2). All the income tax burden will be carried by the taxpayer of CIT, being exempted the income distributed to the respective shareholder. 3.1

Integration between Legal Entities and Individuals: the Exclusion Dividends Method

In 1995, the exclusion dividends method was adopted by the Brazilian legislation.12 According to item 12 of the Memorandum of Explanation attached to the 1995 statute, ‘regarding the taxation of profits and dividends, a complete integration between individuals and legal entities is established, the income being taxed exclusively at the level of the company and exempted when received by the beneficiaries’ (authors’ translation). Under this method, the domestic profits are fully taxed at the corporate level and the corresponding dividends are entirely exempt from withholding tax or income tax, whether paid to resident or non-resident shareholders. Irrespective of the tax regime adopted by the legal entity (see section 4, infra), the income tax burden impacts only the corporate level; the dividends received by the shareholders are exempted. The current Brazilian system focuses on the taxation of legal entities and not their shareholders. One may find some reasons to justify this option. On the one hand, the tax system does not interfere with the decision of the companies to distribute dividends or to reinvest their profits. On the other hand, this system provides an easier environment for tax audit and tax collection, because the Brazilian Revenue Service (Secretaria da Receita Federal do Brasil – RFB) shall mostly assess legal entities and not individuals. For instance, under the exclusion of dividends method like the Brazilian one, the legislation on disguised distribution of profits loses importance, since companies can distribute all the profits exempted of taxation. Previous Brazilian legislation had already established different methods. One should mention the partnership method, which focused only on the taxation of the partners. Under this regime, all the profits obtained by the partnership were automatically attributed to the

See sole paragraph of Article 6 of Law No. 7,689/1988. See Article 10 of Law No. 9,249/1995.

11 12

Corporate taxation in Brazil  333 respective partners at the end of the tax period.13 The partnership was not properly a taxpayer. It was deemed transparent for tax purposes. This regime was revoked in 1996.14 In short: since 1995, Brazilian legislation has adopted the exclusion dividends method. Even though other integration methods had been adopted before, they were limited to certain circumstances and taxpayers. In a general way, only with the 1995 statute was economic double taxation relieved.15 As the income tax burden is shifted entirely to CIT, the question on the notion of legal entity for CIT arises. 3.2

The Notion of Legal Entity for CIT

According to Article 153, paragraph 2, item I, of the Brazilian Federal Constitution, the Brazilian Income Tax shall be governed by the Generality Principle. This means that income taxation shall be imposed on all taxpayers. The Constitution forbids the creation of regimes to exclude some groups from taxation, as one would find previously for judges, congressmen and the military. In light of the Generality Principle, the notion for legal entity for CIT has a wide scope. All private companies (irrespective of their purposes or nationality),16 all public companies and all government-controlled private companies (sociedades de economia mista)17 are taxpayers. Brazilian legislation also extends the status of taxpayer to branches and subsidiaries of non-resident companies,18 as well as to entities not formally registered, to ‘individual companies’ (firmas individuais) and to individuals that carry out, habitually and professionally, activities aiming to make profits.19 Two exceptions shall be mentioned. First, investment funds usually are exempted from CIT because the Brazilian taxation focuses on their investors. The purpose of this regime is to provide neutrality for the financial market, since the investor carries a similar tax burden by either investing directly in the investment target (stocks, bonds, etc.), or investing indirectly via funds. Only in specific situations, the investment funds may be treated as legal entities for CIT purposes.20 Second, the Brazilian Federal Constitution limits the tax jurisdiction it has granted to the federal subdivisions by means of establishing tax immunities (tax protection).21 Immunities regard circumstances or entities valued as of great importance in terms of values protected by the Constitution or in which no ability to pay is to be found. Thus, a legal entity may have immunity depending on whether it carries out its activity in the public sector or in the economic domain. The threshold regards whether the entity reveals ability to pay, as well as

See Articles 1 and 2 of Decree-Law No. 2,397/1987. See Article 55 of Law No. 9,430/1996. 15 See Natalie Matos Silva, ‘A integração da tributação das pessoas jurídicas e das pessoas físicas: análise dos métodos teóricos e de sua adequação ao princípio da capacidade contributiva’, 23 Revista Direito Tributário Atual 366–401 (2009), 370. 16 See Article 27 of Decree-Law No. 5,844/1943. 17 See Article 1 of Law No. 6,264/1975. 18 See Article 42 of Law No. 4,131/1962. 19 See Article 27, paragraphs 1 and 2, of Decree-Law No. 5,844/1943. 20 See, e.g., Article 2 of Law No. 9,779/1999. 21 See Article 150, item VI, of Brazilian Federal Constitution. 13 14

334  Research handbook on corporate taxation whether the entity affects free competition or not. These tax immunities are rather important for political parties, non-profit organizations and for entities that provide public services outside of the market. In addition, Brazilian domestic law does not provide for a concept of permanent establishment. The main example of Brazilian legislation that approaches this concept is the taxation of foreign branches, since, as already mentioned, they are treated as legal entities for tax purposes. However, the creation of a branch of a foreign company in Brazil is subject to a burdensome and lengthy procedure such as a specific governmental authorization.22 Given these bureaucratic steps, foreign companies usually do business in Brazil through subsidiaries and not branches. In any case, despite being treated as legal entities for Brazilian CIT purposes, foreign branches are subject to specific rules, since Brazil does not tax them by reason of a personal connection.23 Although some rules applicable to companies resident in Brazil are applicable to them, they shall be liable to taxation, for example, only on a territorial basis.24 In spite of the existence of controversies around the concept of domicile for legal entities, one may argue that legal entities are domiciled in Brazil once their head office is in Brazil. Brazilian legislation is not concerned with substantial aspects such as where management decisions are in fact taken, but rather formal aspects of the management (i.e., where the company declares to be its head office). In short: once the headquarters are situated in Brazil, the entity will be regarded as resident in Brazil.25 Furthermore, the notion of legal entity for CIT purposes in Brazil follows the separate entity approach. There is no fiscal consolidation. The taxable profit of each company is calculated separately and irrespective of any losses verified in companies within the same group. The Brazilian legislation had already established an option for fiscal consolidation. During a brief period, companies of the same group could opt to calculate a common tax base. The option depended on the existence of a group of companies as defined by private law26 or the existence of a controlling relation, in which the parent held at least an 80 percent share of the controlled company.27 The group treatment was revoked one year after its creation.28 When explaining the integration between taxation on the income of shareholders and taxation on the income of legal entities, as well as the notion of taxpayer for CIT, one should address the Brazilian tax regimes for CIT.

See Articles 1.134–1.141 of Brazilian Civil Code. See, e.g., Articles 52, sole paragraph, and 64 of Law No. 4,506/1964. 24 See Guilherme Galdino, A Residência das Pessoas Jurídicas nos Acordos para evitar a Dupla Tributação (Doutrina Tributária Series, vol XLVIII, IBDT 2022), 165–71. For a contrary position, see RFB, Tax Ruling COSIT No. 17/2015. 25 See Guilherme Galdino, A Residência das Pessoas Jurídicas nos Acordos para evitar a Dupla Tributação (Doutrina Tributária Series, vol XLVIII, IBDT 2022), 182–8. 26 See Article 265 of Law No. 6,404/1976. 27 See Articles 2 and 30 of Decree-Law No. 1,598/1977. 28 See Article 5 of Decree-Law No. 1,648/1978. 22 23

Corporate taxation in Brazil  335

4.

THE BRAZILIAN TAX REGIMES FOR CIT

In Brazil, there are three tax regimes for CIT: the actual profit regime (see section 4.1); the deemed profit regime (see section 4.2); and the arbitrated profit regime, which has minor importance. The arbitrated profit regime is to be adopted by tax authorities when the method followed by the taxpayer cannot be accurately calculated (e.g., given that the accounting books are unreliable). Despite not being properly a tax regime for CIT, but rather for many taxes, including CIT, there is also a special regime for micro and small enterprises (see section 4.3). 4.1

The Actual Profit Regime

One of the methods to ascertain the tax base of IRPJ provided by Article 44 of the CTN is the actual profit (lucro real). The actual profit (provided for by tax law) derives from the net profit calculated in the company’s accounting books (provided for by corporate law), to which additions and exclusions are made to reach the taxable profit. Thus, even though it relies on the accounting profit, the actual (taxable) profit does not necessarily correspond to it. For example, there are expenses which are deductible in accounting books but not for tax purposes. This is the case of a traffic ticket; although deductible in the accounting book (since it is an effective expense incurred by the company), tax authorities do not accept its deduction for tax purposes. The amount is thus ‘added’ to the accounting profit when calculating the actual profit. There may be exclusions of the accounting profit as well. For instance, some revenues may be exempted for tax purposes; although included in the accounting book (since it is an effective revenue obtained by the company), they cannot be part of the tax base for tax purposes. A very similar actual profit regime is applicable to CSL. Correspondingly, the net profit provided for by corporate law shall be adjusted in order to achieve the taxable profit under the CSL. With respect to tax rates, Brazilian legislation provides for a progressive taxation of IRPJ due to Article 153, paragraph 2, item I, of the Brazilian Federal Constitution. IRPJ is imposed at a tax rate of 15 percent on the annual tax base,29 with 10 percent surtax on the income surpassing BRL 20,000 monthly or BRL 240,000 yearly.30 Although CSL is not governed by the progressive criterion, its tax rates differ depending on the activity carried on by the legal entity. The general tax rate is 9 percent.31 For financial institutions and private insurance companies, rates are higher than 9 percent. On the one hand, financial institutions are subject to a tax rate of 21 percent until December 2022, which will be reduced to 20 percent starting from January 2023.32 On the other hand, private insurance companies are subject to a tax rate of 16 percent until December 2022, which will be reduced to 15 percent starting from January 2023.33

31 32 33 29 30

See Article 3 of Law No. 9,249/1995. See Article 3, paragraph 1, of Law No. 9,249/1995. See Article 3, item III, of Law No. 7,689/1988. See Article 3, item I and sole paragraph, of Law No. 7,689/1988. See Article 3, item II-A and sole paragraph, of Law No. 7,689/1988.

336  Research handbook on corporate taxation From a company’s perspective, computing IRPJ and CSL altogether, Brazilian CIT tax rate is 34 percent (15 + 10 + 9 percent). For financial institutions and private insurance companies, this combined tax rate can reach 46 percent (15 + 10 + 21 percent) and 41 percent (15 + 10 + 16 percent). If the legal entity fulfills certain conditions, it may opt to be subject to the deemed profit. This option is made for each calendar year, which means taxpayers may vary their option from one year to the other. 4.2

The Deemed Profit Tax Regime

Along with the actual profit regime, Article 44 of the CTN establishes the deemed profit (lucro presumido) as a method to ascertain the tax base. Under this regime, the taxable income is achieved through the application of predetermined margins on the gross revenue. These predetermined margins are not the tax rate, because they are applicable to ascertain the tax base. In other words, the tax base is calculated as the gross revenue multiplied by the percentage of the predetermined margin. Only when the tax base is formed, one shall impose the same tax rates as adopted by the actual profit regime. The deemed profit regime is not concerned with the ‘revenue minus expenses’ formula. The deemed profit regime assumes what is the margin of the legal entity, which depends on its economic activity. As a general rule, the predetermined margin is 8 percent.34 For some activities, this percentage is higher or lower. For example, the percentage is: 1.6 percent for resale, for consumption, of fuel derived from petroleum, ethyl alcohol, fuel and natural gas; and 32 percent for services in general (except for hospital services).35 Compared to the actual profit method, the deemed profit regime provides for more simplicity, since the matching of revenues and expenses in accounting books is irrelevant to calculate the tax base. At the same time, depending on how many deductible expenses the company has, and which is the predetermined margin of the legislation, the adoption of the deemed profit regime may result in a higher or lower tax burden. On the other hand, under the deemed profit regime, the company has to pay CIT, irrespective if it incurred losses. After all, the deemed profit regime is calculated from the gross revenue and not the net profit (as the actual profit method). The deemed profit regime is only available to companies whose gross revenue does not exceed a given amount (currently set at BRL 78 million annually or 6.5 million monthly).36 Also, there are companies that are required to calculate their taxable income pursuant to the actual profit regime; therefore, they cannot be subject to the deemed profit regime. This is the case, for instance, of financial institutions, private insurance companies, factoring companies, credit securitization companies and also companies that obtain profits or capital gains from foreign sources.37 Under the legislation on the CSL, besides the method being very similar to the actual profit of the IRPJ, there is a method akin to the deemed profit of the IRPJ.38 Thus, the same con-

36 37 38 34 35

See Article 15 of Law No. 9,249/1995. See Article 15, paragraph 1, of Law No. 9,249/1995. See Article 13 of Law No. 9,718/1998. See Article 14 of Law No. 9,718/1998. See Article 20 of Law No. 9,249/1995.

Corporate taxation in Brazil  337 sideration above is applicable to ascertain the tax base of CSL if the legal entities opt for the deemed profit regime. Differently from the actual profit regime,39 in the deemed profit regime, the taxpayer is not obliged to adopt accrual basis accounting; the company may adopt either accrual basis accounting or cash basis accounting.40 Every company shall opt to be subject to the deemed profit regime until the payment of the income related to the first quarter of the year. Also, at this time, the company shall opt to be subject to accrual basis accounting or to cash basis accounting. This choice is revealed according to the assessment of the tax base linked to that payment. Along with the accrual profit and the deemed profit regimes, if the legal entity fulfills certain conditions, one may opt to be subject to the tax regime for micro and small enterprises. 4.3

The Tax Regime for Micro and Small Enterprises

Article 179 of the Constitution establishes that the Union, States and Municipalities must grant to micro and small businesses ‘a differentiated legal treatment as to encourage them by means of the simplification of their administrative and tax obligations’. While different regulations had been enacted by the Union and States for this purpose, since 2003, such special regime shall be provided for by a (national) complementary law.41 To this effect, Complementary Law No. 123/2006 establishes a simplified regime, well known as Simples Nacional. This regime is not confined to Brazilian CIT, but rather covers several Brazilian taxes, thereby reducing the tax burden and the accessory duties of Brazilian micro and small companies. Besides CIT, Simples Nacional includes: two social security contributions on gross revenues (Programa de Integração Social – PIS) and (Contribuição para Financiamento da Seguridade Social – COFINS); a social security contribution on payroll (Contribuição Patronal Previdenciária – CPP); the tax on industrial products (Imposto sobre Produtos Industrializados – IPI); the State sales tax (Imposto sobre a Circulação de Mercadorias e a Prestação de Serviços de Transporte Interestadual e de Comunicação – ICMS); and the Municipal tax on services (Imposto sobre Serviços de qualquer natureza – ISS).42 Under the Simples Nacional, the tax base is the gross revenue of the company, calculated following the accrual or cash basis accounting methods. The tax base is divided into six taxation bands: (i) up to BRL 180,000.00; (ii) from BRL 180,000.01 to BRL 360,000.00; (iii) from BRL 360,000.01 to BRL 720,000.00; (iv) from BRL 720,000.01 to BRL 1,800,000.00; (v) from BRL 1,800,000.01 to BRL 3,600,000.00; and (vi) from BRL 3,600,000.01 to BRL 4,800,000.00. To each tax band, a different tax rate applies, in a progressive manner. There are five different groups of tax rates, which vary essentially according to the activity carried out by the company: (a) commercial activities;43 (b) industries;44 (c) leasing of movable properties,

See Article 177 of Law No. 6,404/1976. See Article 215, paragraph 9, of Normative Ruling (Instrução Normativa) of RFB No. 1,700/2017. 41 See Article 146, item III, ‘d’, of the Brazilian Federal Constitution, as included by Constitutional Amendment No. 42/2003. 42 See Article 13 of Complementary Law No. 123/2006. 43 See Annex I Complementary Law No. 123/2006. 44 See Annex II Complementary Law No. 123/2006. 39 40

338  Research handbook on corporate taxation schools, technical courses, insurance brokerage, transport, architecture and urbanism, medicine, dentistry, psychology, and travel, tourism and lottery agencies;45 (d) construction activities, engineering works in general, cleaning and legal services;46 and (e) the other services.47 The destination of the tax collection varies according to each tax band for each group of tax rates. Therefore, the gross revenue is a proxy from which the amount due for each tax is assumed.48 Normally, Simples Nacional is a more beneficial regime in comparison to the deemed profit regime and to the actual profit regime, since the tax rates are lower, even though the tax base is the gross revenue. Simples Nacional is available for companies not exceeding BRL 4.8 million in annual gross revenue.49 Even within the limits of annual gross revenue, some situations prevent companies from enjoying the Simples Nacional.50 They may concern the nature of the legal entity (e.g., corporations), the activity performed by it (e.g., financial and similar activities) and the constitutive capital or membership of it (e.g., in whose capital another legal entity participates). A branch of a legal entity with headquarters abroad and legal entities that have a partner resident abroad cannot apply for Simples Nacional. If the legal entity receives income from abroad, such entity shall be subject to the actual profit regime according to the Brazilian Worldwide Income Taxation rules.

5.

THE BRAZILIAN WORLDWIDE INCOME TAXATION

Until 1995, corporate profits were taxed on a territorial basis. CIT would not cover income earned abroad. Since 1995, any profit, earnings or capital gains obtained abroad became subject to taxation.51 Although, as a general rule, companies that receive foreign profits shall be subject to the actual profit regime,52 this rule does not include mere export of goods and/or direct rendering of services abroad.53 Considering operations of a Brazilian company without any establishment abroad, Brazilian legislation allows the ordinary credit from any foreign income tax payment, up to a limit of the Brazilian CIT in relation to the foreign income.54 Any losses arising from foreign operations shall not be offset against domestic profits.55 See Annex III Complementary Law No. 123/2006. See Annex IV Complementary Law No. 123/2006. 47 See Annex V Complementary Law No. 123/2006. 48 See Luís Eduardo Schoueri and Guilherme Galdino, ‘Tratamento favorecido a pequenas empresas: entre nacionalidade, livre concorrência e uniformidade’, in Alexandre Evaristo Pinto (ed.), Ordem Econômica Constitucional: estudos em celebração ao 1º Centenário da Constituição de Weimar (Revista dos Tribunais 2019) 316–18. 49 See Article 3, item II, of Complementary Law No. 123/2006. 50 See Article 3, paragraph 4, and Article 17 of Complementary Law No. 123/2006. 51 See Article 25 of Law No. 9,249/1995. For CSL, see Article 21 of Provisional Measure No. 2,158-35/2001. 52 See Article 14, item III, of Law No. 9,718/1998. 53 See Interpretative Ruling Act (Ato Declaratório Interpretativo) RFB No. 5/2001. 54 See Article 26 of Law No. 9,249/1995. 55 See Article 25, paragraph 5, of Law No. 9,249/1995. 45 46

Corporate taxation in Brazil  339 Regarding the operation of a Brazilian company through foreign branches, controlled or affiliated companies, Brazilian legislation establishes a different treatment. In 1995, the introduction of the worldwide income taxation was due to anti-avoidance concerns related to resident companies which were shifting their profits to low-tax countries. However, no distinction was created in order to separate normal operations from abusive ones, or tax havens from regular taxing countries. Simply, in the past, Brazilian legislation provided for immediate taxation of profits derived by Brazilian resident companies through their related legal entities domiciled abroad regardless of: the status of such entities (whether controlled or associated to the Brazilian parent company); the location of such entities (whether in low taxation jurisdictions or not); and also irrespective of the nature of the income derived (whether active or passive). This regime was set by Provisional Measure No. 2,158/2001 and endured until the Brazilian Supreme Court held it partially unconstitutional. Under the Direct Action of Unconstitutionality No. 2,588, the Supreme Court decided for: the constitutionality of the taxation of profits earned by controlled companies located in tax havens and the unconstitutionality of the rule to associate companies located outside tax havens.56 The decision was inconclusive with respect to situations involving controlled companies located outside tax havens and associated companies located in tax havens. In 2014, inspired by the decision of the Supreme Court, Law No. 12,973 created four subgroups of taxation on a worldwide basis, using both the jurisdiction and the tainted approach.57 The first group is formed by direct or indirect controlled companies by a Brazilian company, as well as associated companies treated as controlled companies given a constructive ownership clause, as long as these companies are subject to regular taxation.58 Their profits are taxed, irrespective of any distribution, by the Brazilian CIT. Such profits, considered before the foreign corporate income tax, are added to the tax basis of the Brazilian parent company. That is why Brazilian legislation provides for both indirect and direct tax credits.59 Until the end of 2022, the Brazilian parent company may put all foreign results in one basket, allowing profits and losses to be offset against each other (and thus only the net positive amount shall be taxed in Brazil).60 Also, until 2022, the Brazilian parent is allowed by Law No. 12,973/2014 to use a deemed-paid foreign tax credit equivalent to 9 percent of the foreign profit in addition to ordinary foreign tax credit,61 which may be able to fully neutralize the Brazilian tax burden whenever the foreign company is taxed at a 25 percent rate.62 The second group is formed by the same status as the companies above, except for the fact that they do not comply with the jurisdiction and tainted approaches as adopted by the 2014 statute.63 Their tax regime is the same as the first group, but not regarding the access to the

56 See Brazilian Federal Supreme Court, Direct Action of Unconstitutionality No. 2,588/DF, 10 April 2013. 57 See Luís Eduardo Schoueri and Guilherme Galdino, ‘Controlled foreign company legislation in Brazil’, in Georg Kofler (ed.), Controlled foreign company legislation (WU Series, vol 17, IBFD 2020) 107–29. 58 See Articles 76, 77, 80 and 83 of Law No. 12,973/2014. 59 See Article 87 of Law No. 12,973/2014. 60 See Article 78 of Law No. 12,973/2014. 61 See Article 87, paragraph 10, of Law No. 12,973/2014. 62 See Guilherme Galdino, ‘Tributação universal com efeitos territoriais? O crédito presumido na Lei n. 12.973/2014’, 6 Revista Direito Tributário Internacional Atual 197–223 (2019). 63 See Article 79 of Law No. 12,973/2014.

340  Research handbook on corporate taxation deemed-paid foreign tax credit nor the possibility to consolidate foreign results in one basket. Thus, each foreign company is taxed individually. The third group is composed of foreign associate companies that do not fulfill the jurisdiction approach.64 In this case, regardless of any distribution, their profits are taxed by the Brazilian CIT, including any result obtained through another legal entity in other tiers. Brazilian legislation provides also for both indirect and direct tax credits.65 Finally, the fourth group is formed by foreign associate companies that are subject to regular taxation.66 These companies are the only ones whose profits are taxed in Brazil only upon distribution. That is why the Brazilian company may offset the Brazilian CIT on these profits against the tax on dividends imposed abroad (direct credit).67 From the perspective of tax treaties, it is under dispute whether Brazilian Worldwide Taxation applies in case the invested company is resident in other Contracting State. Under the previous regime, the Superior Court of Justice ruled in favor of the taxpayers, establishing that Article 7 of the Brazilian tax treaties precluded the application of the previous Brazilian Worldwide Taxation legislation.68 However, RFB reaches a different conclusion in regard to the current legislation,69 despite the existence of such precedent and the absence of an anti-abusive character of these rules – since for controlled companies the rule is to tax regardless of the distribution and irrespective of the nature of the income or where it is located.

6.

SELECTED ISSUES OF THE ACTUAL PROFIT REGIME

Since in the actual profit regime the taxation does follow the ‘revenue minus expenses’ formula, some rules have a major importance to calculate the tax base. In this context, one presents the deductibility rules (see section 6.1), the tax losses treatment (see section 6.2) and the interest on net equity payments (see section 6.3). To prevent abusive operations, Brazilian legislation contains transfer pricing (see section 6.4) and thin cap rules (see section 6.5). 6.1

Deductibility Rules

Companies subject to the actual profit regime shall follow the ‘revenue minus expenses’ formula. In this approach, the deductibility rules take a central position because the company shall test each expense, in order to deem if it shall diminish the revenue or not. According to the general rule for the deductibility of expenses, an expense (not computed as cost, that is, as payment for the acquisition of a given asset) may only be deducted from the

See Article 82 of Law No. 12,973/2014. See Article 26 of Normative Ruling (Instrução Normativa) of RFB No. 1,520/2014. 66 See Article 81 of Law No. 12,973/2014. 67 See Article 88 of Law No. 12,973/2014. 68 See Brazilian Superior Court of Justice, Appeal No. 1,325,709/RJ, 24 April 2014, which is known as the Vale case. On this matter, see Luís Eduardo Schoueri and Mateus Calicchio Barbosa, ‘Brazil: CFC rules and tax treaties in Brazil – A case for Article 7’, in Michael Lang, Erick C.C.M. Kemmeren, Daniël S. Smit, Peter Essers, Jeffrey Owens, Pasquale Pistone and Alexander Rust (eds), Tax treaty case law around the globe 2015 (IBFD 2016) 69–85. 69 See, e.g., RFB, Tax Ruling COSIT No. 400/2017. 64 65

Corporate taxation in Brazil  341 taxable basis to the extent it is necessary to the undertaking of the transactions required by the activity of the company.70 Thus, deductible expenses are those which are normal or usual within the context of the activity undertaken by the company. On the other hand, expenses incurred by the company that are unnecessary or not usual to its object and to the maintenance of its income source shall not be deducted in the calculation of its taxable profit. The application of the deductibility rule is essential to materialize the notion of income, according to which income shall be available to the taxpayer. That is why one shall deem available only the income that is net from expenses.71 6.2

Tax Losses

To understand the treatment of tax losses under the current Brazilian CIT legislation, one should consider: (i) how tax losses may be formed under the relation between accounting and tax law; (ii) how tax losses impact the taxable profits; (iii) how much of the profits can be offset; and (iv) for how long the tax losses may be carried forward. Regarding (i) how tax losses may be formed under the relation between accounting and tax law, a result is achieved under the actual profit after considering the accounting recordings and modifying them according to the additions and exclusions required by tax law. If this result is positive, it will be taxable; if it is negative, it will be considered a tax loss, to be offset against profits in the following tax periods. In this context, tax losses can be defined as the negative tax result of a given tax period.72 Due to additions and exclusions required by tax law, neither do accounting losses necessarily lead to tax losses, nor do accounting profits necessarily lead to taxable profits. Accounting results only induce tax results (since tax law is partially based on accounting), but they are independent. As explained above, tax law provides for additions and exclusions to be made on the accounting results. For instance, even where accounting losses exist, it is possible that a positive (taxable) result is found as a consequence of additions and exclusions. The same applies to accounting profits. Although profitable in accounting books, it is possible that, once the additions and exclusions are made, a negative (non-taxable) result is found (i.e., a tax loss).73 Given these considerations, one may have four possibilities: 1. The first possibility is the existence of accounting profits and, after the additions and exclusions, there are actual profits, which shall be taxed by the CIT; 2. The second possibility is the existence of accounting profits, but, after the additions and exclusions, there are no actual profits; then, one may find tax losses to carry; 3. The third possibility is the existence of accounting losses, but, after the additions and exclusions, there are actual profits, which shall be taxed by the CIT; or See Article 47 of Law No. 4,506/1964. See Luís Eduardo Schoueri, ‘Considerações acerca da Disponibilidade da Renda: Renda Disponível é Renda Líquida’, in Fernando Aurélio Zilveti, Bruno Fajersztajn and Rodrigo Maito da Silveira (eds), Direito Tributário: princípio da realização no imposto sobre a renda – estudos em homenagem a Ricardo Mariz de Oliveira (IBDT 2019) 19–32. 72 See Ricardo Mariz de Oliveira, Fundamentos do Imposto de Renda (Quartier Latin 2008) 859. 73 See Ricardo Mariz de Oliveira, Fundamentos do Imposto de Renda (Quartier Latin 2008) 860. 70 71

342  Research handbook on corporate taxation 4. The fourth possibility is the existence of accounting losses and, after the additions and exclusions, there are no actual profits; then, one may find tax losses to carry. As seen in the second and fourth possibilities, Brazilian tax law allows tax losses to be carried forward by legal entities.74 Thus, if in year 1 a legal entity does not derive taxable profits, but rather tax losses, it will be able to use these losses to offset taxable profits it may have in the following years (year 2, 3, etc.). In this sense, for the following periods, tax losses (ii) may impact the calculation of the taxable bases of both IRPJ and CSL. Along with additions and exclusions, tax losses form the taxable bases for both IRPJ and CSL:75 they are a negative element in the calculation of their taxable bases. Tax losses are not to be credited against taxes. Tax losses are to be considered in the very calculation of the taxable base. Only after the taxable base is determined (with the consideration of additions, exclusions and tax losses), a tax rate will apply, and a tax will arise. Therefore, tax losses operate at a level before the rise of taxes, that is, reducing the taxable base upon which taxes are finally calculated. Thus, if, in year 1, a company does not derive taxable profits, but rather tax losses, such fact generates legal consequences beyond year 1. It is true that such a company will not be taxed in year 1, as it has not derived taxable profits in that year. But not only this: if such a company comes to derive taxable profits in the following tax periods, it will be able to use the losses previously assessed to offset these profits, thereby reducing its taxable base. On the one hand, the taxpayer may only use their tax losses if in the following tax periods there are taxable profits; otherwise, such tax losses are continuously carried forward. On the other hand, the possibility of carrying losses greatly changes the burden of taxation: taxable profits derived in a given tax period will only be partially taxed, that is, only a portion of the taxable profits will form the taxable base; otherwise, taxable profits derived in a given tax period would necessarily be fully taxed, that is, all taxable profits would form the taxable base. In the latter situation, the amount of taxable profits that can be excluded from taxation depends on how much losses the entity concerned carries from earlier tax periods, as well as on possible limitations imposed by tax legislation. Currently, the Brazilian legislation (iii) limits the amount of taxable profits that can be offset by tax losses in a sole tax period. The limitation consists of 30 percent of the taxable profits of a tax period.76 As one may see, there is no limitation on the amount of tax losses themselves, but rather on the amount of taxable profits that can be offset by the losses in a sole tax period. In other words, the losses can be fully used to offset the taxable profits in one tax period, provided that they do not exceed 30 percent of the taxable profits. Then, no accumulated tax losses remain. However, once the tax losses reach 30 percent of the taxable profits, no tax losses can further be used in that tax period. This does not mean, however, that remaining tax losses have no value: they remain valid and may be offset in future tax periods, that is, against future taxable profits, provided the amount of tax losses offset in each tax period does not exceed 30 percent of the profit.

See Articles 42 and 58 of Law No. 8,981/1995 and Articles 15 and 16 of Law No. 9,065/1995. See Article 6, paragraph 3, item I of Decree-Law No. 1,598/1977. 76 See Articles 42 and 58 of Law No. 8,981/1995 and Articles 15 and 16 of Law No. 9,065/1995. 74 75

Corporate taxation in Brazil  343 Currently, the Brazilian tax law (iv) does not impose any time limitation to benefit from tax losses. Tax losses can be used to offset profits regardless of time. In short, tax losses are the negative tax result of a given tax period, which can impact the taxable base of the IRPJ and the CSL in the following tax periods, at a maximum of 30 percent of the taxable profits for each tax period, with no time limitation for carrying them forward.77 6.3

Interest on Net Equity

Besides dividends, Brazilian companies can distribute another kind of income named interest on net equity (juros sobre capital próprio).78 On the one hand, this payment is similar to a dividend because it is paid only to shareholders, in proportion to their equity participation and only if the company has profits to be distributed. For financial demonstration purposes, companies shall present them as distribution of profits – like dividends. On the other hand, interest on net equity presents similar tax effects as any interest payment from both perspectives of the payer and of the recipient. It may be deducted from the company’s profit up to a certain limit. The deduction corresponds to the Brazilian long-term interest rate – which is fixed on a quarterly basis (currently at approximately 7.01 percent for the third quarter of 2022) – applied to the net equity. Since 2014, the net equity for this calculation shall be composed of the following accounts: share capital; capital reserve; profit reserve; treasury shares; and accrued losses.79 The deduction is capped at 50 percent of the sum of profits contained in reserves or the current profits (whichever is higher). Given this limitation, the payment of the interest on net equity becomes interesting only if there is a considerable amount of equity capital invested and profits from the current or previous years to distribute. As a general rule, interest on net equity payments is subject to a 15 percent withholding tax. For Brazilian companies subject to the actual profit regime, the interest on net equity received is also part of the taxable base. Also, such company would be further subject to a levy of PIS and COFINS (at a total 9.25 percent rate). The payment to Brazilian individuals, non-residents, and companies not subject to the actual profit regime becomes especially interesting insofar as it will be only subject to a 15 percent withholding tax, while the payment is deducted at a 34 percent rate. In summary: the company shall deduct the amount from its 34 percent taxable base, and the recipient shall be taxed on a 15 percent basis. A (34−15) 19 percent saving is thus perceived. Interest on net equity should not be seen as a tax incentive, but rather as a mechanism for equal treatment for companies financed by their own equity holders and those financed by third parties. Accordingly, since the latter may deduct the amount of interest paid to capital holders, Brazilian legislation grants the same treatment for the former.

For further analysis, specially, considering tax planning issues, see Luís Eduardo Schoueri and Vinicius Feliciano Tersi, ‘The use of tax loss carry-forwards in Brazil: Look, but don’t touch’, 19 International Transfer Pricing Journal 199–203 (2012). 78 See Article 9 of Law No. 9,249/1995. 79 See Article 9, paragraph 8, of Law No. 9,249/1995, as amended by Law No. 12,973/2014. 77

344  Research handbook on corporate taxation Due to its hybrid characterization, interest on net equity may be especially attractive, from an international tax perspective, in cases where the investor’s jurisdiction qualifies such payments as (non-taxable) dividends, despite being deducted as interest in Brazil.80 6.4

Transfer Pricing Rules

Transfer pricing relies on a fiction and a presumption.81 Based on the arm’s length principle, transfer pricing rules establish that transactions between related parties shall be taxed as if they had been carried out between independent (i.e., unrelated) parties. In other words, the arm’s length principle requires the consideration, for taxation purposes, of what independent parties would have negotiated. Thus, the arm’s length principle consists of a legal fiction. Besides this legal fiction, transfer pricing rules assume, for taxation purposes, that independent parties would have negotiated in a certain way. To reach this way, transfer pricing rules set methods, which all have in common the fact that they presume a certain way of independent parties negotiating. In line with this approach, Brazil adopted transfer pricing rules in 1996.82 However, Brazilian transfer pricing rules do not follow the Organisation for Economic Co-operation and Development (OECD) approach due to both their wide scope and the use of fixed margins.83 Brazilian transfer pricing rules reveal a wide scope, since they apply not only to transactions between related parties, but also to any transaction with an individual or legal entity resident in a favored tax jurisdiction or subject to a preferential tax regime. Favored tax jurisdictions are defined as low-tax jurisdictions or whose domestic legislation provides for secrecy of corporate ownership.84 Preferential tax regimes are defined as any set of rules that provide for low taxation, any other tax benefit associated with the absence of substantial activity, low or no taxation on foreign profits or whose domestic legislation provides for secrecy of corporate ownership.85 Both favored tax jurisdictions and preferential tax regimes are listed.86 The anti-avoidance scope of Brazilian transfer pricing rules is clear-cut: not only does it aim at controlled transactions, whose price may not follow the market price, but also to uncontrolled transactions carried out between a Brazilian resident and a resident in a listed jurisdiction. The methods concerning the import of goods, services or rights are: (i) the comparable independent price method (PIC); (ii) the resale price less profit method (PRL); (iii) the pro-

For further analysis, see Luís Eduardo Schoueri and Gabriel Bez-Batti, ‘Brazil’, in Guglielmo Maisto (ed.), Taxation of interest under domestic law, EU law and tax treaties (EC and International Tax Law Series, vol 19, IBFD 2022) 447–8. 81 For further analysis, see Luís Eduardo Schoueri and Ricardo André Galendi Jr., ‘The arm’s length standard: Justification, content, and alternative proposals’, in Yariv Brauner (ed.), Research handbook on international taxation (Edward Elgar Publishing 2020) 153–73. 82 See Articles 18–24-B of Law No. 9,430/1996. 83 There are some challenges for Brazil to be an OECD member in this regard, see Luís Eduardo Schoueri and Ricardo André Galendi Jr., ‘Brazil: Challenges to Brazilian transfer pricing rules upon accession to the OECD’, 26 International Transfer Pricing Journal 1–19 (2019). 84 See Article 24 of Law No. 9,430/1996. 85 See Article 24-A of Law No. 9,430/1996. 86 See Normative Ruling (Instrução Normativa) of RFB No. 1,037/2010. 80

Corporate taxation in Brazil  345 duction cost-plus profit method (CPL); and (iv) the quotation price on imports method (PCI). For exports, the methods applicable are: (a) the export sales price method (PVEx); (b) the resale price method (RPM); (c) the purchase or production cost-plus tax and profit method (CAP); and (d) the quotation price on exports method (PCEX). There is no ‘best method rule’, but, during the same fiscal year, the same method must be applied to the same product or transaction.87 Differently from the OECD that adopts the criteria for pricing intercompany transactions, Brazilian legislators preferred to adopt the international practice to the country’s economic context, providing for legal certainty through the fixed margins under the equivalents of the resale and cost-plus methods. The fixed margins approach establishes a presumption of profitability by economic sector. One can say, then, that the presumption, typical of any transfer pricing legislation, goes further in the Brazilian law: not only a way of independent parties negotiating, but also a profitability percentage in their transactions is presumed (which will serve as the basis for the taxation of transactions between related parties). Although the Brazilian approach goes toward simplicity, one may criticize the absence of flexibility, considering that the fixed margins are not, in fact, rebuttable. The advantage of practicability provided by such approach is not followed by the needed flexibility to adjust the profit margin in particular cases. Even though Brazilian legislation establishes the possibility for the taxpayer to challenge the legal profit margin and claim its modification, no case is known where such a claim has succeeded. 6.5

Thin Cap Rules

Brazilian thin capitalization rules limit interest payments to related parties or to persons located in favored tax jurisdictions or subject to a preferential tax regime on an equity-based ratio. Thus, no limit is based on the amount of profits. There are two different situations. First, Brazilian thin capitalization rules apply to any interest payment from the company resident in Brazil to a non-resident (individual or legal entity) located in favored tax jurisdictions or which is under a preferential tax regime.88 The debt must not surpass 30 percent of the debtor’s net equity; otherwise, the excess expense is not deductible. Second, Brazilian thin capitalization rules apply to any interest payment from the company resident in Brazil to a related person (individual or legal entity) resident abroad.89 To this situation, any loan is subject to a debt-to-equity 2:1 maximum ratio for deductibility purposes. In other words, the sum of all debts with that kind of creditor may not exceed twice the value of the sum of their shares in the debtor’s net equity. This is called the global limit. There is also an individual limit, which depends on whether the creditor is a related person to the company. For related persons that have a share of the company’s capital, the debt of each creditor may not exceed more than twice the value of its share in the debtor’s net equity. For

For an in-depth analysis of the Brazilian transfer pricing methods, see Luís Eduardo Schoueri and Ricardo André Galendi Jr., ‘Brazil’, in Cahiers de Droit Fiscal International (vol 102b, IFA 2017) 194–202. 88 See Article 25 of Law No. 12,249/2010. 89 See Article 24 of Law No. 12,249/2010. 87

346  Research handbook on corporate taxation related persons that do not have a share of the company’s capital, the debt of each creditor may not exceed more than twice the value of the debtor’s net equity. In summary, besides the global limit, interest remitted abroad to a related party shall only be deductible from the income tax base if the amount of the debt is not superior to twice (i) the equity participation owned by the related person abroad on the resident company or (ii) the debtor’s net equity, if the related person does not hold any share in the resident company’s capital. All interest exceeding these limits shall be deemed as non-deductible expenses.

7. CONCLUSION The current Brazilian CIT rules may be characterized essentially by the attempt to provide for simplicity. Several rules aim at legal certainty through simplicity such as the deemed profit regime, Simples Nacional and transfer pricing rules. At the same time, however, the design of each set of rules usually reveals complexity. For instance, one may criticize the so-many divisions of tax rates under the Simples Nacional and deemed profit regimes. In other situations, Brazilian CIT may be challenged for lack of competitivity in the international scenario when addressing tax abuse such as in the Worldwide Taxation rules.

PART IV CORPORATE TAX PLANNING

21. Corporate tax shelters Joshua Blank and Ari Glogower

1. INTRODUCTION Corporations and their shareholders have always sought opportunities to avoid entity- and shareholder-level tax liabilities under the US corporate tax system.1 Shortly after the enactment of the corporate income tax in 1909, corporations used simple tax avoidance strategies, such as by characterizing themselves as partnerships, which were not subject to entity-level taxation, rather than corporations.2 In the late 1990s, major accounting firms marketed colorfully named tax shelter products, such as BOSS (bond and options sales strategies),3 Son-of-BOSS (option position transfers),4 and COBRA (currency options bring reward alternatives),5 among many others6 to Fortune 500 companies. In more recent years, corporate managers have pursued aggressive tax avoidance strategies involving transfer pricing,7 tax preferences,8 and choice of business entity.9 Throughout the history of the US corporate tax, one common characteristic of corporate tax shelters is that they have frequently escaped detection and challenge by the US Internal Revenue Service (IRS). 1 See Dep’t of Treasury, ‘The Problem of Tax Shelters: Discussion, Analysis, and Legislative Proposals’ (1999); IRS, Office of Tax Shelter Analysis, ‘Abusive Corporate Tax Shelters’ Background paper (2001) at 1. For further discussion, see Reuven S. Avi-Yonah, ‘Corporate Social Responsibility and Strategic Tax Behavior’, in Taxation and Corporate Governance (MPI Studies on Intellectual Property, Competition and Tax Law, vol 3, Wolfgang Schoen, ed., Springer 2008); Joshua D. Blank, ‘What’s Wrong with Shaming Corporate Tax Abuse’ (2009) 62 Tax L. Rev. 539; Marvin A. Chirelstein and Lawrence A. Zelenak, ‘Tax Shelters and the Search for a Silver Bullet’ (2005) 105 Colum. L. Rev. 1939; Michael S. Knoll, ‘Compaq Redux: Implicit Taxes and the Question of Pre-Tax Profit’ (2007) 26 Va. Tax Rev. 821; Susan Cleary Morse, ‘The How and Why of the New Public Corporation Tax Shelter Norm’ (2006) 75 Fordham L. Rev. 961; George Yin, ‘The Problem of Corporate Tax Shelters: Uncertain Dimensions, Unwise Approaches’ (2002) 55 Tax L. Rev. 406. 2 See, e.g., Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925) (holding an unincorporated association taxable as a corporation); Sec. Flour Mills Co. v. Comm’r, 321 U.S. 281, 287 (1944) (rejecting a corporation’s attempt to manipulate its taxable year to avoid a tax). 3 IRS Notice 99-59, 1999-52 I.R.B. 761. 4 IRS, ‘IRS Offers Settlement for Son of Boss Tax Shelter’ (2004), accessed 28 March 2023 at https://​www​.irs​.gov/​pub/​irs​-news/​ir​-04​-064​.pdf. 5 IRS Notice 2002-35, 2002-1 C.B. 992. 6 See S. Rep. No. 109-54, at 77–8 (2005). 7 See, e.g., Jesse Drucker, ‘An Accidental Disclosure Exposes a $1 Billion Tax Fight with Bristol Myers’ N.Y. Times, 1 Apr. 2021; Reuven S. Avi-Yonah, ‘International Tax Law: Status Quo, Trends and Perspectives’ in The Oxford Handbook of International Tax Law (Florian Haase and Georg Kofler, eds, OUP 2021). 8 See, e.g., Hayley Roth, ‘Opportunity Zones: Whose Opportunity? Remedying Failed Federal Policy via State Pro Bono Policy Toolkits’ (2021) 34 Geo. J. Legal Ethics 1285. 9 David Kamin, principal author, ‘The Games They will Play: Tax Games, Roadblocks, and Glitches under the 2017 Tax Legislation’ (2019) 103 Minn. L. Rev. 1439, 1451–2; Gladriel Shobe, ‘The Substance Over Form Doctrine and the Up-C’ (2018) 38 Va. Tax Rev. 249.

348

Corporate tax shelters  349 In response to the tax shelter boom of the late 1990s, Congress adopted an activity-based approach to corporate tax enforcement, which focuses on the specific transactions and activities which tend to enable tax abuse. The ‘reportable transaction’ disclosure rules target specific corporate activities and transactions that may be abusive.10 Because corporate tax shelters are often difficult for the IRS to detect, US tax law mandates that taxpayers and their advisors disclose to the IRS instances in which they have participated in transactions that bear tax shelter traits. Every year, thousands of US taxpayers and their advisors mail special disclosure forms that may reveal potentially abusive tax strategies, including ‘listed transactions’ and ‘transactions of interest,’ to the IRS Office of Tax Shelter Analysis in Ogden, Utah.11 The Internal Revenue Code (Code) also contains several tax penalties that may result when taxpayers or their advisors participate in these transactions or fail to disclose them properly to the IRS.12 Government officials, practitioners, and scholars have praised the reportable transaction disclosure rules as ‘powerful tax enforcement tools’ that serve important objectives.13 Proponents have argued that mandatory disclosure of corporate tax shelter activity provides the IRS with valuable information, enabling it to detect abusive tax planning that would otherwise remain hidden,14 and that provides taxpayers and their advisors with early warnings of the tax positions that the IRS will challenge.15 Government officials have also praised the reportable transaction disclosure rules for chilling the tax shelter market.16 Despite their potential tax enforcement benefits, the reportable transaction disclosure regime faces an uncertain future. Even though taxpayers and advisors must disclose potential tax shelters to the IRS using special forms, it is unclear whether the IRS has the resources necessary to review these disclosures and pursue audits and potential tax controversies. The IRS has also significantly curtailed its designation of tax strategies as listed transactions and transactions of interest.17 And in 2021, the US Supreme Court held that taxpayers and their advisors may seek pre-enforcement actions against the IRS’s notices that designate tax strategies as reportable transactions without violating the Anti-Injunction Act.18 In this chapter, we introduce a new approach to tax enforcement against corporate tax shelters. The reportable transaction rules have played significant roles in the government’s designation, detection, and deterrence of corporate tax shelters, which helped quell the corporate tax shelter boom of the early 2000s. At the same time, however, we argue that these rules face three significant limitations as the government’s primary response to abusive corporate 10 Treas. Reg. § 1.6011-4(d). For criticism, see Joshua D. Blank and Ari Glogower, ‘The Trouble with Targeting Tax Shelters’ (2022) 74 Admin. L. Rev. 69. 11 Treas. Reg. § 1.6011-4(d); see also IRS, ‘Abusive Tax Shelters and Transactions’ (2023) accessed 28 March 2023 at https://​www​.irs​.gov/​businesses/​corporations/​abusive​-tax​-shelters​-and​-transactions. 12 See IRC §§ 6707A(b)(2)(A), (B). 13 Ronald A. Pearlman, ‘Demystifying Disclosure: First Steps’ (2002) 55 Tax L. Rev. 289, 323; Joseph Bankman, ‘The Tax Shelter Problem’ (2004) 57 Nat’l Tax J. 925, 929; Pamela Olson, ‘Now that You’ve Caught the Bus, What Are You Going to Do with It? Observations from the Frontlines, the Sidelines, and between the Lines, So to Speak’ (2006) 60 Tax Law. 567, 567; Brief of Amici Curiae Former Government Officials in Support of Respondents, CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021). 14 See id. 15 See id. 16 See, e.g., Olson, supra note 14 at 567. 17 See infra note 82 and accompanying text for further discussion. 18 CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021).

350  Research handbook on corporate taxation tax shelters. The reportable transaction rules are reactive in that they often apply to emerging tax avoidance schemes rather than as a means of preempting abusive corporate tax planning more generally. In addition, these rules may fail to deliver information that the IRS can use to detect corporate tax abuse, including as a result of manipulation of the disclosed information by the taxpayer. Finally, the IRS is likely to face litigation hurdles in designating listed transactions and transactions of interest through preemptive taxpayer challenges under the Administrative Procedure Act (APA), which can impede the IRS’s ability to implement these rules. As a result, we argue that the government should seek preemptive disclosure of broader categories of information related to tax planning from corporate taxpayers, in addition to the specific information that the reportable transaction rules currently target. We suggest three reforms that policymakers should consider that would broaden the tax planning information that corporations must disclose.19 First, we propose that Congress should create an affirmative duty for corporate taxpayers to disclose to the IRS tax positions that are in conflict with regulations. Second, we propose that Congress should require corporations that seek to rely on written legal opinions to assert the ‘reasonable cause and good faith’ defense against civil tax penalties to disclose those opinions to the IRS when filing their initial tax returns. Last, we propose that the IRS should expand the type of information that it requires corporations to provide in their reportable transaction disclosure statements to include certain non-tax documentation.

2.

A TARGETED APPROACH TO CORPORATE TAX SHELTERS

A corporate tax shelter is a transaction or tax strategy that may appear to comply with the literal words of the tax law, yet that provides a corporation and/or its shareholders with tax benefits that Congress did not intend.20 The Code provides a general description of a tax shelter as a partnership, entity, plan, or arrangement where a ‘significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.’21 This broad definition could encompass corporate tax preferences authorized in the Code, such as the tax-deferred reorganization provisions.22 In practice, the IRS, judges, and legal scholars identify transactions as potential tax shelters when they lack economic substance, including a corporate business purpose, and do not appear to be consistent with the legislative history of the relevant tax statutes.23 As Professor Michael Graetz once famously commented, a corporate tax shelter is ‘a deal done by very smart people that, absent tax considerations, would be very stupid.’24 The following section (1) describes the common badges of abusive corporate tax shelters, (2) provides an overview of the reportable transaction rules, which reflect the government’s See infra section 4. See Dep’t of Treasury, supra note 1. 21 IRC § 6662(d)(2)(C). 22 IRC § 368. 23 See, e.g., Leandra Lederman, ‘W(h)ither Economic Substance?’ (2010) 95 Iowa L. Rev. 389, 391; Shannon Weeks McCormack, ‘Tax Shelters and Statutory Interpretation: A Much Needed Purposive Approach’ 2009 U. Ill. L. Rev. 697, 715. 24 Tom Herman, ‘Tax Report’ Wall St. J., 10 Feb. 1999, at A1. 19 20

Corporate tax shelters  351 targeted approach to specific potentially abusive tax activities and (3) presents justifications for the government’s targeted approach to corporate tax abuse articulated by government officials, practitioners, and scholars. 2.1

Badges of Corporate Tax Shelters

Corporate tax abuse has been a perennial feature of the corporate income tax in the United States from the time of its enactment. In the decades following the introduction of the corporate income tax in 1909, taxpayers attempted to avoid corporate-level and/or shareholder-level taxes through strategies, including characterizing business entities as partnerships rather than corporations,25 distributing appreciated property to shareholders rather than selling it directly,26 and paying salaries and other deductible expenses to shareholders.27 Nearly a century later, in the late 1990s and early 2000s, major accounting firms and other tax advisors marketed and sold tax shelter products to major US corporations, including American Home Products,28 Black & Decker,29 Borden,30 Colgate-Palmolive,31 Coltec Industries,32 Compaq,33 Dow Chemical,34 General Electric,35 GlaxoSmithKline,36 H.J. Heinz,37 Merck,38 Merrill Lynch,39 Procter & Gamble,40 UPS,41 Winn-Dixie,42 and Wal-Mart.43 For an example of one strategy, a corporation would buy millions of dollars of stock, sell that stock back to its original owner several minutes later, and then claim millions of dollars in foreign tax credits.44 Or a corporation would participate in a multi-step transaction with a non-US bank that allowed it to increase its tax basis in stock, which it then sold to a third party, generating a large tax-deductible loss.45 More recently, corporations and tax advisors have shifted away from the use of such tax shelter

See, e.g., Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925). See Gen. Utils. & Operating Co. v. Helvering, 296 U.S. 200 (1935). 27 See, e.g., John Kelley Co. v. Comm’r, 326 U.S. 521, 530 (1946). 28 Randall Smith, ‘IRS Battles Colgate over an Arcane Deal that Cut Its Tax Bill’ Wall St. J., 3 May 1996 at A1. 29 Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006). 30 Smith, supra note 28 at A1. 31 ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998). 32 Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). 33 Compaq v. Commissioner, 277 F.3d 778 (5th Cir. 2001). 34 Dow Chemical Co. v. United States, 435 F.3d 594 (6th Cir. 2006). 35 TIFD III-E Inc. v. United States, 459 F.3d 220 (2d Cir. 2006). 36 IRS, ‘IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute’ Press release (11 Sept. 2006), accessed 28 March 2023 at http://​www​.irs​.gov/​newsroom/​article/​0​,​,id​=​162359​,00​.html. 37 H.J. Heinz Co. v. United States, 76 Fed. Cl. 570 (Fed. Cl. 2007). 38 IRS, ‘Merck Agrees to Pay IRS $2.3 Billion’ Press release (14 Feb. 2007), accessed 28 March 2023 at https://​www​.irs​.gov/​pub/​irs​-news/​ir​-07​-035​.pdf. 39 ACM Partnership v. Commissioner, 157 F.3d 231, 233 (3d Cir. 1998). 40 Janet Novack and Laura Saunders, ‘The Hustling of X-Rated Tax Shelters’ Forbes, 14 Dec. 1998, at 198. 41 United Parcel Service of America, Inc. v. Commissioner, 254 F.3d 1014 (11th Cir. 2001). 42 Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001). 43 Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 860 A.2d. 312 (Del. 2004). 44 See, e.g., Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001) (‘dividend-stripping’ tax shelter). 45 See IRS Notice 2001-45, 2001-2 C.B. 129 (‘basis-shifting’ tax shelter). 25 26

352  Research handbook on corporate taxation products and have focused instead on tax avoidance strategies involving transfer pricing, choice of form, depreciation deductions, among many others.46 While corporate tax shelter strategies may appear in different forms, they feature several common badges of tax abuse. The following is a summary of the primary features of abusive corporate tax shelters, as identified by judicial decisions and regulatory guidance. Economic substance Courts may reject a corporation’s tax position as abusive if it does not result in economic gain or loss that matches the tax treatment and if it lacks a non-tax business purpose.47 Since 2010, the Code has contained a statutory version of the ‘economic substance’ doctrine that courts had previously applied with varying degrees of consistency.48 Under this provision, a taxpayer’s transaction possesses economic substance only if (1) it changes the taxpayer’s economic position in a meaningful way, apart from tax effects, and (2) the taxpayer has a substantial purpose, apart from tax reasons, for entering into the transaction.49 Judges, however, retain freedom to ignore the economic substance doctrine and apply other anti-abuse doctrine to recharacterize a taxpayer’s tax treatment or transaction.50 Tax losses Many abusive tax shelter strategies trigger tax losses that corporations can use to offset taxable gains.51 While tax losses often result from non-abusive business transactions, government officials have stated that they view transactions that ‘accelerate a loss or duplicate a tax deduction’ as potentially abusive.52 Related and tax-indifferent parties Last, many corporate tax shelter strategies are only possible with the participation of a related party (such as a controlled subsidiary) or tax-indifferent party (such as a tax-exempt entity).53 These parties may enable the corporate taxpayer to engage in non-arm’s length transactions that allow it to recognize a tax loss or avoid taxable income. 2.2

The Reportable Transaction Regime

The badges of corporate tax shelters described above formally appear in the Code and related Treasury regulations governing ‘reportable transactions.’54 When corporations participate in See supra notes 7–9. For discussion see David P. Hariton, ‘Sorting Out the Tangle of Economic Substance’ (1999) 52 Tax Law. 235, 239; Lederman, supra note 23 at 391; Martin J. McMahon, Jr., ‘Random Thoughts on Applying Judicial Doctrines to Interpret the Internal Revenue Code’ (2001) 54 SMU L. Rev. 195, 195. 48 See, e.g., Hariton, supra note 47 at 239; Daniel N. Shaviro and David A. Weisbach, ‘The Fifth Circuit Gets It Wrong in Compaq v. Commissioner’ (2002) 94 Tax Notes 511, 518. 49 IRC § 7701(o). 50 IRC § 7701(o)(5)(C). 51 Treas. Reg. § 1.6011-4(b)(5)(A). 52 See IRS, ‘Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties’ (2022), accessed 28 March 2023 at http://​www​.irs​.gov/​Businesses/​Guidance​-for​ -Examiners​-and​-Managers​-on​-the​-Codified​- Economic-Substance-Doctrine-and-Related-Penalties. 53 See id. 54 Treas. Reg. § 1.6011-4(d). 46 47

Corporate tax shelters  353 reportable transactions, they are required to file special disclosure statements with the IRS Office of Tax Shelter Analysis.55 In addition, their tax advisors are also required to file disclosure statements when they advise regarding reportable transactions in exchange for a minimum fee and must maintain a list of these taxpayers, which the IRS may request to review at any time.56 The specific activities that comprise reportable transactions are described below. Listed transactions By designating a specific tax strategy as a ‘listed transaction,’ the IRS states that it views the strategy is abusive because it lacks economic substance or is otherwise inconsistent with congressional intent.57 As of June 2022, there were 36 separate transactions designated as ‘listed transactions’ on the IRS website.58 Regulations also require taxpayers to disclose any tax strategies that are ‘substantially similar’ to listed transactions.59 Transactions of interest Corporations and their advisors must also report their participation in any ‘transaction of interest’ or substantially similar transactions.60 Transactions of interest are potentially abusive tax strategies, but the Treasury and IRS ‘lack enough information’ about them to make a determination about their legal merits.61 Other reportable transactions Reportable transactions also include more general categories. For instance, corporations must disclose any transactions where tax advisors guarantee refunds of fees or limit taxpayers’ ability to share information about their advice.62 Corporations must also disclose any transaction that results in a large tax loss (at least $10 million in a single year),63 even if the transaction that generated the loss is not abusive. Penalties The Code contains significant penalties for noncompliance with the reportable transaction disclosure rules. For each act of nondisclosure of a listed transaction, corporate taxpayers are charged a $200,000 penalty.64 This penalty is reduced to $50,000 for the nondisclosure of any other type of reportable transaction.65 Further, where taxpayers’ returns show a ‘reportable transaction understatement,’ a 20 percent accuracy-related tax penalty applies.66 This penalty

Id. Treas. Reg. § 301.6111-3(d)(1). 57 Treas. Reg. § 1.6011-4(b)(2). 58 See IRS, ‘Recognized Abusive and Listed Transactions’ (2023), accessed 28 March 2023 at https://​www​.irs​.gov/​businesses/​corporations/​listed​-transactions (listing 36 transactions in chronological order). 59 Treas. Reg. § 1.6011-4(c)(4). 60 Treas. Reg. § 1.6011-4(a), (b)(6). 61 T.D. 9350, 2007-38 I.R.B. 607, 608. 62 Treas. Reg. § 1.6011-4(b)(3), (4). 63 Treas. Reg. § 1.6011-4(b)(5). 64 IRC § 6707A(b)(2)(A). 65 IRC § 6707A(b)(2)(B). 66 IRC § 6662A(a). 55 56

354  Research handbook on corporate taxation increases to 30 percent if the taxpayer failed to disclose the transaction to the IRS.67 Finally, the law also imposes high monetary penalties on material advisors that fail to comply with the reportable transaction disclosure rules.68 As will be discussed in greater depth in section 3, in 2021 the US Supreme Court held that taxpayers and their advisors may seek pre-enforcement actions against the IRS’s notices that designate tax strategies as reportable transactions without violating the Anti-Injunction Act, a US statute that prevents taxpayers from seeking to enjoin the IRS from assessing or collecting taxes.69 This decision directly affects the future efficacy of the reportable transaction disclosure rules as tax enforcement tools. 2.3

Why Target Corporate Tax Shelters?

The US government has adopted an activity-based approach to corporate tax shelter enforcement.70 The reportable transaction rules described above only apply when taxpayers, including corporations large and small, engage in certain specified activities. Government officials and scholars have articulated several justifications for the use of this approach. By targeting specific activities through the reportable transaction rules, the Treasury and IRS may be empowered to designate, detect, and, ultimately, deter abusive corporate tax shelter activity. Designation The statutory and judicial definitions of a tax shelter are ambiguous. In contrast, when the IRS issues a public announcement that it considers a tax strategy to be a listed transaction or transaction of interest, the IRS uses this announcement as a mechanism for designating the transaction as abusive or potentially abusive. When the IRS has issued reportable transaction announcements, it has described the mechanical details of the transaction or tax strategy in order to inform taxpayers and advisors when disclosure is necessary. In addition, the IRS often uses these announcements to offer its legal reasoning for why it views the transaction or strategy as inconsistent with congressional intent or in violation of the economic substance or other judicial anti-abuse doctrines. Detection The reportable transaction rules require taxpayers to raise red flags to the IRS regarding potentially abusive tax strategies underlying the positions that they have claimed on their returns. A typical annual corporate tax return of a large corporation may be tens of thousands of pages in length.71 If corporations were not obligated to provide some clues to the IRS regarding abusive tax positions, the IRS field agents who initially review corporations’ returns would have a difficult time detecting them. For example, if a large corporation claimed a $20 million dollar tax loss as a result of an abusive corporate tax shelter, without a special disclosure form IRC § 6662A(c). IRC § 6707A(b)(2)(A). 69 See CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021). 70 For discussion of activity-based approaches to tax enforcement, see Joshua D. Blank and Ari Glogower, ‘Progressive Tax Procedure’ (2021) 96 NYU L. Rev. 668. 71 IRS, ‘IRS E-file Moves Forward; Successfully Executes Electronic Filing of Nation’s Largest Tax Return’ Press release (31 May 2006), accessed 28 March 2023 at https://​www​.irs​.gov/​pub/​irs​-news/​ir​-06​ -084​.pdf. 67

68

Corporate tax shelters  355 IRS field agents might not be able to flag this loss as abusive. The loss would appear as a tax loss on a schedule of the corporate tax return (likely Schedule D of IRS Form 1120), along with many other tax gains and losses resulting from transactions such as ordinary, non-abusive sales of property to unrelated parties.72 Mandatory disclosure of reportable transactions may thus provide the IRS with an ‘audit roadmap.’73 The required disclosure statement may lead the IRS agent who initially reviews this tax return to select it for audit and quickly issue an information document request (IDR) to the taxpayer. This request could enable the IRS to collect pertinent information regarding the transaction, which may result in a successful challenge of the tax benefits claimed. Deterrence Last, the reportable transaction disclosure rules, including high penalties for nondisclosure, can deter taxpayers from engaging in abusive tax planning. As a New York State Bar Association Tax Section report noted following the introduction of the reportable transaction regime, ‘Many taxpayers have a written policy against engaging in any listed transaction and it appears that some malpractice insurers want to know whether their insureds provide advice with respect to listed transactions.’74 Since then, government officials and academics have credited the reportable transaction rules with chilling the market for corporate tax shelters.75 When the IRS has announced that a tax strategy is a listed transaction or transaction of interest, market demand for that strategy among taxpayers subsequently ceased.76 As a former top government official has asserted, as a result of the reportable transaction rules, ‘the tax shelter war is over’ and ‘[t]he government won.’77

3.

THE LIMITATIONS OF TARGETING CORPORATE TAX SHELTERS

The reportable transaction rules are often characterized as powerful weapons in the government’s corporate tax shelter arsenal. At the same time, these rules also feature significant limitations and weaknesses as the government’s primary approach to corporate tax shelter enforcement. As we discuss in this section, the reportable transaction rules are reactive rather than preemptive, they may fail to deliver information that the IRS can use to detect corporate tax abuse, and, in the future, they are likely to be the subject of litigation challenges under the

See IRS Form 1120, Schedule D (2021). See Ronald A. Pearlman, supra note 14 at 323 (2002). 74 Tax Section, ‘N.Y. State Bar Ass’n, Report No. 1126, Report on Proposed Regulations Amending the Reportable Transaction Disclosure and List Maintenance Rules’ (2007) at 6. 75 See, e.g., Bankman, supra note 14; Olson, supra note 14; Pearlman, supra note 14 at 323; Brief of Amici Curiae Former Government Officials in Support of Respondents, CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021). Professor David Weisbach has criticized the current tax shelter disclosure rules as a poor alternative to the introduction of a strong anti-abuse doctrine as a response to the tax shelter problem. David A. Weisbach, ‘The Failure of Disclosure as an Approach to Shelters’ (2001) 54 SMU L. Rev. 73, 73–4. But even Weisbach concedes that the use of tax shelter disclosure as a means of detection ‘will do no harm.’ Id. at 73. 76 See Chirelstein and Zelenak, supra note 1. 77 Olson, supra note 14 at 567. 72 73

356  Research handbook on corporate taxation APA. As a result, in section 4, we argue that the government should also seek disclosure of broader categories of information related to tax planning from corporate taxpayers. 3.1

Reactive, Not Preemptive

By targeting specific tax shelter strategies and transactions, the reportable transaction rules react to existing tax avoidance activities utilized by corporations and other taxpayers. In listed transaction and transaction of interest notices, the IRS typically begins its discussion by stating that the agency has ‘become aware of certain types of transactions … that are being marketed to taxpayers for the avoidance of federal income taxes.’78 A significant drawback of this reactive approach is that by the time the IRS has issued its notice, corporations have already pursued the abusive tax activity. For example, by the time the IRS issued its listed transaction notice regarding the contingent liability tax shelter, a tax strategy that would generate a large tax loss that could offset unrelated gains, hundreds of corporations had already used this strategy.79 The reportable transaction rules, consequently, do not allow the IRS to preempt their initial spread nor to deter the pursuit of new tax avoidance strategies. When the IRS uses the reportable transaction rules to target specific tax strategies and transactions, corporate managers often shift their focus to other strategies that are not subject to mandatory disclosure. For example, in the early 2000s, when the IRS designated the contingent liability tax shelter and strategies such as BOSS80 and CARDS (custom adjustable rate debt structure)81 as reportable transactions, corporations stopped pursuing these transactions and instead moved on to other tax avoidance tactics. Corporations typically pursue tax positions that do not fall into the specific disclosure categories or that would lead to additional tax shelter penalties. The reportable transaction regime thus acts like the rubber mallet in a game of corporate tax shelter ‘Whac-A-Mole.’ IRS reactions to existing tax avoidance strategies also tend to occur slowly. During the first years in which the reportable transaction rules were in effect, the IRS identified listed transactions and transactions of interest routinely.82 Yet the current list of listed transactions contains only 36 abusive tax shelters, and only two of them have been designated as such since 2010.83 The result of this slow pace is that the current list of listed transactions and transactions of interest addresses tax strategies that were popular during the corporate tax shelter boom of the early 2000s. They do not address more current corporate tax avoidance techniques, such as abusive transfer pricing strategies, abusive use of non-recourse debt to create inflated basis and increased depreciation deductions, aggressive characterization of initial public offering structures as partnerships, retained corporate earnings strategies, among many others.84 And by design, they cannot apply to new tax avoidance strategies of which the IRS is not yet aware.

See, e.g., IRS Notice 2001-16, 2001-1 C.B. 730. See Richard M. Lipton, ‘New Tax Shelter Decisions Present Further Problems for the IRS’ (2005) 102 J. Tax’n 211, 211–17. 80 IRS Notice 99-59, 1999-52 I.R.B. 761. 81 IRS Notice 2002-21, 2002-1 C.B. 730. 82 See IRS, ‘Recognized Abusive and Listed Transactions’ (2023), accessed 28 March 2023 at https://​www​.irs​.gov/​businesses/​corporations/​listed​-transactions. 83 See id. 84 See supra notes 7–9 and accompanying text. 78 79

Corporate tax shelters  357 3.2

Manipulability and Scope

Despite their stated purpose, the reportable transaction rules may not deliver information to the IRS that enables the agency to detect abusive corporate tax shelters. This limitation is due to inherent weaknesses in the structure of the rules and the many opportunities they offer corporate taxpayers to escape disclosure. In some cases, corporations with aggressive managers who seek to avoid IRS detection (‘aggressive types’) may capitalize on these weaknesses. At other times, corporations with conservative managers (‘conservative types’) who attempt to comply with all legal requirements may ‘overdisclose’ information to the IRS regarding non-abusive transactions and tax strategies. As discussed below, these limitations of the reportable transaction rules result in wasteful tax shelter compliance (and noncompliance) by corporate managers and prevent the IRS from detecting and challenging corporate tax abuse. Content of disclosure A significant limitation of the current reportable transaction rules is that taxpayers, including large corporations, retain control over the content of the disclosures they provide to the IRS. Under the applicable regulations, taxpayers that file IRS Form 8886 (Reportable Transaction Disclosure Statement) must ‘describe the expected tax treatment and all potential tax benefits expected to result from the transaction’ and ‘identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the reportable transaction and the identity of all parties involved in it.’85 Notwithstanding this directive, the IRS has reported that the reportable transaction disclosure forms they receive often do not provide enough information to allow IRS agents to evaluate the underlying transactions. Conservative types may submit pages of detailed and thorough discussion in order to convince the IRS that their disclosed transactions are not abusive, while aggressive types may do so to prevent the IRS from detecting the true tax avoidance purpose of their transactions.86 In addition, aggressive types may file required disclosure forms, but provide minimal details regarding the transaction, to support a future claim that they should not be subject to increased tax penalties due to nondisclosure.87 Nondisclosure and underdisclosure Further, by targeting a specific activity, such as a listed transaction or transaction of interest, the reportable transaction rules provide taxpayers with opportunities to alter their tax avoidance strategy in order to avoid disclosure. When the IRS attempts to require taxpayers to submit information about a specific abusive tax shelter, there is a risk that the agency will define the strategy in terms that are too narrow to result in effective disclosure. For example, in the notices describing the intermediary corporation tax shelter and Section 302 basis-shifting tax shelter, the IRS attempted to describe the transaction with enough specificity to elicit disclosure.88 Treasury and the IRS require taxpayers to disclose not only tax strategies and transactions that appear in the IRS notices, but also those that are ‘substantially similar’ to them.

Treas. Reg. § 1.6011-4(d). For discussion, see Joshua D. Blank, ‘Overcoming Overdisclosure: Toward Tax Shelter Detection’ (2009) 56 UCLA L. Rev. 1629. 87 See id. 88 See IRS Notice 2001-45, 2001-33 I.R.B. 129 (Section 302 basis-shifting transactions). 85 86

358  Research handbook on corporate taxation Without this requirement, taxpayers and advisors could easily avoid any disclosure obligation by tweaking a potentially abusive tax strategy to distinguish it from the listed transactions and transactions of interest. Overdisclosure The substantial similarity requirement, combined with the tax penalties that apply to nondisclosure, however, can also cause taxpayers to overdisclose information regarding transactions and tax strategies that are not abusive to the IRS. The threshold for ‘substantial similarity’ is so low that taxpayers often use this requirement as a way to justify disclosure of non-abusive tax strategies and transactions. Under the applicable regulations, taxpayers and advisors must disclose any transaction that is ‘expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy.’89 When corporations and other taxpayers overdisclose information to the IRS, they provide information that fails to report participation in a potential abusive tax shelter, and that the IRS cannot easily identify as failing to report participation in a potential abusive tax shelter. During the past two decades, IRS officials have confirmed that corporate and other taxpayers have engaged in overdisclosure in response to the reportable transaction rules. For instance, when the IRS first described transactions involving notional principal contracts as listed transactions, it reported that it received ‘tens of thousands of unnecessary disclosures’ regarding total return equity swaps and other non-abusive transactions.90 As another example, immediately following the IRS’s designation of the intermediary corporation tax shelter (in which parties would attempt to avoid corporate-level gain by the seller), many taxpayers and advisors responded by disclosing routine, non-abusive business transactions. IRS officials later commented that the notices had resulted in ‘too many routine business transactions … being reported to the IRS.’91 When the IRS receives disclosure statements regarding complex transactions that lack tax avoidance motivation, its agents must investigate and distinguish these transactions from those that are abusive. This distraction slows both the enforcement and statutory responses to emerging abusive corporate tax strategies. 3.3

Administrative Law Challenges

A final limitation of the reportable transaction rules is that, as a result of recent judicial decisions, corporations and other taxpayers may pursue litigation that prevents the IRS from designating transactions as subject to mandatory disclosure. CIC Services v. IRS,92 a 2021 US Supreme Court case, has major implications for the future of the reportable transaction regime. CIC Services was a tax advisor in Tennessee that specialized in advising clients regarding micro-captive insurance strategies. CIC Services sought to enjoin the IRS from designating the micro-captive insurance strategy as a transaction of interest, which would subject it to mandatory disclosure to the IRS by taxpayers and their advisors. The petitioner’s core objection was that the IRS failed to comply with the notice-and-comment

Treas. Reg. § 1.6011-4(c)(4). IRS Advisory Council, ‘Public Meeting Briefing Book’ 12 (2006). 91 Crystal Tandon, ‘Too Many Unlisted Transactions Being Reported, IRS Officials Say’ (2006) 113 Tax Notes 203, 203. 92 CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1586–88 (2021). 89 90

Corporate tax shelters  359 process required by the APA when it issued its notice (IRS Notice 2016-66).93 Prior to this case, the lower courts had rejected the argument of CIC Services, holding that the Anti-Injunction Act applied. Under this Act, plaintiffs may not file any action ‘for the purpose of restraining the assessment or collection of any tax,’ but instead must first pay the tax liability due and then seek a refund from the IRS.94 In a unanimous decision, the US Supreme Court reversed the lower court and held in favor of the petitioner.95 The Court rejected the government’s argument that the injunction request was prohibited by the Anti-Injunction Act, despite the fact that noncompliance with the notice could lead to a tax penalty. First, the Court found that the IRS Notice imposed an affirmative reporting obligation on taxpayers and advisors, inflicting costs separate from the statutory tax penalty. Second, the Court found that the required reporting by taxpayers and tax advisors and the potential statutory tax penalty for noncompliance were several steps removed from one another, casting doubt on the characterization of the reporting requirement as a tax covered by the Anti-Injunction Act. Last, the Court found that the potential criminal penalty resulting from noncompliance with the reporting requirement negated the argument that the IRS Notice involved a tax. The CIC Services decision has significant potential implications for the IRS’s future use of the reportable transaction disclosure rules as tax enforcement mechanisms. The decision will likely cause taxpayers to challenge IRS notices designating transactions as listed transactions or transactions of interest on the grounds that they violate the APA if the IRS does not subject them to the notice-and-comment process. As Professor Daniel Hemel has noted, under CIC Services, ‘the IRS’s reportable-transaction designations can be challenged in federal district court by tax-shelter promoters, without the promoters having to follow the Anti-Injunction Act’s pay first/sue later procedure.’96 Hemel and other scholars have offered several approaches the Treasury and IRS could adopt in response to the CIC Services decision.97 Under one approach, the IRS could publish all existing reportable transaction notices in the Federal Register as proposed rules and notify members of the public that they may submit comments within 60 days. This act, scholars have argued, would enable the Treasury to argue that they have complied with the APA.98 Another possibility could be for Congress to amend the APA and the Anti-Injunction Act to exempt the reportable transaction disclosure rules.99 Without these actions or other remedies, the decision in CIC Services v. IRS is likely to cause the IRS to face legal challenges from corporations and other taxpayers, as well as from their advisors, regarding the validity of its notices designating transactions as reportable transactions in future years. This additional legal risk may further impede the IRS’s ability to apply the reportable transaction rules to address emerging abusive corporate tax strategies promptly and effectively. Notice 2016-66, 47 I.R.B. 745 (1 Nov. 2016). Memorandum in Support of the Defendant’s Motion to Dismiss at 12, CIC Servs., LLC v. IRS, No. 3:17-cv-110, 2017 WL 5015510 (E.D. Tenn. 30 May 2017) (quoting Anti-Injunction Act, I.R.C. § 7421). 95 CIC Servs., LLC, 141 S. Ct. 1582 (2021). 96 Daniel Hemel, ‘Treasury Needs to Act Fast to Save the Tax-Shelter Disclosure Regime’ Substance Over Form (18 May 2021), accessed 28 March 2023 at https://​substanceoverform​.substack​.com/​p/​ treasury​-needs​-to​-act​-fast​-to​-save 97 See id. 98 See id. 99 See id. 93 94

360  Research handbook on corporate taxation

4.

BEYOND REPORTABLE TRANSACTIONS: DISCLOSURE REFORM OPTIONS

The IRS requires different and better information regarding corporations’ tax planning than the reportable transaction rules alone can provide. As section 3 illustrated, under the current reportable transaction rules, the IRS reacts to specific abusive tax activities rather than attempts to learn about – and preempt – new and emerging tax avoidance strategies. Instead of relying only on the targeted approach to corporate tax shelter enforcement, the government should also seek broader categories of information related to tax planning from corporate taxpayers. This section presents three possibilities that policymakers should consider as supplements to the reportable transaction rules: an affirmative taxpayer duty to disclose tax positions which conflict with regulations; disclosure of tax advice as a condition to penalty defenses; and disclosure of non-tax documentation regarding reportable transactions. 4.1

Affirmative Disclosure Duty for Positions Conflicting with Regulations

Under current law, corporations do not have a duty to disclose to the IRS their tax positions that conflict with regulations at the time they file their tax returns. Rather, they are only required to file the reportable transaction disclosure statements described earlier, among other forms, such as Schedule UTP (Uncertain Tax Positions) and Schedule M-3 (Net Income (Loss) Reconciliation).100 However, taxpayers, including corporations, have the option to disclose tax positions that are in conflict with regulations by filing IRS Form 8275-R (Regulation Disclosure Statement) at the time they file their tax returns.101 In the event that the IRS audits and challenges these positions, under current law, the taxpayer can then assert a ‘reasonable basis’ defense against certain accuracy-related penalties, the penalties for disregard of rules and regulations and substantial understatements.102 Because the filing of such a disclosure statement serves as a red flag for the IRS that may lead to further review, many corporate taxpayers do not disclose to the IRS voluntarily.103 As an alternative to current law, Congress could require that corporations have an affirmative duty to disclose any tax positions on their returns that are in conflict with regulations, or face a tax penalty for failing to disclose these items. In 2022, the Biden Administration proposed that all taxpayers should be required to disclose tax positions that are contrary to regulations to the IRS by filing IRS Form 8275-R.104 In the event that taxpayers fail to disclose these positions, the reform would impose a penalty equal to 75 percent of the decrease in tax shown on the return as a result of the position, but that the penalty would not be more than $200,000 adjusted for inflation.105 In order to address corporate tax abuse specifically, Congress could enact a provision similar to that of the Biden Administration, but with modifications. For

100 IRS, Schedule UTP (Form 1120) (Uncertain Tax Position Statement); IRS, Schedule M-3 (Form 1065) (Net Income (Loss) Reconciliation for Certain Partnerships). 101 IRS, Form 8275-R (Regulation Disclosure Statement). See Treas. Reg. § 1.6662-3(c). 102 See Treas. Reg. §§ 1.6662-3(c)(1), (2). 103 See Dep’t of Treasury, ‘General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals’, March 2022, at 80. 104 Id. 105 Id.

Corporate tax shelters  361 example, Congress could restrict application of the duty to disclose to large corporate taxpayers (based on total asset value) and high-end individual taxpayers and significantly raise or remove the cap on the maximum penalty amount. A benefit of this proposal is that it would expand the types of potentially abusive tax strategies that corporations must disclose to the IRS beyond those activities that current law addresses, the reportable transactions. As discussed earlier, corporate managers and their advisors deliberately avoid engaging in transactions and tax strategies that may fit within any of the reportable transaction definitions and can instead pursue other forms of abusive tax planning.106 These strategies may even conflict with regulations, yet taxpayers may not disclose them. Where corporations have not recorded a reserve regarding the position or claim that they do not expect to litigate the position with the IRS, they do not raise a red flag regarding the conflicting position on Schedule UTP.107 As the Treasury has commented, a growing number of taxpayers, ‘especially large multinational entities,’ have taken tax positions that are contrary to regulations, but they are not visible to the IRS because the taxpayers have chosen not to disclose them ‘in the hopes of avoiding scrutiny.’108 In contrast to the narrow focus of the reportable transaction rules, Congress could provide the IRS with a more comprehensive view of corporations’ tax planning by enacting an affirmative duty to disclose certain questionable tax positions to the IRS. A potential drawback of a new duty to disclose is that it could result in the same type of overdisclosure that occurs under the current reportable transaction rules. To deter corporations from disclosing vague or unnecessary information, the IRS could state that it will assert the proposed nondisclosure tax penalty when corporations file IRS Form 8275-R without providing information that ‘can reasonably be expected to apprise the IRS of the identity of the item, its amount, and the nature of the controversy or potential controversy.’109 Further, the affirmative duty to disclose requirement is unlikely to be effective unless the IRS has the budgetary resources necessary to review the disclosures and investigate potential abusive tax positions. 4.2

Tax Advice

When exploring corporate tax disclosure alternatives to current law, policymakers should also consider the role of written tax advice. When corporations engage in abusive tax planning, they often avoid the application of civil tax penalties by showing that they acted in ‘reasonable cause and good faith’ relying on tax advice from an advisor.110 While this defense is not available for all tax penalties, such as those that apply where a court or the IRS determine that a transaction violated the codified economic substance doctrine, corporations may assert the defense when they have claimed tax positions that show negligence or disregard of rules and regulations or result in substantial understatements of income tax.111 Corporations who engage in reportable transactions face additional requirements and limitations, and cannot rely on tax opinions where the advisor has a fee arrangement that is contingent on all or part of the

See supra section 3.2. See infra note 114 and accompanying text. 108 See Dep’t of Treasury, supra note 1 at 86. 109 IRS, Instructions for Form 8275 (01/2021). 110 I.R.C. § 6664(c); Treas. Reg. § 1.6664-4(c). 111 Treas. Reg. § 1.6664-4(c). 106 107

362  Research handbook on corporate taxation intended tax benefits from the transaction being sustained.112 Corporations and advisors can generally circumvent these opinion reliance limitations by avoiding the specific elements of ‘disqualified opinions’ under Section 6664(d) and related regulations and by avoiding participating in reportable transactions.113 For many corporate taxpayers, the written tax opinion thus represents a form of ‘tax insurance’ in the event that they face accuracy-related tax penalties due to abusive tax planning. An alternative approach could be to condition the availability of the reasonable cause penalty defense on the disclosure of written tax advice by corporate taxpayers to the IRS. Under this proposal, where a corporation has relied on written tax advice, the corporation could only use that tax advice to assert the reasonable cause defense against civil tax penalties if it had previously submitted that written tax advice to the IRS at the time of the filing of the initial tax return. Corporations could be required to submit the written tax opinion as an attachment to either IRS Form 8275 (Disclosure Statement) or IRS Form 8886 (Reportable Transaction Disclosure Statement), whichever is relevant. This condition could be restricted to corporate taxpayers, but it could also be extended to other business entities and high-end individual taxpayers. The condition could be further restricted to situations where a tax advisor has received a minimum fee in exchange for the written tax advice. A conditional reasonable cause penalty defense could aid tax enforcement and deter abusive corporate tax planning in several ways. First, a written tax opinion would provide the IRS with far greater insight into the motivation, structure, and tax treatment of a transaction than a corporate taxpayer’s self-prepared disclosure statement or tax return. Written tax opinions describe the facts of transactions, as the taxpayer has represented them, consider the application of statutory and regulatory tax laws and caselaw to these facts, and, finally, reach an opinion. Second, this approach would move beyond the activity-based focus of current law by allowing the IRS to learn about aggressive and abusive corporate tax planning that may not fit within the specific categories of the reportable transaction rules. For example, when corporations engage in tax-free spin-off transactions, some of which may feature aggressive or abusive elements, they often seek an opinion from legal counsel. Yet these transactions are not included in the list of reportable transactions. Third, mandated disclosure of a tax opinion at the time of tax return filing would likely deter corporate taxpayers from engaging in abusive tax planning based on questionable legal positions. Compared to current law, corporate taxpayers would no longer be able to benefit from the possibility that the IRS does not audit specific tax returns or question certain transactions, about which advisors may have offered written tax advice. Corporate taxpayers and advisors may object that a conditional reasonable cause defense would intrude upon their relationships and interactions with tax advisors, including legal counsel. A response to this concern is that, under the proposal, corporations would not face any limitation on their ability to obtain legal advice, or even to keep that advice secret. Only corporations that seek to assert the reasonable cause defense against tax penalties as a result of reliance on tax advice would be required to disclose it at the time of tax return filing. Further, the proposal is not unprecedented as current law often requires taxpayers to reveal elements of tax advice to the IRS, directly and indirectly. For example, certain large corporations must I.R.C. § 6664(d)(4)(B). I.R.C. § 6664(d)(4)(B)(ii)–(iii).

112 113

Corporate tax shelters  363 file Schedule UTP to disclose uncertain tax positions to the IRS at the time of filing their tax returns.114 Corporations file this schedule when they have recorded a reserve with respect to a tax position in audited financial statements or when they did not record a reserve for that tax position because they expect to litigate the position. Additionally, material advisors, including lawyers, must maintain lists of clients whom they have advised regarding reportable transactions and to disclose that list to the IRS upon demand.115 Similar to the tax opinion filing requirement, these examples show situations where corporations must share beliefs regarding tax positions, as well as their dealings with tax advisors, with the IRS. 4.3

Non-Tax Documentation

Policymakers should also consider reforming the disclosure requirements to include non-tax documentation. As section 3 discussed, a weakness of current law is that it allows the taxpayer to control the delivery of information to the IRS regarding reportable transactions. Some corporate managers may decide to describe the steps of a transaction in detail, including references to the applicable law, while others may provide minimal description or explanation.116 In either case, by allowing taxpayers to craft a description specifically for the IRS, the reportable transaction rules yield disclosure of inconsistent, and potentially detrimental, benefit to the IRS. A different approach could be to require corporations filing reportable transaction disclosure statements to not only provide a written description of the transactions to the IRS, but also to include descriptions of the transactions that the corporation prepared for parties other than the IRS. For example, the Treasury could require corporations that disclose participation in a reportable transaction to include any written descriptions of the transaction that the corporation has provided to its board of directors, shareholders, or financial institutions. A requirement to disclose non-tax documentation would provide several tax enforcement benefits. First, descriptions of tax-motivated transactions that a corporation provides to directors, shareholders, or financial institutions are likely to be more comprehensive than the types of descriptions that a corporation includes with a reportable transaction disclosure form. When corporate managers communicate with members of the board, for instance, they may provide bullet point slides and memoranda that describe the structure of the transaction, its business motivation, and its significant tax implications.117 Compared to a description prepared for the IRS – which may include extensive technical discussion of transaction steps and relevant legal authorities, or no such details at all – these types of communications are likely to help the IRS distinguish between ordinary business transactions and abusive corporate tax strategies.118 Second, non-tax documentation might reveal the involvement of parties that have been involved in tax shelter transactions of which the IRS is aware, such as certain tax advisors, tax shelter promoters, or financial institutions. Last, a non-tax documentation requirement could enhance the IRS’s ability to identify emerging tax avoidance trends among large corporations. For example, in the past tax shelter boom, many corporations considered the same tax shelter

116 117 118 114 115

IRS, Schedule UTP (Form 1120) (Uncertain Tax Position Statement). IRS, Instructions for Schedule UTP (Form 1120) (Uncertain Tax Position Statement). See id. See Blank, supra note 86 at 1711–12. See id.

364  Research handbook on corporate taxation strategies, which were often described using similar terms by promoters. A non-tax documentation requirement could enable the IRS to better anticipate and preempt future tax shelters. A likely objection to the non-tax documentation requirement is that it could worsen rather than improve the overdisclosure limitation of the reportable transaction rules. This objection, however, ignores the changes the IRS would likely make to its review of reportable transaction disclosures in response to the non-tax documentation requirement. With non-tax documentation, the IRS could identify deviations between a corporation’s description of a transaction in its disclosure statement and its characterization of the same transaction to its chief executive officer or board of directors. For example, one team of IRS agents could review a corporation’s description of a reportable transaction in its IRS disclosure form, another team could review the descriptions of the same transaction in non-tax documentation, and the two teams could eventually compare notes. Consistent with its other investigative approaches, such as its review of book/tax differences,119 the IRS could then further examine transactions where there are deviations between the descriptions. Further, if this requirement resulted in excessive burden for the IRS or for taxpayers, the Treasury could narrow the requirement. For example, it could apply the non-tax documentation requirement only to large corporations based on the value of their total assets and/or could explore other restrictions, such as limiting the period to which the non-tax documentation disclosure requirement applies.

5. CONCLUSION The government’s effort to detect and deter abusive corporate tax strategies has reached a critical juncture. While the reportable transaction rules have allowed the government to detect and deter mass-marketed tax shelters and other forms of corporate tax abuse, especially during the corporate tax shelter boom of the late 1990s and early 2000s, they also are subject to significant limitations. As this chapter has illustrated, the reportable transaction rules are reactive in that they often apply to emerging tax avoidance schemes rather than as a means for preempting abusive corporate tax planning, often fail to deliver information that the IRS can use to detect corporate tax abuse, and, as a result of recent judicial decisions, can face significant legal obstacles. As a result, we have argued that the government should seek disclosure of broader categories of information related to tax planning from corporate taxpayers, in addition to the specific information that the reportable transaction rules currently target. Specifically, we have suggested that policymakers should consider as supplements to the reportable transaction rules: an affirmative duty to disclose tax positions that are inconsistent with regulations; a requirement to disclose written tax advice as a condition for certain tax penalty defenses; and a requirement to disclose non-tax documentation regarding reportable transactions. Policymakers and scholars should consider these and other possibilities for empowering the IRS to identify abusive corporate tax strategies as they are emerging rather than after they have already begun to spread.

See IRS, Schedule M-3 (Form 1065) (Net Income (Loss) Reconciliation for Certain Partnerships); Daniel N. Shaviro, ‘The Optimal Relationship between Taxable Income and Financial Accounting Income: Analysis and a Proposal’ (2009) 97 Geo. L. J. 423, 427. 119

Corporate tax shelters  365

REFERENCES Avi-Yonah, R.S., ‘Corporate Social Responsibility and Strategic Tax Behavior’, in Taxation and Corporate Governance (MPI Studies on Intellectual Property, Competition and Tax Law, vol 3, Wolfgang Schoen, ed., Springer 2008) Avi-Yonah, R.S., ‘International Tax Law: Status Quo, Trends and Perspectives’, in The Oxford Handbook of International Tax Law (Florian Haase and Georg Kofler, eds, OUP 2021) Bankman, J., ‘The Tax Shelter Problem’ (2004) 57 National Tax Journal 925 Blank, J.D., ‘What’s Wrong with Shaming Corporate Tax Abuse’ (2009) 62 Tax Law Rev. 539 Blank, J.D., ‘Overcoming Overdisclosure: Toward Tax Shelter Detection’ (2009) 56 UCLA Law Review 1629 Blank, J.D. and Glogower, A., ‘Progressive Tax Procedure’ (2021) 96 New York University Law Review 668 Blank, J.D. and Glogower, A., ‘The Trouble with Targeting Tax Shelters’ (2022) 74 Administrative Law Review 69 Chirelstein, M.A. and Zelenak, L.A., ‘Tax Shelters and the Search for a Silver Bullet’ (2005) 105 Columbia Law Review 1939 Hariton, D.P., ‘Sorting Out the Tangle of Economic Substance’ (1999) 52 Tax Lawyer 235 Hemel, D., ‘Treasury Needs to Act Fast to Save the Tax-Shelter Disclosure Regime’ (2021) Substance Over Form (18 May 2021), accessed 28 March 2023 at https://​substanceoverform​.substack​.com/​p/​ treasury​-needs​-to​-act​-fast​-to​-save Kamin, D., principal author, ‘The Games They will Play: Tax Games, Roadblocks, and Glitches under the 2017 Tax Legislation’ (2019) 103 Minnesota Law Review 1439 Knoll, M.S., ‘Compaq Redux: Implicit Taxes and the Question of Pre-Tax Profit’ (2007) 26 Virginia Tax Review 821 Lederman, L., ‘W(h)ither Economic Substance?’ (2010) 95 Iowa Law Review 89 Lipton, R.M., ‘New Tax Shelter Decisions Present Further Problems for the IRS’ (2005) 102 Journal of Taxation 211 McMahon, M., ‘Random Thoughts on Applying Judicial Doctrines to Interpret the Internal Revenue Code’ (2001) 54 Southern Methodist University Law Review 195 Morse, S.C., ‘The How and Why of the New Public Corporation Tax Shelter Norm’ (2006) 75 Fordham Law Review 961 Olson, P., ‘Now that You’ve Caught the Bus, What Are You Going to Do with It? Observations from the Frontlines, the Sidelines, and between the Lines, So to Speak’ (2006) 60 Tax Lawyer 567 Pearlman, R.A., ‘Demystifying Disclosure: First Steps’ (2002) 55 Tax Law Review 289 Roth, H., ‘Opportunity Zones: Whose Opportunity? Remedying Failed Federal Policy via State Pro Bono Policy Toolkits’ (2021) 34 Georgetown Journal of Legal Ethics 1285 Shaviro, D.N., ‘The Optimal Relationship between Taxable Income and Financial Accounting Income: Analysis and a Proposal’ (2009) 97 Georgetown Law Journal 423 Shaviro, D.N. and Weisbach, D.A., ‘The Fifth Circuit Gets It Wrong in Compaq v. Commissioner’ (2002) 94 Tax Notes 511 Shobe, G., ‘The Substance Over Form Doctrine and the Up-C’ (2018) 38 Virginia Tax Review 249 Weeks McCormack, S., ‘Tax Shelters and Statutory Interpretation: A Much Needed Purposive Approach’ (2009) 2009 University of Illinois Law Review 697 Weisbach, D.A., ‘The Failure of Disclosure as an Approach to Shelters’ (2001) 54 Southern Methodist University Law Review 73 Yin, G., ‘The Problem of Corporate Tax Shelters: Uncertain Dimensions, Unwise Approaches’ (2002) 55 Tax Law Review 406

22. Economic substance Amandeep S. Grewal

1. INTRODUCTION This chapter addresses the standards for invoking the economic substance doctrine1 under Section 7701(o).2 That statute, enacted in 2010,3 provides that the doctrine will apply when ‘relevant,’ with no meaningful elaboration of that term.4 Congress apparently left relevance determinations entirely to the courts. But thus far, courts have offered limited guidance on Section 7701(o).5 Uncertainty over the codified economic substance doctrine lingers. The Internal Revenue Service (IRS) has taken a measured approach to Section 7701(o), possibly because its violation leads to a severe, strict liability penalty.6 However, in recent internal guidance, the IRS has somewhat relaxed restrictions on when its personnel may invoke the economic substance doctrine.7 Thus, courts might soon need to address when the doctrine becomes relevant to a transaction under Section 7701(o). The time is thus ripe to consider the Section 7701(o) relevancy standard. This chapter first explains the approaches that courts used to invoke the economic substance doctrine prior to 1 By statute, Congress has defined the economic substance doctrine as ‘the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.’ I.R.C. § 7701(o)(5)(A). In the case law, the economic substance doctrine sometimes gets blended or confused with other doctrines and may go by other names, like the ‘sham-transaction doctrine.’ See, e.g., Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001). 2 Section references in this chapter are to the Internal Revenue Code of 1986, as amended (I.R.C.). 3 See Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409 (2010). 4 Section 7701(o)(1) provides: (o) Clarification of economic substance doctrine (1) Application of doctrine In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if: (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. 5 See generally Kristen A. Parillo, Economic Substance Test Case Settles Before Trial, 2019 Tax Notes Today 104-3 (30 May 2019). In Alternative Carbon Resources v. United States, 939 F.3d 1320 (Fed. Cir. 2019), the Federal Circuit referred to Section 7701(o) when it held that the taxpayer’s purported sale lacked economic substance. The court’s economic substance analysis was brisk and raises as many questions as it answers. See also Monte A. Jackel, Guidance Is Needed on the Codified Economic Substance Doctrine, 165 Tax Notes Federal 117 (7 Oct. 2019) (‘[T]he Federal Circuit’s opinion jumped from the common law of economic substance to the codified doctrine under section 7701(o) without clearly delineating whether its decision rested upon the codified doctrine or the common law cases, or both’). 6 See I.R.C. §§ 6662(b)(6) and 6664(c)(2). 7 I.R.S. LB&I-04-0422-0014.

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Economic substance  367 Section 7701(o)’s enactment. It then explains the basic elements of Section 7701(o). Last, the chapter explains that interpretive challenges will necessarily arise if a court tries to reconcile Section 7701(o) with pre-enactment case law. The statute may be doomed to failure.

2.

JUDICIAL APPROACHES TO ECONOMIC SUBSTANCE

Judicial doctrines abound in the tax law. The substance over form doctrine, the step transaction doctrine, and the assignment of income doctrine, to name a few, appear in numerous judicial opinions. Although many refer to them as ‘common law’ doctrines, that does not strictly describe their function. Federal common law, strictly speaking, refers only to ‘a rule of decision that amounts, not simply to an interpretation of a federal statute or a properly promulgated administrative rule, but, rather, to the judicial creation of a special federal rule of decision.’8 Tax-related judicial doctrines, however, do not create special rules of decision. Instead, courts typically use tax-related judicial doctrines to help determine the meaning of the authoritative statute at issue. For example, under the substance over form doctrine, if a taxpayer nominally transferred title in property to another person but retained all other benefits associated with the ownership of the property, the taxpayer could not claim that he had sustained a loss ‘from the sale or other disposition’ of property under Sections 165 and 1001. Courts generally give statutory terms their ordinary meaning, and the phrase ‘sale or other disposition’ contemplates that a taxpayer has surrendered rights to property. Thus, to determine whether a sale or other disposition had taken place, the court would examine whether the taxpayer transferred substantive rights in his property.9 The formal shift in title would not control the analysis. Used this way, the substance over form doctrine aids the construction of a statute and does not override it. The economic substance doctrine operates differently. Under the majority approach, when the economic substance doctrine applies, a court neither interprets statutory language nor believes itself constrained by it.10 Instead, the court will demand that a transaction exhibit objective economic substance or a subjective business purpose (or both), regardless of whether any statute imposes those requirements. Consequently, courts may hold against a taxpayer even after finding that the taxpayer has complied with all relevant statutes.11 Or, a court may dispense entirely with statutory analysis and simply hold that a taxpayer loses because the economic substance doctrine has not been satisfied.12 Under this extrastatutory approach, the Atherton v. FDIC, 519 U.S. 213, 218 (1997) (internal quotation marks omitted). See Cottage Sav. Ass’n v. Commissioner, 499 U.S. 554, 568 (1991) (deductible loss sustained under Section 165 because taxpayer dealt at arm’s length and did not ‘retain[] de facto ownership’). 10 The Supreme Court has never applied or addressed the extrastatutory economic substance doctrine. See Amandeep S. Grewal, Economic Substance and the Supreme Court, 116 Tax Notes 969 (2007). In one case, the Supreme Court acknowledged that the lower court had applied the doctrine. But the Court declined to express any view of it. See United States v. Woods, 134 S. Ct. 557, 562 n.1 (2013) (expressing no view on ‘the District Court’s application of the economic-substance doctrine’). See also Brief of Amicus Curiae Professor Amandeep S. Grewal in Support of Neither Party, United States v. Woods, 134 S. Ct. 557 (2013) (explaining why the Court should not endorse an extrastatutory economic substance doctrine). 11 See, e.g., WFC Holdings Corp v. US, 728 F.3d 736 (8th Cir. 2013). 12 See, e.g., In re CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002) (setting forth relevant provisions of the tax code but concluding that the court could ‘forgo examining the intersection of these statutory details’ because the economic substance doctrine applied). 8 9

368  Research handbook on corporate taxation economic substance doctrine provides an independent rule of decision and reflects true federal common law. Under a minority view, economic substance principles apply only to the extent that the governing statute makes them relevant. Courts following this statutory approach believe that the economic substance doctrine should aid statutory interpretation. These courts do not treat the doctrine as true federal common law. A circuit split nicely illustrates the conflict between the extrastatutory and statutory approaches. That circuit split arose in cases that addressed so-called straddle transactions. Those complicated transactions, which involved commodities trading, were designed to produce tax losses. They did not serve any legitimate business or profit-oriented purpose. In the 1970s, the use of straddle transactions became widespread, and the IRS undertook massive enforcement efforts. Congress then stepped in and enacted retroactive rules for straddles to help deal with the judicial logjam.13 By statute, Congress stated that a loss from a pre-1982 straddle transaction would be allowed only ‘if such loss is incurred in a trade or business, or if such loss is incurred in a transaction entered into for profit though not connected with a trade or business.’14 This law effectively denied taxpayers losses if they had entered into straddle transactions for purely tax avoidance purposes. However, in another part of the law, Congress established a special rule for commodities dealers. The other part stated that ‘any loss incurred by a commodities dealer in the trading of commodities shall be treated as a loss incurred in a trade or business.’15 Various commodities dealers consequently argued that they could enjoy losses on their straddle transactions. After all, in one part of the statute, Congress said that straddle losses could be enjoyed if they were incurred in a trade or business. And in another part, Congress created an irrebuttable presumption that losses claimed by commodities dealers were so incurred. Thus, the dealers argued, they should be able to enjoy deductions even if they were motivated solely by tax avoidance. Nonetheless, several circuit courts, using the extrastatutory approach to the economic substance doctrine, denied the tax losses claimed by commodities dealers. As the Third Circuit explained, ‘[i]f a transaction is devoid of economic substance—as the transactions involved here undeniably were—, it simply is not recognized for federal taxation purposes, for better or for worse.’16 And, as the court continued, if a transaction is ‘not recognized for tax purposes, [the statute] does not even come into play.’17 The commodities dealers could not rely on the statute and their claimed losses were denied. By contrast, the D.C. Circuit applied a statutory approach to the economic substance doctrine and held for the commodities dealers.18 In that court’s view, the statute’s plain language granted the claimed deductions. The court was ‘at a loss to understand the Commissioner’s suggestion, adopted by several courts, that the [economic substance] doctrine applies inde See Glass v. Commissioner, 87 T.C. No. 68 (1986) (consolidated case involving approximately 1,400 taxpayers) (subsequent history omitted). 14 Section 108(a) of the Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 630, as amended by the Tax Reform Act of 1986, Pub. L. No. 99-514, § 1808(d), 100 Stat. 2817-18. 15 Section 108(b) of the Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 630, as amended by the Tax Reform Act of 1986, Pub. L. No. 99-514, § 1808(d), 100 Stat. 2817-18. 16 Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir. 1991). 17 Id. at 52. 18 Horn v. Commissioner, 968 F.2d 1229 (D.C. Cir. 1992). 13

Economic substance  369 pendently’ of the statute.19 By refusing to even consider the statute, the IRS and three circuit courts had ‘close[d] off any consideration of whether Congress intended the “loophole”’ offered by the statute and thereby ‘read it completely out of existence.’20 Congress clearly granted deductions to commodities dealers to help address the judicial logjam caused by straddle transactions – it was ‘inconceivable that Congress intended that the [economic substance] doctrine be laid over the statute.’21 Although the D.C. Circuit reached its holding ‘with some trepidation in light of the contrary conclusions reached by three sister circuits,’22 the court would not allow the economic substance doctrine to ‘trump the plainly expressed intent of the legislature.’23 The circuit split over straddle transactions squarely illustrates the fundamental conflict between the extrastatutory and statutory approaches. Under the extrastatutory approach, Congress cannot grant tax benefits to transactions unless they pass judge-made economic substance requirements. Consequently, a court may refuse to look at a statute unless economic substance requirements are satisfied. But under the statutory approach, although a court recognizes that it should think twice before blessing a tax-motivated transaction, it also recognizes that Congress can grant tax benefits to economically meaningless behavior. Thus, under the statutory approach, even if a transaction unquestionably lacks economic substance, the court must examine the relevant statute ‘to see whether it nonetheless authorizes’ the taxpayer’s claimed tax benefits.24 Through most of the government’s battles against tax shelters, the statutory approach remained a quiet, minority position within the lower courts. However, sparks flew when, in Coltec v. United States, the Court of Federal Claims stated that the Constitution compelled the statutory approach.25 The court concluded that the extrastatutory approach, if followed, would allow courts to rewrite or ignore legislative enactments.26 In other words, the extrastatutory approach would violate the separation of powers. Though the Court of Federal Claims was later reversed on appeal, doubts over the extrastatutory approach began to grow. Eventually, to help offset costs associated with health care reform,27 Congress added Section 7701(o) to the tax code.28 As explained next, the new statute addresses some aspects of the economic substance doctrine but fails to resolve the extrastatutory-statutory conflict that persists within the case law.

Id. at 1238. Id. at 1234–8. 21 Id. at 1238. 22 Id. at 1234. 23 Id. at 1231. 24 Id. at 1238 (emphasis in original). 25 Coltec Indus., Inc. v. United States, 62 Fed. Cl. 716 (2004), vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006). 26 62 Fed. Cl. at 756 (‘[T]he court has determined that where a taxpayer has satisfied all statutory requirements established by Congress, as Coltec did in this case, the use of the “economic substance” doctrine to trump “mere compliance with the Code” would violate the separation of powers’). 27 See Richard M. Lipton, ‘Codification’ of the Economic Substance Doctrine: Much Ado about Nothing?, 112 J. Tax’n 324, 325 (2010) (‘Congress enacted Section 7701(o) in order to raise an estimated $4.5 billion of revenue’); Joint Committee on Taxation, Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal as Described by the Department of the Treasury, May 2009, JCX-28-09 (2009). 28 See Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409 (2010). 19 20

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3.

THE RELEVANCE STANDARD

Under Section 7701(o), a transaction will have economic substance only when the transaction meaningfully changes the taxpayer’s economic position (the objective test), and when the transaction is supported by a substantial nontax purpose (the subjective test). Under prior case law, courts differed on whether a transaction had to satisfy both the objective and subjective tests, or whether satisfying one would suffice.29 The new statute establishes that both tests must be satisfied. If every transaction faced the Section 7701(o) economic substance requirement, then even straightforward tax planning could be thwarted. For example, if a taxpayer moved $10,000 out of her brokerage account and into a tax-favored retirement account, that transaction would likely fail both of Section 7701(o)’s requirements. The transaction would not have meaningfully changed the taxpayer’s economic position (the objective test), and tax incentives alone likely motivated the taxpayer’s transaction (the subjective test). Thus, if the economic substance doctrine applied here, a congressionally intended incentive would be nullified. To protect against this untoward result, Congress did not mandate that Section 7701(o) apply to all transactions. Instead, the statute carves out some transactions undertaken by individuals,30 and beyond that applies only when the economic substance doctrine is ‘relevant.’ A legislative committee report, for whatever it is worth,31 thus explains that Section 7701(o) does not ‘alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.’32 Unfortunately, Congress itself did not define ‘relevant’ in Section 7701(o). Nor did Congress allow taxpayers or courts to look to the statute for guidance on that term. Under Section 7701(o)(5)(C), ‘[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.’ Thus, a cloud of uncertainty lingers: When is the economic substance doctrine relevant to a transaction? The IRS, in Notice 2010-62,33 issued guidance on Section 7701(o) and could have defined ‘relevant,’ but it did not. That notice instead reiterates that under Section 7701(o)(5)(c), economic substance relevance should be determined as if Section 7701(o) had never been enacted. The IRS thus stated that it would ‘continue to analyze when the economic substance Compare, e.g., Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir. 2006) (embracing a disjunctive test, under which a transaction must be respected if it exhibits either objective economic substance or a subjective business purpose), with Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 n.14 (Fed. Cir. 2006) (explicitly rejecting Fourth Circuit’s approach in favor of a conjunctive test). 30 See I.R.C. § 7701(o)(5)(B) (for individuals, economic substance doctrine applies ‘only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income’). 31 In Alternative Carbon Resources v. United States, the taxpayer relied on a committee report to argue that the economic substance was not relevant to its transaction, but the court rejected that reliance. See 939 F.3d 1320, 1330-31 (Fed. Cir. 2019). The court both discounted the value of a committee report and concluded that the taxpayer had misread it. 32 Staff of the Joint Comm. on Taxation, Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as Amended, in Combination with the ‘Patient Protection and Affordable Care Act’ JCX-18-10 (2010) 152. 33 2010-40 I.R.B. 411. 29

Economic substance  371 doctrine will apply in the same fashion as it did prior to the enactment of Section 7701(o).’34 Notice 2010-62 makes no attempt to resolve the judicial conflict between the extrastatutory and statutory approaches. In 2011, the IRS issued further guidance about the ‘relevant’ standard but, perhaps unintentionally, that guidance only adds to the confusion over that term.35 The guidance lays out numerous factors showing that the economic substance doctrine might be relevant to a taxpayer’s transaction and numerous factors showing that it might not.36 If, after analyzing those many factors, an IRS examiner believes that the economic substance is relevant, the examiner must then resolve a long series of inquiries. Depending on how those inquiries are resolved, the examiner, with the consultation of his or her manager, may then seek approval from an executive-level IRS official to apply the economic substance doctrine. That approval request itself then triggers further procedural steps. These many procedural hurdles might help explain why Section 7701(o) has not led to significant litigation.37 However, the IRS somewhat relaxed its internal procedures in a recent memorandum.38 Under the new procedures, examiners and managers may together assert the economic substance doctrine without executive-level approval. This relaxed framework might make it more likely that the IRS will deem Section 7701(o) relevant to a transaction. Courts may thus soon be asked to define ‘relevant’ under Section 7701(o).

4.

DEFINING ‘RELEVANT’

Determining how to reconcile pre-enactment case law with the Section 7701(o) ‘relevant’ standard presents a difficult interpretive challenge. This section shows that difficulties will arise whether a court adheres to the extrastatutory approach or the statutory approach to the economic substance doctrine. Someone familiar with the doctrine might wonder whether those difficulties could be avoided through a judicial refusal to define ‘relevant.’ Unpredictability and uncertainty have long been hallmarks, if not features, of the economic substance doctrine.39 Thus, the argument might go, courts should apply the doctrine to specific transactions but refuse to define ‘relevant’ under Section 7701(o). However, basic judicial principles do not permit this approach. Congress has now codified the economic substance doctrine and has used a specific word (‘relevant’) to guide how the doctrine applies. If, in court, taxpayers and the government offer competing arguments over

Notice 2010-62. I.R.S. Treas. Dir. LB&I 1-4-0711-015. 36 I.R.S. Treas. Dir. LB&I 1-4-0711-015. 37 See Rebecca Rosenberg, Codification of the Economic Substance Doctrine: Agency Response and Certain Other Unforeseen Consequences, 10 Wm. & Mary Bus. L. Rev. 199, 226–35 (2018) (describing how IRS guidance poses hurdles to application of the economic substance doctrine). 38 I.R.S. LB&I-04-0422-0014. 39 See, e.g., Alexandra M. Walsh, Formally Legal, Probably Wrong: Corporate Tax Shelters, Practical Reason and the New Textualism, 53 Stan. L. Rev. 1541, 1560 (2001) (‘[T]he economic substance doctrine usually produces a result that is inconsistent with the text of the tax code, a tendency that raises concerns about predictability and determinacy’). 34 35

372  Research handbook on corporate taxation ‘relevant,’ the court must define that term before it applies Section 7701(o). It would be rather odd, and likely portend reversal, if a court applied a statutory term while refusing to define it. Arguably, rather than give ‘relevant’ a single definition, a court could decide that the word means different things in different cases. That way, the court could maintain flexibility over the doctrine. But that approach would raise tensions with the court’s proper role. The Supreme Court has rejected ‘the dangerous principle that judges can give the same statutory text different meanings in different cases.’40 If, in a given case, a court defines ‘relevant’ in one way then it must follow that definition in future cases, unless it meets the lofty burdens associated with overruling precedent. As Section 7701(o) leads to litigation, courts will need to define ‘relevant.’ And, under Section 7701(o)(5), courts must define that word as if the statute had never been enacted. Thus, a court will probably look to prior case law. That is, a court may try to incorporate the extrastatutory approach or the statutory approach into Section 7701(o). However, as the next two subsections show, interpretive difficulties will arise whichever path the court follows. A.

Relevance under an Extrastatutory Approach

Under the extrastatutory approach, courts state that ‘economic substance is a prerequisite to the application of any Code provisions allowing deductions.’41 If this approach applies to Section 7701(o), then the extrastatutory approach calls for an economic substance inquiry in all cases. That approach would be profoundly unworkable. As described in the previous section, if the extrastatutory approach always applies, then a transaction could be disregarded even when it created benefits unequivocally intended by Congress. To some extent, Section 7701(o)(5)(B) addresses this by excluding non-business or non-investment transactions from the economic substance doctrine. But the extrastatutory approach, if taken seriously, could thwart straightforward business transactions, like the choice to incorporate a business or issue debt rather than equity. Under prior law, courts avoided this overbreadth problem by inconsistently applying the economic substance doctrine. That is, courts might have claimed that the economic substance was a prerequisite to every transaction. But they did not adhere to that principle. Sometimes they applied the economic substance doctrine, and sometimes they did not. Had the economic substance doctrine remained a common law doctrine, courts might have been able to continue with that ad hoc approach. But now, under Section 7701(o), courts must explain relevance before they apply the economic substance doctrine to a transaction. A court cannot properly state, in one case, that the Section 7701(o) relevance standard makes the doctrine a prerequisite to every transaction and then, in a later case, simply ignore the statute. If a court nonetheless insists on an ad hoc approach, due process concerns arise, especially given the severe economic substance penalty. Under Section 6662(b)(6), a 20 percent penalty applies to any underpayment attributable to a failure to satisfy the economic substance doctrine or a ‘similar rule of law’ (an undefined phrase). That penalty increases to 40 percent if the taxpayer did not make proper disclosures on her return.42 Although a taxpayer can usually Clark v. Martinez, 543 U.S. 371, 386 (2005). Lerman v. Comm’r, 939 F.2d 44, 52 (3d Cir.1991) (emphasis in original). 42 See I.R.C. § 6664(i). 40 41

Economic substance  373 escape the various Section 6662 penalties if she had reasonable cause for her underpayment and acted in good faith, no such defense exists for the economic substance penalty.43 In other words, a taxpayer faces a strict liability penalty for violating the economic substance doctrine or a similar rule of law. When one analyzes the Section 6662(b)(6) penalty together with Section 7701(o), a concerning set of circumstances arises: 1. Congress codified a powerful doctrine; 2. Congress declined to specify when the doctrine applies; 3. Congress said the statute should be disregarded when determining whether the doctrine applies; and 4. A failure to satisfy the doctrine, or an undefined ‘similar rule of law,’ results in a strict liability penalty. It is hardly obvious that the due process clause allows Congress to do this. If taxpayers face a severe, strict liability penalty for violating the economic substance doctrine, then the law should explain when the doctrine applies.44 Yet Section 7701(o) provides no guidance on that issue. Additionally, it would be perverse if courts upheld Section 6662(b)(6) penalties while asserting the authority to define relevance on a case-by-case basis. A taxpayer should face penalties under law established at the time of her transaction, rather than under law retroactively tailored to her. A major challenge will thus arise if a court tries to reconcile the extrastatutory approach with Section 7701(o). Simply announcing that the economic substance doctrine establishes a prerequisite to every tax benefit will cast too wide a net. If courts instead believe that Section 7701(o) contemplates an ad hoc approach, then the statute raises serious due process concerns. B.

Relevance under a Statutory Approach

Courts that follow a statutory approach to the economic substance doctrine will also face interpretive challenges under Section 7701(o). The statutory approach contemplates that a court will use economic substance principles to aid rather than override statutory language. For example, if a statute makes the taxpayer’s business purpose relevant, then the court will demand the same. But if a statute grants benefits whatever the taxpayer’s motive, then motive inquiries will have no place. In theory, a court could reconcile the statutory approach with Section 7701(o) in a relatively straightforward way. That is, a court could treat Section 7701(o) as an interpretive guide for tax code provisions that contemplate meaningful economic activity. Take, for example, Section 162(a), which allows deductions related to ‘carrying on any trade or business.’ For this

See I.R.C. § 6664(c)(2). See, e.g., Karem v. Trump, 960 F.3d 656, 664 (D.C. Cir. 2020) (explaining that fair notice and clarity requirements apply whenever the government imposes ‘civil penalties’) (quoting BMW of North America, Inc. v. Gore, 517 U.S. 559, 574 n.22 (1996)). See also Thomas A. Cullinan and Shane A. Lord, Economic Substance Doctrine: Unconstitutionally Vague?, 130 Tax Notes 700, 703 (2011) (‘Under the void-for-vagueness doctrine, the codified economic substance doctrine could be deemed unconstitutionally vague for at least two reasons: It arguably denies taxpayers notice of what it prohibits and promotes the exercise of arbitrary and discriminatory enforcement’). 43 44

374  Research handbook on corporate taxation statute, a court could invoke the codified economic substance doctrine to help analyze whether the taxpayer’s transaction satisfies the statutory test. Under this approach, the court would first declare the economic substance doctrine ‘relevant’ because Section 162(a) refers to meaningful economic activity. Then, in trying to determine whether the taxpayer met the ‘carrying on any trade or business’ requirement, the court could apply the objective and subjective tests required by Section 7701(o). In contrast, if a tax code section does not refer to meaningful economic activity, then a court could skip the Section 7701(o) analysis. Under Section 1001, for example, a loss arises on the ‘sale or other disposition’ of property. The statute does not include a business limitation like that seen in Section 162(a). Thus, if a taxpayer claimed benefits under Section 1001, a court following the statutory approach could state that Section 7701(o) is not relevant to the taxpayer’s transaction. The court would instead focus on the basic requirements contemplated by the phrase ‘sale or other disposition.’ The court would not impose the additional objective and subjective tests described in Section 7701(o). The challenge for the statutory approach to Section 7701(o) relates to expectations. Congressional committees apparently wanted to codify a doctrine that allows courts considerable authority to override tax code provisions.45 Yet, Section 7701(o) would serve a relatively modest purpose if courts read it consistently with a statutory approach. Nonetheless, courts should probably accept a modest purpose for Section 7701(o). After all, Congress could have fully embraced an extrastatutory approach and demanded economic substance as a prerequisite to every transaction. But the legislature did not do so. Congress instead enacted an awkward statute that fails to address the most fundamental question: When does the economic substance doctrine apply? Powerful minds have endlessly debated that question, and no discernible consensus has emerged.46 A judicial attempt to provide an answer seems doomed to failure.

5. CONCLUSION Although styled as a clarification, Section 7701(o) has sown further confusion into the tax law. Congress failed to resolve the fundamental conflict over when the economic substance doctrine applies. In a way, Section 7701(o) makes things even worse. Courts had already struggled to sensibly apply the economic substance doctrine. And now, they must determine how to integrate the doctrine with an awkwardly structured statute. Section 7701(o) could have clarified the law had it resolved judicial doubts over extrastatutory tax doctrines. However, those doubts continue to grow. In Summa Holdings v. Commissioner, for example, the Sixth Circuit compared common law tax doctrines to See, e.g., S. Rep. No. 108-11, 76-81 (2003); S. Rep. No. 110-206, 88-94 (2007); H.R. Rep. No. 111-443, pt. 1, 291-98 (2010). See also Staff of the Joint Comm. on Taxation, Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as Amended, in Combination with the ‘Patient Protection and Affordable Care Act’ JCX-18-10 (2010) 152–6 (stating that Section 7701(o) ‘enhances’ the economic substance doctrine and describing the doctrine in largely extrastatutory terms). 46 See David P. Hariton, When and How Should the Economic Substance Doctrine Be Applied?, 60 Tax L. Rev. 29, 31 (2006) (‘[S]o much has now been written about tax shelters and economic substance that even the brightest and most diligent clerk can do little more than skim a few recent contributions to the ever burgeoning literature and then get on with the task of producing the first draft of an opinion’). 45

Economic substance  375 Caligula’s practice of ‘post[ing] the tax laws in such fine print and so high that his subjects could not read them.’47 Other courts have expressed similar skepticism.48 Ideally, Congress would replace the ‘relevant’ language in Section 7701(o) with specific standards that govern when the economic substance doctrine applies. Until Congress does so, courts will need to define ‘relevant’ on their own. As this chapter has explained, courts will face a monumental task as they try to establish a definition. The inevitable judicial confusion, with luck, will motivate Congress to act.

848 F.3d 779, 781 (6th Cir. 2017). See Mazzei v. Comm’r of Internal Revenue, 998 F.3d 1041, 1044 (9th Cir. 2021) (discussing how three federal appellate courts have ‘disallowed the invocation of substance-over-form principles’ to disregard a statutory scheme designed to provide tax benefits). 47 48

23. Corporate tax and corporate social responsibility Peter Barnes

When discussing the duties of taxpayers and tax professionals, the word ‘morality’ has rarely been top-of-mind. But that is changing. For the past 25 years – and we can mark the date by two developments in the mid- to late-1990s, discussed more fully below – the moral dimension of tax planning and tax compliance has risen to prominence.1 Further, the pressure to be ‘moral’ in tax affairs (and not just legally compliant) continues to rise. The peak is not in sight. So, important questions emerge: ● What caused this relatively new expectation? ● What does this development mean for tax professionals and corporate taxpayers? ● Why are corporate taxpayers expected to meet a higher and different standard than individual taxpayers? ● And, most importantly, what does it mean for a corporate taxpayer to be moral, or socially responsible, in tax planning and compliance? Is that standard appropriate? Achievable? Despite the seductive lure of demanding that taxpayers be moral, and not just legal, the effort to change the historic expectation of taxpayer behavior does not stand up to careful scrutiny. But the dichotomy – morality versus legality – is also false; taxpayers have never ignored the social consequences of their tax planning.

I. BACKGROUND The corporate social responsibility (CSR) movement has roots in many fields apart from tax. Although there is no single definition of CSR, the core concept is that a corporation will seek to act responsibly for a wide variety of stakeholders, and not just the shareholders who have an economic interest in the profits of the corporation. A corporation striving to serve CSR goals will limit its adverse environmental impact, follow good employment practices, respect (and not exploit) its suppliers, and enhance the communities in which the corporation operates. Under CSR principles, it is expected that a corporation will exceed the legally required minimums in many areas: for instance, pay scales will not simply satisfy state minimum wage laws but will compensate employees at a level that allows workers to support families and live in dignity.

1 The literature on taxes and corporate social responsibility is large and growing. Two leading articles are Avi-Yonah, Reuven S., ‘Corporate Taxation and Corporate Social Responsibility,’ NYU J.L. & Bus. vol. 11, no. 1 (2014); and Narotski, Doron, ‘Corporate Social Responsibility and Taxation: An Evolving Theory’ (25 January 2016), Tax Notes, vol. 150, no. 4 (2016).

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Corporate tax and corporate social responsibility  377 These practices, CSR advocates aver, are not just beneficial to stakeholders (employees, communities, the public affected by land use and environmental policies) but also benefit corporate shareholders. By following CSR best practices, the company will earn positive public regard, which in turn will enhance the value of the corporation through benefits such as better employee relations and hiring, a more attractive environment for workers, and higher brand value. Where is tax in this equation? In broad discussions of CSR, tax is rarely mentioned. For instance, the Business Roundtable, an important and prominent business lobbying group, released a highly significant ‘Statement on the Purpose of a Corporation’ in August 2019 that reversed a 22-year-old position.2 The earlier statement said the principal purpose of a corporation is to maximize the financial returns to shareholders. The 2019 statement ‘overturned’ (in the words of the Business Roundtable itself) that view and explained that corporations ‘share a fundamental commitment to all of our stakeholders’ (emphasis in the original). The word ‘tax’ does not appear in the 2019 statement adopting a CSR approach. The statement does say that ‘supporting the communities in which we work’ is a goal, but that is only a tangential nod to taxes. Nonetheless, significant voices in the tax world now echo the CSR message and focus directly on the responsibility of corporate taxpayers to be good citizens and not just good stewards of shareholders’ finances. These voices come primarily from academic writers and nongovernmental organizations. The message is not unified, but several tax-related themes repeat: ● Taxpayers, particularly corporate taxpayers, should not engage in ‘aggressive’ tax planning. The implication (though it is rarely stated explicitly) is that a corporate taxpayer’s liability should be just the arithmetic consequence of various non-tax business decisions. Tax compliance is necessary, of course, but not tax planning that minimizes a corporation’s tax liability. ● Some commentators assert that ‘non-business-related’ transactions that reduce a corporation’s tax liabilities should not be adopted. In other words, transactions that have the effect of reducing taxes but are not essential to core business transactions are disfavored. As discussed further below, these standards are difficult – indeed, impossible – to define, and critics rarely even try. For instance, is it ‘aggressive’ to negotiate with a governmental authority to seek tax incentives before making an investment? Some ‘non-business’ decisions may be identifiable, such as entering into a standalone financial transaction that accelerates tax losses and defers offsetting gains, with no impact on the business. But other non-business decisions are difficult to categorize; for instance, is a decision to use debt (which creates tax deductible interest payments) rather than equity (which does not create a deduction in most tax systems) acceptable under this standard?



2

Business Roundtable, ‘Statement on the Purpose of a Corporation,’ released 19 August 2019.

378  Research handbook on corporate taxation

II.

TRADITIONAL VIEW OF A TAXPAYER’S OBLIGATION

While the CSR view of a taxpayer’s obligation to society – and, by extension, the professional standard that CSR proponents believe should apply to tax advisors – is clearly ascendent, that was not the view that prevailed for the first 80 years of the United States’ (US) tax system. The traditional view is generally explained by two quotes from the esteemed jurist, Learned Hand: Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. (Helvering v. Gregory, 69 F.2d 809, 810 (2d. Cir. 1934)) [T]here is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does so, rich and poor alike all do right, for nobody owes any public duty to pay more than the law demands. (Commissioner v. Newman, 159 F.2d 848, 850-851 (2d. Cir. 1947) (Hand dissenting))

Although many other judges and commentators have advanced the same view (almost without opposition), the two quotes from Judge Hand capture the generally accepted moral standard that prevailed until recently. The same principle was articulated at approximately the same time in England, in the case of Inland Revenue Commissioners v. Duke of Westminster [1936] AC 1, 19 TC 490. The language echoed Judge Hand: Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow tax-payers may be of his ingenuity, he cannot be compelled to pay an increased tax.

There is a limit to tax-reduction behavior, of course, even under the view of Judge Hand or the Duke of Westminster case. Fraud is never permitted, for instance. Indeed, the Duke of Westminster case would likely be decided differently today, because a court would consider the tax planning in that case to be a sham. But ‘patriotic duty,’ as Judge Hand framed it, or morality was not a standard to be applied under this long-standing view of the responsibilities of taxpayers and tax advisors. Until the past 25 years, the debate regarding tax and morality generally focused on centuries-old philosophical and religious debates regarding taxes: What did Christian, Jewish, Islamic, and other religious ethics and texts require of citizens with regard to the payment of taxes? The Biblical question and answer is well familiar: Chief priests asked Jesus Christ whether it is ‘lawful’ for them to pay taxes to Julius Caesar, and Jesus replied: ‘Render to Caesar that which is Caesar’s, and to God the things that are God’s.’3 Religious traditions widely accept that paying taxes to governments is a requirement that is fully consistent with the duties of citizenship and living a moral life.4 There have been skirmishes throughout history with respect to the boundaries that apply to taxes and morality, of course, even under the Learned Hand approach. One significant experi Luke 20:21–26. In a few cases, religious groups have focused directly on the intersection of religion and taxes – and morality. Most notably, the Presbyterian Church (USA) published a 40-page report, ‘Tax Justice: A Christian Response to a Second Gilded Age’ (2014), which thoughtfully and extensively explored the moral imperatives that should guide US and international tax policy. See https://​www​.presbyterianmission​ .org/​resource/​tax​-justice​-a​-christian​- response-to-a-second-gilded-age-2014/, accessed 4 April 2023. 3 4

Corporate tax and corporate social responsibility  379 ence for the US is the objection by some taxpayers that a portion of their taxes is used to fund the military. In general, however, organized religious groups do not tilt the decisionmaking with respect to whether an individual taxpayer should pay more or less tax: render unto Caesar, or whomever is in charge of the government right now, the amount of tax required by law, but there is no requirement to render more. At most, religious groups suggest broad principles for appropriate tax rules, such as progressive rates and strong enforcement (as discussed in the Presbyterian report cited in footnote 4). The Learned Hand standard – pay what you owe in tax, but do not feel obliged to pay more – is not as simple as it appears, of course. Modern tax planning may well have vexed even Judge Hand. For instance, would Judge Hand have objected if a taxpayer ‘arranged his affairs’ by valuing pre-IPO (initial public offering) stock options at zero, or near zero, and putting the options into a tax-deferred Individual Retirement Account so that the account was worth tens of millions of dollars after the IPO? Would Judge Hand have objected to modern cost-sharing agreements for transfer pricing that result in a multinational corporation’s offshore affiliate earning billions of low-taxed (and, pre-2017, deferred tax) income from intellectual property developed in the US? Nonetheless, the Learned Hand standard, or the Duke of Westminster doctrine, has a major advantage over a standard that seeks to apply CSR principles: the Learned Hand approach is much more administrable. Taxpayers must obey the law, but otherwise are free to tax plan.

III.

WHAT CHANGED?

It is rare that a major shift in perceptions can be traced to specific events. But, the shift from Judge Hand’s position regarding appropriate taxpayer behavior to the emerging standard that taxpayers should follow CSR principles can be tracked to two developments, each of them arising in the mid- to late-1990s. A.

Corporate Restructuring

The first development was the restructuring of corporate value chains. Some background: prior to the 1990s, most US-based multinational corporations, in most situations, operated with ‘siloed’ subsidiaries around the globe. (Multinational corporations headquartered in countries other than the US also followed this model, but the effort to restructure multinational operations began with US companies.) In a major foreign country, such as France or Germany, the US company would establish a subsidiary or multiple subsidiaries that handled many functions, such as manufacturing, distribution, sales, and after-sales services. In each country, the affiliates had entrepreneurial responsibilities and risks. These siloed operations were sometimes required to be established by foreign law; in any event, seamless cross-border business was challenging because of, among other issues, foreign currency differences. In 1992, the European Community took a major step toward creation of a common market, with significantly reduced barriers for trade among members of that market. Creation of the euro in 1999 as a single currency used in multiple countries furthered the ability of companies to operate seamlessly across borders in Europe. At the same time, transfer pricing rules were receiving a new level of attention. Transfer pricing refers to the requirement that related companies sell goods or services to each other at

380  Research handbook on corporate taxation ‘arm’s-length’ prices, which are the prices that would be charged between the companies if they were not related. These arm-length prices are necessary so that each company can prepare standalone financial information and, subsequently, the required tax returns for each entity. Tax systems in almost every country operate on a ‘separate entity’ basis. A country (for instance, France) can tax the French subsidiary of a US corporation but, with some exceptions, cannot tax the operations of the US parent or a subsidiary located in a country outside of France. The French subsidiary must be able to prepare accurate financial statements so that it can report its French income properly and France can both audit the company and collect the proper tax due. The arm’s-length standard is a cornerstone for determining the prices at which goods and services are transacted between related parties, so the parties can prepare their financial statements. Appropriate prices are also essential for compliance with customs laws. The full range of transfer pricing law is beyond the scope of this chapter. It is sufficient to recognize here that during the 1990s there was a focus within the US, and later across other countries through the leadership of the Organization for Economic Cooperation and Development (OECD), on the importance of risk in determining the proper transfer price for transactions of goods and services.5 For instance, assume a US company establishes a sales subsidiary in France for the widgets produced by the US company. If the French subsidiary assumes significant entrepreneurial risks (such as inventory risk, foreign exchange risk, warranty risk, risk of noncollection on customer receivables), then the French company needs to earn a higher pre-tax profit in order to be able to absorb those risks when they arise. On the other hand, if the French subsidiary is a low-risk distributor (for instance, the company can return any unsold products; the parent absorbs the risk of noncollection if the subsidiary follows reasonable sales guidelines), then the French company should earn a lower pre-tax profit. That lower profit reflects the lower risks of the French company and also allows for a higher profit to be earned by another legal entity in the affiliated group that bears the risks. Tax advisors, often with the Big Four accounting firms but also with law firms and other advisory groups, identified an opportunity for large corporate taxpayers to both save on income taxes and simplify transfer pricing. In the simplest version, a multinational company would establish a ‘principal company’ in a low-tax jurisdiction such as Switzerland or Ireland. Manufacturing sites would be converted into low-risk manufacturers, earning a modest profit because the risks would be shifted to the principal company. (For instance, the manufacturer would agree to build 1,000 units of a machine for $1,000 each, or for a price determined as all costs incurred by the manufacturer plus $30/machine. All risks, such as inventory risk and foreign exchange risks would be borne by the principal company.) Similarly, distributors would be treated as low-risk distributors, earning a fixed fee on each unit with the ability to shift any unexpected costs back to the principal company. As a result of this restructuring, the manufacturing sites earned – properly earned, under transfer pricing principles – a small predictable profit. Likewise, the distributors earned a small predictable profit. The principal company (again, in Switzerland, Ireland, or another low-tax jurisdiction) would bear the entrepreneurial risks and earn larger profits. 5 In 1995, the OECD published its first version of the ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,’ building on an OECD report in 1979. The 1995 Guidelines discussed risk at paragraphs 1.23 to 1.27. The Guidelines, regularly updated, are the leading transfer pricing resource for both taxpayers and tax administrators.

Corporate tax and corporate social responsibility  381 This restructured operation had two notable features: ● The pricing, which shifted profits from higher-taxed jurisdictions where the manufacturing and distribution occurred to the lower-taxed jurisdiction of the principal company, was not only correct but absolutely required by transfer pricing principles. Transfer pricing mandated that a portion of any profits be assigned to the entity bearing the risks. ● In many cases, the outward appearances of how the legal entity operated were not changed significantly. The corporate taxpayer’s ‘footprint’ in terms of manufacturing locations, distribution sites, and even management teams was often relatively unchanged (except for changes driven by business needs). What shifted was risks, along with the attendant income needed to bear those risks. Indeed, in many cases the tax advisors touted the fact that the tax savings could be achieved without the need for the corporation to make significant changes in its business operations. Governments, and critics of corporate tax planning, railed against this corporate restructuring of the value chain (and the reshuffling of income associated with each step of the value chain). The planning was ‘legal,’ but in critics’ views, not moral or appropriate. B.

Tax Shelters

The second development, which occurred in the same mid- to late-1990s time frame, was the advent of mass-marketed tax shelters.6 The term ‘tax shelter’ is pejorative; declaring a transaction or a structure as a ‘tax shelter’ is intended to express a conclusion that the transaction lacks any proper purpose and should be disregarded and likely penalized. That conclusion was correct for many if not all of the planning techniques marketed by tax advisors to wealthy clients in the tax shelter era. The mass-marketed programs followed on corporate tax shelters that had started a decade earlier. The corporate tax shelters were often hideously complex and difficult to understand. A 180-page report in 1999 by the US Department of the Treasury summarized the concern and identified multiple strategies that tax planners had developed and implemented for corporate tax departments seeking to reduce their tax costs.7 The strategies, including corporate owned life insurance; lease-in, lease-out transactions; fast-pay preferred stock; and other techniques frequently lacked a business purpose and had little or no economic effect on the corporation. The government (including the Treasury Department, the Internal Revenue Service (IRS), and even Congress) could and did attack specific strategies, but new tax shelter programs continued to be developed. And tax advisors, both in-house at corporations and at law firms and accounting firms, were willing to adopt strategies even when the results seemed – and often were – too good to be true. In the late 1990s, the tax shelter business expanded from the corporate realm to individual taxpayers. Most of the tax shelter ‘opportunities’ were sold to individuals experiencing once-in-a-lifetime wealth events, such as individuals selling a business built up over many A fascinating and extensive discussion of the tax shelter industry is the subject of a book, Rostain, Tanina and Regan, Jr., Milton C., Confidence Games: Lawyers, Accountants, and the Tax Shelter Industry (The MIT Press, 2014). 7 Department of the Treasury, ‘The Problem of Corporate Tax Shelters (Discussion, Analysis and Legislative Proposals)’ (July 1999). 6

382  Research handbook on corporate taxation years or, in the dot-com period, individuals exercising highly profitable stock options. The tax shelters were indeed ‘sold’; clients with relatively little tax knowledge were advised by trusted tax professionals that various programs could reduce the income tax charge on these one-time gains, at a cost that was less than the tax otherwise due. A wide group of tax advisors were engaged in developing and selling these tax shelters, although the level of involvement by various accounting firms and law firms differed. When the IRS began its audits and rejection of these structures, both members of the tax profession and critics outside the profession expressed horror that ‘professionals’ could drive these programs. The defense raised by advisors that they had an obligation (or at least a right) to try to minimize clients’ taxes was not well received, particularly because of the deceit that was often involved. (In many cases, the tax result was predicated on a statement of facts that both the advisor and the client knew was incorrect or at least unlikely to be correct.) Together, the corporate tax restructuring programs (which shifted income and tax liabilities while shifting few if any people or assets) and the tax shelter programs (which involved structures that were artificial and often deceitful) cast a brutal negative light on tax advisors and tax planning. The traditional touchstone for tax professionals – organizing a client’s affairs to minimize tax, so long as the planning did not violate tax rules – was difficult to sustain in view of these developments.

IV.

OUT WITH THE OLD, IN WITH THE WHAT?

It is easy to criticize taxpayers for ‘aggressively’ reducing their taxes. At least it is easy to criticize other taxpayers. Your tax planning is ‘aggressive’ and not appropriate. My tax planning is just that, planning. In seeking to reject the traditional Judge Hand standard, tax academics and other commentators must find a different standard of behavior to substitute for the historic approach. Enter: corporate social responsibility. CSR is not new; economist William Bowen is generally regarded as the father of CSR, based on his use of the phrase in 1953 in a seminal work, ‘Social Responsibilities of the Businessman.’ But CSR has grown in prominence during the past few decades, as evidenced by the Business Roundtable pronouncement in 2019. So, it is unsurprising that in rejecting ‘aggressive’ tax planning, there would be a move to require taxpayers – and especially corporate taxpayers – to adopt social responsibility as the new standard for tax planning and tax advice. But what does CSR mean with respect to tax planning? And does it mean anything at all? A.

Corporate Tax Planning

At its extreme, CSR would support the view that corporate tax planning should not occur at all. Taxpayers must comply with tax laws, of course, but planning – any planning! – to minimize taxes reduces the funds available for governmental and social benefits. That position is unsustainable (or nonsensical). First, what is ‘tax planning’? Even before an analysis of what might constitute ‘aggressive’ tax planning, it is useful to consider what is ‘tax planning’ for a business entity.

Corporate tax and corporate social responsibility  383 The litany of tax issues that must be addressed in establishing and then operating a business is almost endless. And it is a familiar list to all tax professionals and most corporate lawyers. A short sample would include: ● The form of business entity to select (C Corporation, partnership, Subchapter S corporation, sole proprietorship). ● The location in which to create the entity. The location in which the entity conducts business. ● The use of debt or equity, or what proportion of each. ● What intellectual property (IP) to use (or create); how the IP is owned. Each of these decisions has profound tax consequences. For instance, using a C corporation results in two levels of income tax, while forming a partnership or Subchapter S corporation generally subjects the business and its owners to one level of tax. Is it ‘tax planning’ to make a choice of entity? Of course. And tax planning continues on a daily basis throughout the life of the business enterprise. A ‘slippery slope’ analysis is never favored, but examining the wide range of tax decisions that a business must make during the course of its operations demonstrates that defining ‘CSR’ in the arena of tax planning is not feasible, except at the very extremes. B.

The Inversion Experience

A useful example is the issue of corporate inversions, transactions that sparked public outrage at various times in recent history and particularly during the period from 2010 through 2016. These transactions are addressed in primary part by Section 7874 of the Internal Revenue Code.8 In simple terms – and in the cases that triggered the most public and government concern – a US-headquartered company merges with a small non-US company located in a low-tax jurisdiction. The shareholders of the US corporation (most of whom, it is presumed, are US persons) receive shares of the foreign corporation in exchange for the stock of the US corporation. After the transaction, the US shareholders own shares of the foreign corporation (and may have almost 100 percent ownership of the foreign corporation) while the US corporation is now a first-tier subsidiary of the foreign corporation. As in the case of the corporate value chain reorganizations, a key objection from critics is that ‘nothing changed’ except the tax profile – or, more precisely, the potential for current and future tax savings. In most inversions, the controlling shareholders (primarily, US persons) remained in control. The management team remained in its prior location (generally, the US), the manufacturing and other facilities remained in their prior locations (often, the US), and functions were performed in a manner identical or nearly identical to the activities of the US company prior to the inversion.

Stanford Business School professors Rebecca Lester and Jaclyn Foroughi wrote an informative case study about the Pfizer-Allergan tax inversion that provides useful background on the tax issues raised by inversions. See ‘The Pfizer-Allergan Tax Inversion,’ Stanford Case No. A230 (2017), accessed 4 April 2023 at https://​www​.gsb​.stanford​.edu/​faculty​-research/​case​-studies/​pfizer​-allergan​-tax​ -inversion. 8

384  Research handbook on corporate taxation The non-US activities of the inverted group were generally small and so did not have a major impact on the overall operations. However, after the inversion, the parent company was now a non-US legal entity, generally located in a low-taxed country. This opened up various tax planning opportunities. A quick first step would be to lend funds from the new non-US parent to the US corporation, often to fund a dividend; the new debt created interest deductions that could reduce US income taxes. New operations outside the US could be owned by the non-US parent and thereby eliminate any US tax on the new operations. In some cases, earnings of foreign subsidiaries owned by the US company could be accessed by the new foreign parent without triggering US tax. The effects of an inversion could be dramatic. One estimate found that Pfizer would save roughly $2 billion a year in taxes from an inversion it planned with Allergan in 2016, which was not completed.9 The Walgreens inversion with Alliance Boots in 2014 was estimated to save Walgreens at least $580 million a year in taxes.10 The inversions – both inversions that actually occurred and other inversions that were planned but not consummated – stirred major controversy within the tax community and among politicians and critics outside of tax. Then-President Barak Obama proposed legislative changes to prevent (or at least, dramatically reduce) the ability of companies to gain tax benefits from an inversion. The Treasury Department and International Revenue Service issued regulations during the period 2014–18 to limit the range of inversions that would be tax efficient. Congress did not pass legislation directly affecting inversions, although the Tax Cuts and Jobs Act of 2017 imposed new and tighter restrictions on the ability of a US company to take tax deductions for interest paid to a non-US-related party lender. While Congress did not act, political leaders from both parties were critical of inversions. As Republican Senator Charles Grassley (R-Iowa) famously stated: ‘These corporate expatriations aren’t illegal, but they are sure immoral!’11 Assume, for instance, that a group of US entrepreneurs develops a business plan they expect will be highly successful. They expect the products or services to be marketed globally, although the initial business will be in the US. After consulting a tax advisor, the entrepreneurs decide to form a foreign corporation (in Ireland, or Switzerland, or Luxembourg) as the parent company. The foreign corporation creates a US subsidiary through which the US operations are conducted. All activities outside of the US are conducted by the foreign parent or subsidiaries owned by the foreign parent. In this case, all of the potential tax benefits of an inverted company are available from the beginning stages of the new business. The foreign parent can use debt financing as a portion of the capital for the US entity; interest deductions (within the limits of section 163(j) of the Internal Revenue Code) will be available to reduce US income taxes.

See, a Harvard Business Review article, Benjamin Gomes-Casseres, ‘The Pfizer-Allergan Deal Shouldn’t Be Just about Tax Inversion’ (24 Nov. 2015), accessed 4 April 2023 at https://​hbr​.org/​2015/​ 11/​the​-pfizer​-allergan​-deal​-shouldnt​-be​-just​-about​-tax​-inversion. 10 See ‘Offshoring America’s Drugstore’ (June 2014), accessed 4 April 2023 at https://​hbr​.org/​ 2015/​11/​the​-pfizer​-allergan​-deal​-shouldnt​-be​-just​-about​-tax​-in​versioname​ricansfort​axfairness​.org/​files/​ Offshor​ingAmericasDrugstore​.pdf. 11 David Gelles, ‘The New Corporate Tax Shelter: A Merger Abroad,’ New York Times (8 Oct. 2013), accessed 4 April 2023 at archive​.nytimes​.com/​dealbook​.nytimes​.com/​2013/​10/​08/​to​-cut​ -corporate​-taxes​-a​-merger​-abroad​-and​-a​-new​-home/​. 9

Corporate tax and corporate social responsibility  385 Earnings from operations outside of the US will not be subject to US tax until distributed to the shareholders, which may be many years in the future if the company is growing. The tax profile of the company and potential tax planning techniques available to the company are identical to the profile and strategies available to an inverted company. But critics of ‘aggressive’ tax planning and inversions would be unlikely to criticize this structure, since it existed from the beginning of operations. The mere fact that a US company is purchased by a foreign corporation is not unseemly. Indeed, the US tax and legal system needs to be open to such purchases (apart from national security or antitrust concerns) because US companies want to purchase foreign corporations in order to expand their operations. The primary trigger for criticism of inversions was that a US company had a US tax profile and then took action to change that profile by merging with a smaller foreign corporation in what seemed, to observers, as an artificial action. Inversions are a textbook example of tax planning that frames the debate between the Judge Hand approach (planning to reduce taxes is fully acceptable) and the CSR approach (yes, inversions may be legal, but they are morally wrong and responsible companies will not engage in that conduct). The difference between the two views becomes harder to discern, however, when the facts are changed. In other words, the legal structure of a company after the inversion was not the issue; rather, the source of objection was the fact that the company (and its tax advisors) took a positive action – the merger with a small foreign company – that created potential tax savings. If there is no action, because the tax-beneficial structure existed from the company’s founding, then there is no significant likelihood of criticism. This inversion example shows the hollowness of the CSR model: smart tax planning in the early stages of a taxpayer’s life cycle is acceptable, but if the taxpayer later determines that a different legal structure would be more beneficial, the CSR advocates would raise voices of criticism. C.

Tax Incentives

Similarly – and significantly – the extensive use of tax incentives by governments to attract new investment demonstrates the weakness of the CSR approach. Tax incentives exist in many shapes and sizes. There are widespread incentives, offered to every taxpayer; for instance, accelerated depreciation for the purchase of capital equipment is an incentive for taxpayers to purchase goods and take a tax deduction in excess of the accounting depreciation that attempts to measure the actual reduction in the value of the equipment. Taxpayers may get rebates for purchasing solar equipment or fuel-efficient automobiles. In other situations, governments offer negotiated incentives, particularly for new investment. Developing countries and state governments within the US routinely offer tax incentives in the belief that investors will shift potential investment to the jurisdiction that offers the best tax savings. (In many cases, of course, the tax incentives are packaged with other benefits, such as low-cost land or training grants for employees.) Tax incentives are often criticized. Economists frequently find that the cost of the incentives is greater than the benefits to the jurisdiction offering the incentives, or, at best, cause the taxpayer to shift investment but do not increase investment. Taxpayers win, but governments lose. Incentives are criticized by existing businesses that believe their competitiveness and profitability is hurt by having new entrants gain tax incentives not available to long-standing

386  Research handbook on corporate taxation businesses – businesses that may have been long-time employers and model citizens for the community, and whose taxes have paid for existing infrastructure. If governments routinely seek to lure businesses with incentives, then what is the ‘moral’ objection to taxpayers accepting government offers and reducing their taxes? Is there some cleansing effect when a government initiates the tax reduction, but a taint when the taxpayer adopts measures unilaterally (by increasing debt, shifting a factory location, or even undertaking an inversion) that reduce taxes without the government’s support? In most situations, the government that offers the incentives is the jurisdiction that suffers the reduction in tax revenue. But not always. A current example is the rush by states to offer a ‘work-around’ for the federal limitation on the deduction of state taxes. Under current law, a married couple can deduct no more than $10,000 in state taxes on the couple’s federal income tax return. The limitation was included in the 2017 Tax Cuts and Jobs Act to raise revenue, since the deduction was previously uncapped; prior to 2018, a taxpayer could deduct all of the state income and property taxes incurred. Wealthy taxpayers often pay more than $10,000 in state income and property taxes. Members of Congress from high-taxed states have worked since 2017 to get the cap raised or eliminated, but without success. So, several states have enacted a ‘work-around’ that allows individuals who earn business income (and not solely salary income) to pay state income taxes that are deductible in full against the individual’s business income taxable under the federal and state income tax; at the same, the state tax payment reduces the state income tax the individual would otherwise owe. This strategy is possible only because of recently enacted state laws,12 and the proponents proudly take credit for helping their citizens circumvent the federal limitation. The rule is textbook ‘aggressive’ tax planning, or an ‘artificial’ tax strategy. The rule imposes its costs not on the state that enacted the law, but on federal government tax receipts (and therefore on the revenue that pays for federal programs that benefit all citizens). Is this state-sponsored ‘work-around’ morally unsavory? Should moral taxpayers, or moral tax advisors, forgo this benefit? CSR supplies no guardrails to show when a taxpayer’s decisions in the area of tax are morally reasonable, and when those actions are not. Of course taxpayers plan, in order to reduce their taxes. Corporations likewise seek ways to reduce labor costs, and the cost of raw materials, and transportation costs, and the cost of every other input. It is not meaningful to say that tax planning is permissible, unless that planning is ‘aggressive’ or ‘artificial.’ Those terms are malleable and take a different meaning for each person analyzing the behavior.

V.

CORPORATIONS VERSUS INDIVIDUALS

The weakness of the CSR approach is also evidenced by the difference between public perception of behaviors undertaken by corporations to reduce taxes, and by individuals. Individual taxpayers engage in planning that closely parallels the tax planning of corporations. But, in the eyes of critics, the individual’s decisions are rarely objectionable.

12 For a snapshot summary of the approximately 20 states that offer a workaround, see cnbc​.com/​ 2021/​12/​07/​- these-states-offer-a-workaround-for-the-salt-deduction-limit-/html.

Corporate tax and corporate social responsibility  387 For instance: ● A professional spends her working career in New York State, with relatively high state income taxes. The professional puts a maximum amount in tax-favored retirement accounts, so that the accounts total $5 million or more by age 65. The tax savings against New York taxes may total $500,000 or more. The taxpayer then moves to Florida and withdraws the retirement savings with no state income tax imposed. ● A family moves into a community with high-quality public schools (and high property taxes to support those schools). For 15 years, the children receive a strong education. When the youngest child graduates from high school, the family moves out of the community to a nearby community with lesser schools and lesser property taxes. ● A wealthy couple provides a loan to their child to buy a house. The interest rate qualifies as an arm’s-length rate under the prevailing IRS rules. The couple forgives the loan in annual amounts just under the amount permitted by the annual gift tax exclusion. There are corporate parallels for each of these tax planning techniques and many more techniques adopted by individual taxpayers, because there are only a limited number of tax-reduction strategies available to either individuals or corporations. Corporations shift operations to lower-taxed jurisdictions when appropriate. Corporations use debt and equity in a manner that maximizes the value of interest deductions. But, there is no widespread condemnation of the retiree that moves to Florida or Texas, or even to another community with lower taxes. That criticism is levied only against ‘traitor’ corporations that make decisions based, in part, on tax consequences. It is neither practical nor fair to hold corporations to a higher standard of conduct with respect to tax planning and tax affairs than we hold individuals. That is particularly true for the US, where the revenues from individual income taxes are three or four times as great as the revenues raised from corporate taxes. It is also true because many business activities – by some measures, more than 50 percent of all business revenue – is earned through tax structures that result in the tax being paid at the individual level, not at a corporate level. Should the tax standard for moral conduct be different if an entrepreneur engages in business through a pass-through entity than if the business is conducted through a C corporation for which the income is subject to tax at both the corporate level and at the shareholder level? If anything, a corporate taxpayer for which the income will be taxed at two levels (corporate and shareholder) should be expected to engage in more tax planning than an individual subject to a single level of tax on business income. The standard articulated by Judge Hand – follow all laws, but otherwise plan your activities to minimize tax – cannot be the standard for individuals, but then a different, CSR standard, is sought to be applied to corporate tax matters.

VI.

INTERNATIONAL DEVELOPMENTS

While the US grapples with the issue of how much tax planning is morally acceptable and when tax planning becomes excessive, the same issue is being debated in other countries and through global organizations, most notably, the OECD. The OECD is driving an initiative to limit ‘harmful tax competition’ between and among countries.

388  Research handbook on corporate taxation The belief is that countries compete for investment by providing tax incentives and lax tax enforcement, thereby creating a ‘race to the bottom’ that benefits taxpayers but not governments. This harmful tax competition may shift investment from Country A to Country B, but it does not generate additional net investment. So the benefits are realized by taxpayers, not governments. A.

Harmful Tax Practices

For almost 60 years, the OECD has sought to ensure that tax treaties are not used to reduce taxes in ways that are artificial or lack substance. For instance, the OECD moved from a standard that granted reduced withholding taxes whenever a dividend, interest, or royalty payment was ‘paid’ to a resident of the other country, to a standard that required the ‘beneficial owner’ to be a resident of the other treaty country. A payment could be made to a nominee or agent, and such a payment should not receive treaty benefits if the beneficial owner is a resident of a third country that is not a party to the treaty. From these efforts, the OECD has pushed its member countries and other countries to adopt other rules to prevent perceived abuses. For instance, a company should have substance (employees, assets, and activities) to receive treaty benefits, and not be merely a shell entity. Similarly, the OECD has discouraged the use of tax incentives, for the reasons discussed above. The incentives benefit taxpayers, but generally do not create additional investment; at most, the incentives shift investment from one country to another. The OECD efforts are important and have had significant impact. More than 100 countries have voluntarily agreed to peer reviews to determine how each country is progressing in reducing harmful tax competition and administering tax laws in ways that are fair and equitable. The collective progress, driven in large part by OECD initiatives, has built a more sensible and sturdy foundation for the imposition and collection of taxes on international business. But, the OECD initiative demonstrates the hollowness of a CSR standard for taxpayers and tax advisors. If countries continue to offer tax incentives, notwithstanding the OECD’s efforts and peer pressure from other countries, should taxpayers forgo those incentives? Of course not. Taxpayers, and tax advisors, would fail to meet their fiduciary responsibilities if they refused incentives (or, out of principle, refused to seek and consider what incentives are available). Indeed, the US foreign tax credit rules penalize any taxpayer that fails to reduce its non-US income taxes. If a foreign tax is not compulsory, then the tax is not creditable in the US tax system. IRS regulations provide extensive guidance on what is required of a taxpayer to minimize foreign taxes in order to ensure that the taxes paid will be creditable against US tax on that same foreign-source income. The US foreign tax credit rules effectively put into law the Judge Hand standard and eschew the CSR standard for tax planning with respect to foreign taxes. B.

Pillar Two: A Global Minimum Tax

In addition to fighting against harmful tax competition, the OECD is leading a global initiative to ensure that all income earned by large corporate taxpayers will be subject to a minimum tax of 15 percent in each country where income is earned. The initiative, known as Pillar Two, has widespread support with approximately 140 countries agreeing to the initiative in principle.

Corporate tax and corporate social responsibility  389 The OECD is developing detailed rules for how such a regime would operate. The OECD does not have the authority to impose the rules but is encouraging each country to adopt the rules (or substantially similar rules) in order to create a global minimum tax. A full discussion of Pillar Two is beyond the scope of this chapter, plus, the rules are changing almost monthly and will continue to do so for several years. But the core idea can be explained simply. ● Each country is encouraged to impose a 15 percent minimum tax on the income earned by large corporations that are headquartered in that country. The tax will be computed on a country-by-country basis. For instance, if a US corporation has two subsidiaries that earn income in Germany, the German income from the two subsidiaries will be combined and tested to determine whether the income has been subject to a 15 percent tax by Germany. If the tax is 15 percent or more, then no additional tax will be imposed by the US. If the German income has been taxed at a 12 percent rate, then the US would impose a 3 percent top-up tax. ● If the US fails to agree to the Pillar Two initiative and does not impose a top-up tax, then penalty provisions are triggered. Other countries will be empowered to impose tax on the income earned from Germany by the subsidiaries of the US company. This penalty regime – which is hideously complex – serves two purposes. It ensures that all income will be subject to a minimum 15 percent tax. It also encourages each country to adopt the Pillar Two regime, because income of its companies will be subject to the 15 percent tax in any event and the country in which the corporation is headquartered generally will prefer to obtain that tax revenue rather than have it go to another country. The Pillar Two initiative is a major development in international tax and, if successful, will reduce the benefits of tax planning that critics consider excessive and objectionable. But incentives for tax planning will continue of course. Many countries have tax rates well in excess of 15 percent, so planning that reduces taxes toward the 15 percent rate will be attractive. Furthermore, the Pillar Two initiative does nothing to resolve the question whether the Judge Hand standard for taxpayer behavior still stands tall or whether a CSR standard is workable and should be adopted. Under both approaches, full compliance with all applicable tax laws is essential. Pillar Two simply changes the legal landscape, so that taxpayers will be subject to a minimum tax of 15 percent. There is nothing in Pillar Two that would guide a tax practitioner in deciding to forgo available tax planning. Indeed, the debate around Pillar Two provides further evidence of why a CSR standard is largely unworkable. One of the biggest stumbling blocks in the negotiations at the OECD among countries is how to treat tax incentives. Countries do not want to offer tax incentives to investors, only to find that the tax saving is eliminated because the home country of the investor imposes a top-up tax in an equal amount, to ensure a minimum tax of 15 percent. This concern echoes the tax sparing debate between developing and developed countries. Under tax sparing, one country (typically, a developed country) agrees that it will grant a credit for taxes that the other country (typically, a developing country) ‘spares’ the taxpayer, in order to incentivize the taxpayer to invest. A similar approach may be adopted in implementing Pillar Two. (At the time of this writing, the treatment of tax incentives under Pillar Two is not fully resolved.)

390  Research handbook on corporate taxation

VII.

SOCIAL CONSTRAINTS ON TAXPAYER BEHAVIOR

It is not necessary to impose a CSR model on taxpayers and tax advisors in order for taxpayers to adopt morally preferred behavior. Or, phrased another way, even under the Judge Hand approach, many taxpayers on many occasions will forgo tax planning opportunities that are legal and available. Examples abound. In the UK, Starbucks expanded rapidly (and was entitled to tax deductions for its new investments) and did not pay significant UK income tax, compared to its revenue and prominence in the marketplace. Critics challenged Starbucks as a tax cheat, although no improper tax compliance was ever identified. Starbucks, sensitive to its public-facing image as a progressive retailer, volunteered to pay a minimum tax that was higher than the tax required by law. (The voluntary tax would not be creditable on its US income tax return, of course, because the payment was not compulsory.) Large companies that have significant investments in plant and equipment in a smaller town are under pressure not to reduce their property tax valuations, even if a lower valuation would be legally supportable. The company often is the largest employer in the community and the property taxes it pays are a significant part of the revenue base for local schools. The company must balance a desire to pay lower property taxes against the public criticism it would receive by the community. Tax inversions, discussed above, were a tricky consideration for US multinationals. While several prominent US corporations engaged in inversions, other companies did not, because of concern regarding how the public would perceive the action of converting from a US-headquartered company to a foreign-headquartered company, particularly if the company had federal government contracts or sold primarily to individual consumers who might object (as Starbucks experienced in the UK). So, even under the Judge Hand perspective, tax planning often will not be extended to the maximum limits. The costs of misjudgement – in audit expenses, public censure, and loss of goodwill with tax authorities and customers – are severe.

VIII. CONCLUSION Critics of ‘aggressive’ tax planning are pushing to abandon the long-standing moral standard articulated by Judge Hand that has guided taxpayers and tax advisors: follow all laws, but otherwise engage in planning to minimize tax liabilities. Seizing on the CSR movement, these critics propose that taxpayers forgo at least some tax planning opportunities. The CSR position is bolstered by the fact that many (although not all) tax advisors and analysts of corporate behavior agree with the 2019 Business Roundtable statement that corporations have a duty to multiple stakeholders, including the government, and not solely to its financial shareholders. But the generalized goal of CSR does not provide taxpayers and tax advisors with a meaningful guidepost for how to make tax planning decisions. Accordingly, Judge Hand’s perspective remains the superior standard. Significantly, taxpayers (especially corporate taxpayers) are sensitive to the public perception regarding their tax profiles and tax planning. So, in practice, the differences between the two moral standards is not always as stark as it may at first appear.

24. Executive compensation and corporate governance Michael Doran

Penalty taxes for executive compensation have long attracted support from both liberal and conservative policymakers. In 1984, a Democratic House, a Republican Senate, and a Republican president denied tax deductions to companies making golden-parachute payments and imposed a 20-percent surtax on executives receiving such payments. In 1993, a Democratic Congress and a Democratic president set a $1 million cap on the tax deduction for most forms of compensation paid to a corporation’s top five executives. In 2004, a Republican Congress and a Republican president enacted penalties, including a 20-percent surtax, for certain deferred-compensation arrangements. And in 2017, a Republican Congress and a Republican president repealed the main exceptions to the $1 million deduction cap. It seems that few policymakers on either side want to appear soft on executive compensation. Underlying these penalty taxes are two assumptions widely shared by legislators, the popular press, much of the public, and many academics. First, it is generally assumed that contemporary executive compensation generally represents a failure of corporate governance. In certain quarters, it is very nearly an article of faith that executive pay is too high, both in absolute and relative terms. Such exorbitant compensation, the assumption runs, cannot possibly be the result of arm’s-length bargaining between executives and corporate directors. Rather, it reflects the outsized influence – or even control – that executives exercise over directors. Chief executive officers (CEOs) in particular are said to receive pay far in excess of the value of their services, to the general disadvantage of shareholders and rank-and-file workers. Second, it is generally assumed that tax policy can correct this corporate-governance failure. Since the enactment of the golden-parachute penalty taxes in 1984, Congress has turned to the tax law (along with securities law) as a preferred approach in its efforts to reshape executive compensation. The basic mechanisms for doing so have not been particularly imaginative. Sometimes, as with deferred compensation, Congress imposes a penalty tax on the executive; sometimes, as with the $1 million cap, Congress denies a corporate tax deduction; and sometimes, as with golden parachutes, Congress does both. The underlying expectation (perhaps it is more of a hope) is that directors and executives will structure executive-pay arrangements to avoid those penalties, thereby reaching the outcomes policymakers want. The first assumption has long been contested. Generally known as the ‘managerial-power’ theory of executive compensation, it has some empirical support (Hlaing and Stapleton, 2022). But there is also empirical support for the ‘optimal-contracting’ theory of executive compensation, which maintains that directors bargain with executives at arm’s length to reach compensation arrangements promoting shareholder interests (Edmans et al., 2017; Edmans and Gabaix, 2016; Kaplan, 2012). It is difficult, at this point, to favor either theory as the clearly superior account (Walker, 2012a). It may well be that the managerial-power theory better explains executive pay in certain cases and that the optimal-contracting theory better explains executive pay in other cases (Edmans et al., 2017; Walker, 2012b). And it may also be 391

392  Research handbook on corporate taxation that still other explanations are needed to explain particular compensation arrangements (e.g., Frydman, 2019; Frydman and Papanikolaou, 2018; Murphy, 2013). But after nearly 40 years of using tax law to regulate executive pay, the second assumption should be rejected as almost certainly wrong. Most of the tax rules for executive compensation have had only weak effects, and unintended consequences have often dominated the intended ones. The $1 million cap is particularly instructive. As originally enacted in 1993, Internal Revenue Code section 162(m) denied a deduction for executive pay in excess of $1 million, but it expressly exempted performance-based compensation and it implicitly exempted most deferred compensation. Section 162(m) may have had modest effects on the base salaries paid to executives, but overall executive pay rose substantially during the second half of the 1990s, perhaps in part because the exception for performance-based compensation may have encouraged companies to increase stock-option grants (Walker, 2012a). And there is a more serious concern with the use of tax policy in this area. The adverse tax consequences imposed on golden-parachute payments, deferred-compensation arrangements, and compensation of more than $1 million generally fall on the corporation. The point is readily apparent in the case of denied deductions. Compensation paid to an executive that is otherwise deductible as an ordinary and necessary business expense becomes non-deductible if it is an excess golden-parachute payment or if it exceeds the $1 million limitation. But even the penalty taxes imposed on an executive for a failed deferred-compensation arrangement or for an excess parachute payment are readily shifted to the corporation through an indemnification agreement, often with a requirement that the corporation make a gross-up payment for the additional income and penalty taxes incurred by the executive when the corporation pays on the executive’s behalf. In both cases, the ultimate effect is to increase the tax paid by the corporation. That, in turn, increases the economic burden that the corporate income tax imposes on shareholders and rank-and-file workers. But according to the managerial-power theory, shareholders and rank-and-file workers are the very people harmed by excessive executive compensation in the first place. The outcome is really remarkable. On the assumption that directors and executives conspire against shareholders and non-executive employees – using corporate assets to pay rents to executives rather than to improve the returns to shareholders or to increase the pay of rank-and-file workers – Congress responds by further penalizing those shareholders and rank-and-file workers.

I.

EXECUTIVE COMPENSATION AS A CORPORATE-GOVERNANCE FAILURE

It seems clear that legislators generally assume that corporate directors do not act strictly in the interests of shareholders when they bargain over executive compensation. This corporate-governance failure is thought to manifest itself in both the levels and the components of executive pay. The assumption is that, through the cooperation of pliable directors, executives in many cases effectively set their own compensation.

Executive compensation and corporate governance  393 A.

Excessive Pay Levels

Polls regularly find popular dissatisfaction with executive compensation (Burak, 2018), and it is routine in certain policy circles to describe executive pay in unflattering terms such as ‘bloated,’ ‘outrageous,’ and even ‘obscene’ (AFL-CIO et al., 2021; Baker et al., 2019). Concerns about executive compensation implicate both the narrow interests of corporate shareholders and broad questions of social welfare. Thomas Piketty, for example, argues that executive compensation is a significant determinant of income inequality (Piketty, 2014; see also Brou et al., 2021). Criticisms about the level of executive compensation have two aspects. First, executive pay is said to be too high in absolute terms. In 2020, the average total compensation among CEOs at the 350 largest public companies was $24.2 million (Mishel and Kandra, 2021).1 This reflects impressive growth over the past few decades. After remaining fairly constant from the 1940s to the middle of the 1970s (Frydman and Saks, 2010), the average annual CEO compensation at the 350 largest public companies increased 1,322 percent, in real terms, between 1978 and 2020 (Mishel and Kandra, 2021). As always, pay for executives at the very top attracts considerable attention. In 2019, the CEO of Thermo Fisher Scientific, Inc. was paid more than $85 million, the CEO of HCA Healthcare, Inc. was paid more than $109 million, and the CEO of Oracle Corporation was paid more than $162 million (CG Lytics, 2019). By comparison, the U.S. median household income in 2020 was just over $67,500 (Shrider et al., 2021). Second, executive pay is said to be too high relative to the pay of corporate rank-and-file employees. Critics have long pointed to increases in what is generally known as the ‘pay ratio’ – the ratio determined by comparing the pay of a company’s CEO to median (or sometimes mean) pay of the company’s rank-and-file workers.2 Different analysts calculate the pay ratio differently, but it is clear that the ratio has been increasing for decades. In 1965, the ratio was 21 to 1; in 1978, it was 31 to 1; in 1995, it was 118 to 1; in 2000 (at the height of the technology bubble), it was 368 to 1; and in 2020, it was 351 to 1 (Mishel and Kandra, 2021).3 The objection is obvious: CEO compensation has increased significantly more over the past half century than has the compensation of non-executive employees. B.

Inappropriate Types of Pay

At times, it is not just the level of executive pay that policymakers and others find objectionable; rather, it is the specific type of pay. During the increased merger activity of the early 1980s (Ravenscraft, 1987), critics took aim at golden parachutes – severance payments made to executives of a target company following a takeover (Murphy, 2012). Legislators determined that golden parachutes hinder certain acquisitions that advance shareholder interests,

1 This figure includes the amounts includible in an executive’s gross income when shares of restricted stock become vested and when stock options are exercised. A different measure of compensation, which looks to the value of restricted stock and stock options when granted, yields an average total-compensation amount for 2020 of $13.9 million (Mishel and Kandra, 2021). 2 Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires a public company to disclose the ratio of the median compensation of the company’s employees (other than the CEO) to the total compensation of the company’s CEO. 3 These figures use mean compensation for rank-and-file workers.

394  Research handbook on corporate taxation encourage certain acquisitions that harm shareholder interests, and divert amounts paid by purchasers from shareholders to executives (Joint Committee on Taxation, 1985). Next, by the late 1980s and early 1990s, there were concerns that executive compensation was not closely linked to corporate or individual performance (Crystal, 1991; Jensen and Murphy, 1990a; Jensen and Murphy, 1990b). It was thought that in too many cases, executive pay was effectively guaranteed, either as base salary or as fixed bonuses. But just a few years later, performance-based compensation itself became the target of criticism, with stock options emerging as the new bête noire. By 2000, stock options, on average, accounted for more than half of CEO pay at the largest companies (Murphy, 2013). As critics pointed out, the compensation payable on the exercise of a stock option increases with a rising market, even if a particular company’s performance lags behind that of its competitors (Walker, 2012a). The accounting scandals and corporate failures of the early 2000s – particularly those involving Enron, WorldCom, Tyco, and Global Crossing – put additional pressure on the use of stock options in executive-pay arrangements. Critics argued that stock options give executives a powerful motivation to boost the value of their companies’ stock, including through excessive risk-taking and misrepresenting financial results (Brou et al., 2021; Hlaing and Stapleton, 2022; Murphy, 2013; Tingle, 2017). Revelations that many companies had backdated stock-option grants so that options granted in-the-money (that is, with a strike price below the stock price on the grant date) appeared to have been granted at-the-money (that is, with a strike equal to the stock price on the grant date) only underscored the objections (Lie, 2005). Finally, the collapse of Enron in the fall of 2001 put nonqualified deferred compensation on the hot seat. Measured against common practice, Enron’s deferred-compensation plans were only moderately aggressive, but they included ‘haircut’ provisions allowing executives to request immediate distribution of 90 percent of their deferrals with a voluntary forfeiture of the remaining 10 percent. Several Enron executives used the haircut provisions to withdraw more than $50 million of deferred compensation from the plans as Enron slid toward bankruptcy (Doran, 2004; Joint Committee on Taxation, 2003). Deferred compensation, which previously was considered a relatively benign component of executive pay, was now seen as a way for executives to divert assets from a company’s external creditors prior to bankruptcy. C.

The Theory of Executive Power and Executive Pay

The assumption that executive compensation represents a failure of corporate governance derives from a theory with widespread support in the academy. This is the managerial-power theory, perhaps most closely identified with Lucian Bebchuk and Jesse Fried of Harvard Law School. The theory builds on longstanding insights about the separation of ownership and control in public companies (Berle and Means, 1932) and about the agency costs associated with that separation (Jensen and Meckling, 1976). According to the managerial-power theory, executives have undue influence or even outright control over the directors who determine the executives’ compensation (Bebchuk and Fried, 2004; Chapas and Chassagnon, 2021). Rather than bargain with executives at arm’s length and strictly in the interests of shareholders, directors defer to the demands of executives and approve compensation arrangements that cut against shareholder interests. Managers, in effect, capture pliable boards of directors and extract rents from corporate revenues (Bebchuk and Fried, 2004; Piketty, 2014).

Executive compensation and corporate governance  395 The managerial-power theory offers an explanation not just for the levels but also for the components of executive compensation. Executives, the theory holds, prefer pay that is not contingent on their own performance or the performance of the companies they lead, and they demand protection against the involuntary loss of their sinecures, such as might occur following a change in corporate ownership or control (Bebchuk and Fried, 2004). For these reasons, executives want to be paid salaries and fixed bonuses; they want golden-parachute arrangements and generous severance packages; and they want expansive deferred-compensation arrangements and other forms of ‘stealth compensation’ to help conceal (‘camouflage’) the true value of their pay arrangements, thereby minimizing the ‘outrage costs’ otherwise imposed by shareholders and the public (Bebchuk and Fried, 2004). But the managerial-power theory is contested (e.g., Cremers et al., 2017; Frydman and Saks, 2010; Kaplan, 2012), and there are other theoretical explanations of executive compensation. Most prominently, the optimal-contracting (or shareholder-value) theory holds that executive compensation is a solution to – rather than a symptom of – the agency problem in the management of public companies (Edmans et al., 2017; Jensen and Murphy, 1990b). First, the levels of executive pay reflect the importance of highly talented executives to corporate success. Demand for outstanding executives exceeds supply, and companies must pay a premium to attract and to retain such executives. Second, the components of executive-compensation arrangements align the interests of executives with those of corporate stakeholders. Salaries and guaranteed bonuses discourage executives from undertaking risk, so other types of compensation are needed to provide countervailing incentives. Stock options, restricted stock, and other forms of equity-based compensation align managerial interests with the interests of shareholders, and nonqualified deferred compensation aligns managerial interests with those of unsecured lenders (Jensen and Meckling, 1976).4 Increasingly (if somewhat belatedly), scholars are also analyzing the legal and institutional factors that at least partially determine executive compensation (see, e.g., Doran, 2017a; Edmans et al., 2017; Murphy, 2012; Murphy, 2013; Murphy and Jensen, 2018). These generally cut across both the managerial-power theory and the optimal-contracting theory. For simplicity, consider just the tax rules for executive compensation. Certain tax rules (including some that reflect previous policy interventions) induce distortions in executive-pay arrangements. Whether corporate directors intend for executive-pay arrangements to facilitate executive rent extraction or to optimize executive incentives for the benefit of shareholders, those directors must take such tax distortions into account. Thus, for example, deferred compensation is a preferred type of executive compensation because of the reduced effective tax rate on investment income during the deferral period (Doran, 2017a). Similarly, stock options were long favored at least in part because they automatically avoided the $1 million cap on deductions for executive pay (Doran, 2017b). And the surtax on golden parachutes led to a common practice of corporations providing executives with indemnifications and ‘gross-up’ payments (Murphy, 2013).

4 There are still other theoretical explanations of executive compensation. For example, the tournament theory holds that a principal function of executive compensation is to provide performance incentives for a company’s junior employees and for executive candidates in the labor market (Lazear and Rosen, 1981). The underlying notion is that employees and outside candidates compete for promotions and for the greater pay associated with higher positions. Outsized pay for the CEO represents the prize for the tournament winner (Islam et al., 2022; Lazear and Rosen, 1981).

396  Research handbook on corporate taxation At a minimum, then, the first assumption underlying penalty taxes for executive compensation – specifically, the assumption that executive compensation represents a failure of corporate governance – is problematic. The managerial-power theory, although attractive to the general public and the popular press and accepted in certain segments of the academy, has not cleared the field of competing accounts. The longstanding optimal-contracting account also has considerable empirical support, and it may be that the two theories together more fully explain contemporary executive-compensation practices than does either theory alone. Additionally, legal and other institutional considerations undoubtedly affect various aspects of executive-pay arrangements without regard to the validity of either the managerial-power or the optimal-contracting theory. In particular, past attempts to reform executive compensation through penalty taxes have altered pay practices in ways not foreseen by policymakers.

II.

TAX POLICY AS A CORRECTIVE INSTRUMENT

The second assumption grounding the use of penalty taxes here is that tax policy can correct the underlying corporate-governance failure that leads to excessive levels or inappropriate forms of executive compensation. The precise means by which penalty taxes supposedly correct the assumed corporate-governance failure are often left unstated, but legislators generally take it as given that directors and executives will respond to penalty taxes by changing the terms of executive-compensation arrangements. That appears to be true in some cases, but not in others; and even when true, it appears that the changes made by directors and executives are often not the changes that legislators wanted or anticipated. The penalty taxes on golden-parachute payments and deferred compensation are considered here; the penalty taxes on compensation over $1 million are considered in Section III.5 A.

Golden Parachutes

In the Deficit Reduction Act of 1984, Congress enacted two penalties for what it called ‘excess parachute payments.’ The first penalty falls on the corporation that makes the excess parachute payment; the second falls on the executive who receives it. Specifically, Internal Revenue Code section 280G denies the corporation a tax deduction for the excess parachute payment, and Internal Revenue Code section 4999 imposes a 20-percent surtax on the executive who receives the payment. There was not even a pretense that golden parachutes offend traditional tax-policy concerns. Instead, Congress maintained that golden parachutes benefit executives at the expense of shareholders and characterized the penalty taxes as correctives to a corporate-governance failure (Joint Committee on Taxation, 1985).6 The golden-parachute penalties apply only to what Congress considers an ‘excess parachute payment,’ which is defined as the difference between an executive’s ‘parachute payment’

5 For the sake of brevity, temporary penalty taxes enacted under the Emergency Economic Stabilization Act of 2008 are ignored. 6 Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires a public company that seeks shareholder approval of an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially all the company’s assets to seek shareholder approval of any golden-parachute payments.

Executive compensation and corporate governance  397 and the executive’s ‘base amount.’ A parachute payment is a payment to the executive that satisfies two conditions. First, the payment must be contingent on a change in the ownership or control of the executive’s employer or a change in the ownership of a substantial portion of the employer’s assets. Second, the payment must be at least three times the executive’s base amount, which is the executive’s average annual taxable compensation during the five years preceding the change in ownership or control. Reasonable compensation for services, including services performed after the change in ownership or control, is not a parachute payment. To illustrate, assume that all the outstanding stock of Target Corporation is purchased by Acquiring Corporation. During the five years preceding the purchase, Chief Executive Officer of Target Corporation has an average annual taxable compensation of $10 million. Under Chief Executive Officer’s employment contract with Target, the purchase of Target Corporation’s stock triggers a payment of $30 million to Chief Executive Officer. Because the $30 million payment is contingent on a change in the ownership of Target Corporation and because it is at least three times the Chief Executive Officer’s base amount of $10 million, the entire $30 million is a parachute payment. The excess parachute payment is $20 million, which is the difference between the $30 million parachute payment and the $10 million base amount. Under section 280G, Target Corporation may not deduct the $20 million excess parachute payment; and under section 4999, Chief Executive Officer must pay a $4 million surtax, which is 20 percent of $20 million. Corporations and executives responded to the golden-parachute penalties in several ways that are not consistent with the corporate-governance outcomes that Congress intended. First, many companies that had not previously maintained golden-parachute agreements with their executives adopted such agreements after the penalties were enacted (Murphy, 2013). Second, in an effort to avoid the penalties entirely, many companies and executives agreed to characterize golden parachutes as compensation for consulting or other services to be provided by the executives after a change of ownership or control. Some of those agreements are more aggressive than others – for example, providing very large payments in exchange for nominal services. Third, in some cases companies and executives agree that the company will forgo the tax deduction and will indemnify the executive for the 20-percent surtax. Because the indemnification payment is itself considered a parachute payment, such an agreement typically covers all income taxes and additional surtaxes triggered by the indemnification payment. This is known as a ‘gross-up’ approach, and it quickly becomes very expensive. Assuming that Chief Executive Officer from the example above has a marginal income tax rate of 40 percent, the original $30 million parachute payment becomes $75 million once it is grossed up (a $75 million payment, after all taxes have been paid, leaves the executive with $30 million). No part of the $75 million payment is deductible. The gross-up approach obviously exacerbates the corporate-governance failure that Congress meant to correct. Yet, by 1999, most golden-parachute arrangements included gross-up provisions (Murphy, 2013).7

7 Some agreements limit an executive’s golden parachute to 299 percent of the executive’s base amount, so that no portion of the golden parachute is an excess parachute payment. This approach generally satisfies the objective of limiting golden parachutes to what Congress considered an acceptable amount.

398  Research handbook on corporate taxation B.

Deferred Compensation

In the American Jobs Creation Act of 2004, Congress enacted a 20-percent surtax on any executive whose nonqualified deferred compensation fails certain requirements. Internal Revenue Code section 409A provides that an executive with deferred compensation not meeting those requirements must include the deferred compensation in gross income as soon as it vests, must pay an interest charge, and must pay a 20-percent surtax. Although tax considerations are an important determinant of deferred compensation (Doran, 2017a), the principal objective of section 409A, once again, was to correct a perceived corporate-governance failure – specifically, the undue control that corporations supposedly allowed executives to exercise over their deferred compensation in the event of an impending corporate bankruptcy or insolvency (Doran, 2004). Before section 409A, deferred compensation was not heavily regulated by federal law. To achieve tax deferral for executives, a deferred-compensation plan had to avoid application of three partially overlapping tax doctrines: the economic-benefit doctrine (which Congress codified in 1969 at Internal Revenue Code section 83); the cash-equivalence doctrine; and the constructive-receipt doctrine. Avoiding current taxation under the economic-benefit doctrine and section 83 required that the corporation’s deferred-compensation obligation be an unfunded and unsecured promise to pay and that the corporation not place assets for the payment of the deferred compensation beyond the reach of its creditors. Avoiding current taxation under the cash-equivalence doctrine required that the executive not be able to alienate his or her interest in the deferred compensation for value. The application of the constructive-receipt doctrine to deferred-compensation plans had long been problematic before section 409A. The relevant tax regulation states that an individual is in constructive receipt of income that is ‘credited to [the individual’s] account,’ ‘set apart’ for the individual, or ‘otherwise made available so that [the individual] may draw upon it any time, or so that [the individual] could have drawn upon it during the taxable year if notice of intention to withdraw had been given.’8 But the regulation immediately qualifies that broad rule by stating that ‘income is not constructively received if the [individual’s] control of its receipt is subject to substantial limitations or restrictions.’ The imprecision of the regulation led to decades of cat-and-mouse games between taxpayers and the government. During the 1980s and the 1990s, it became increasingly common for deferred-compensation plans to allow executives to make deferral elections as late as the eve of payment, to allow executives to make elections for the re-deferral of previously deferred amounts, and to allow executives to accelerate payment of their deferred compensation through a ‘haircut’ distribution – that is, the early withdrawal of a specified portion, typically 90 percent, of the deferred compensation in exchange for a voluntary forfeiture of the remaining portion (Doran, 2004). This last practice was of particular concern because haircut distributions potentially allow an executive to receive substantially all his or her deferred compensation as the corporation approaches bankruptcy or insolvency. From the government’s perspective, that is inconsistent both with the requirement that an executive not have control over the payment of his or her deferred compensation and with the requirement that deferred compensation remain subject to the claims of the corporation’s creditors. Additionally, a supposed purpose of deferred



8

Treas. Reg. § 1.451-2.

Executive compensation and corporate governance  399 compensation is to align the interests of executives with a corporation’s third-party lenders (Erkan and Nguyen, 2021; Jensen and Meckling, 1976; Reid, 2018). A haircut distribution allows the executive, but not a third-party lender, to minimize the risk of non-payment, thereby undermining the alignment of interests. But corporations and executives took the position that the haircut constituted a substantial limitation or restriction and so was not inconsistent with tax deferral under the constructive-receipt doctrine (Doran, 2004). Everything changed for deferred-compensation plans with the failure of the Enron Corporation in 2001. Enron executives had taken more than $50 million in haircut distributions during the weeks preceding the company’s bankruptcy (Joint Committee on Taxation, 2003). Lawmakers saw this as a collusive arrangement between the company and its executives to ensure that the executives’ deferred compensation would not really be exposed to the risk of Enron’s insolvency. In response, Congress adopted section 409A, which tightens the constructive-receipt rules and sets out the terms and conditions under which compensation can be deferred, held, and distributed. The constructive-receipt rules in section 409A fall into three groups. First, section 409A regulates distributions, providing that an executive’s deferred compensation may be paid out only upon or pursuant to one of six distribution triggers.9 Second, section 409A bans the acceleration of deferred-compensation payments. This provision was specifically intended to prohibit haircut distributions such as those taken by the Enron executives. Third, section 409A regulates elections, both as to initial deferrals and as to distributions. It requires that an executive’s initial election to defer compensation be made before the start of the taxable year in which the compensation is earned. It also imposes limits on an executive’s elections to change the time or form of a distribution.10 When assessed against the underlying corporate-governance objective, the results under section 409A are mixed. Despite unnecessarily complex and turgid interpretive regulations (Doran, 2008), formal compliance with section 409A generally is not problematic. The statutory requirements are readily incorporated into the written terms of a nonqualified deferred-compensation arrangement, although indemnification agreements usually shift any adverse tax consequences of non-compliance from the executive to the corporation. So long as the administration of a deferred-compensation arrangement remains routine, few difficulties arise. But the circumstances that gave rise to section 409A were not routine. As allegations of fraud at Enron became public and as the company’s share price fell precipitously during the last few months of 2001, executives took extraordinary measures to withdraw their deferred compensation before the company filed for bankruptcy. Faced with similar circumstances today and the prospect of losing much or all of their deferred compensation in bankruptcy proceedings, executives of a failing company presumably would push the company’s directors to agree to accelerated distributions in violation of section 409A. Although such distributions

These are: the executive’s separation from service; the executive becoming disabled; the executive’s death; a date or schedule set out in the plan at the time of the initial deferral; a change in the ownership or effective control of the corporation; or the executive’s unforeseeable financial emergency. 10 Any such election may not take effect for at least 12 months; any election to change a distribution payable at a fixed time or under a fixed schedule must be made at least 12 months before the first payment is due; and any election to defer a distribution (other than one made by reason of death, disability, or unforeseeable financial emergency) must delay the distribution by a minimum of five years. 9

400  Research handbook on corporate taxation would trigger tax inclusion, an interest charge, and a 20-percent surtax, indemnification and a gross-up payment by the corporation would leave the executive no worse off. It is not hard to see why this would be the likely outcome. After all, the assumption underlying section 409A is that directors and executives are disposed to enter into collusive arrangements that protect executives from losing their deferred compensation. Why would that disposition disappear exactly when such an arrangement is most important to the executives? Something is better than nothing, and with the corporation’s bankruptcy on the horizon, the alternative to violating section 409A and receiving at least some deferred compensation may be receiving no deferred compensation. Section 409A thus achieves its core objective only if one assumes away the corporate-governance failure that it is supposed to correct. As long as the corporate-governance failure persists, section 409A does as much to exacerbate the problem as it does to mitigate it.

III.

THE $1 MILLION CAP AND THE ANATOMY OF A POLICY FAILURE

The most prominent penalty tax for executive compensation is the $1 million deduction cap that Congress enacted as part of the Omnibus Budget Reconciliation Act of 1993 and expanded substantially in the Tax Cuts and Jobs Act of 2017. There had been growing criticism in the late 1980s and the early 1990s that executive pay was both too large relative to that of rank-and-file workers and too insensitive to individual and corporate performance. By 1993, the CEO pay at large public companies was more than 100 times average-worker pay; 15 years earlier, it had been only 31 times average-worker pay (Mishel and Kandra, 2021). Additionally, it was said that corporate executives were ‘paid like bureaucrats’ (Jensen and Murphy, 1990a; cf. Hall and Liebman, 1998) – that is, paid in large part just for being employed, regardless of how well or how poorly they performed and regardless of whether they enhanced or diminished organizational value. The perception of complacency and entitlement among U.S. corporate executives was thought to compare unfavorably with the strong work ethic and high level of accountability among their Japanese counterparts (Murphy, 2013; Rose and Wolfram, 2002). In response, Congress passed Internal Revenue Code section 162(m), which generally prohibits a public company from deducting more than $1 million in compensation paid to any of its top five executives. Early legislative proposals for an executive-pay cap applied to all forms of executive compensation, but the version enacted in 1993 had two important exceptions, one implicit and the other express. The implicit exception was probably a drafting oversight. As written, the cap disallowed a deduction only for compensation paid while an executive was still employed by the company; it did not reach nonqualified deferred compensation paid out after the executive had retired or otherwise terminated employment (Doran, 2017b). Because the tax law imposes no limits on nonqualified deferred compensation, such payouts could run into the tens or even hundreds of millions of dollars, all of it deductible by the corporation (Doran, 2017a). The express exception was for performance-based compensation. Specifically, section 162(m) did not apply to any compensation paid ‘solely on account of the attainment of one or more performance goals,’ as long as the performance goals were set by a compensation committee of outside directors, the material terms of the compensation were disclosed to and approved by the company’s shareholders, and the compensation was not paid unless the

Executive compensation and corporate governance  401 compensation committee certified that those material terms had been met. Because section 162(m) set no deduction limit on performance-based compensation, legislators expected companies to respond by shifting performance-insensitive compensation to performance-based compensation. Officials in the Clinton Administration, which had proposed the $1 million cap, confirmed that the cap was intended to change executive-pay practices rather than to raise revenue (Reilly, 1994). Although included in the tax code, section 162(m) was enacted as a corporate-governance measure. It was meant to change the nature of executive pay from the guaranteed, rubber-stamped compensation of bureaucrats to performance-sensitive pay approved both by shareholders and by outside directors. And yet, the exception for performance-based compensation proved to be a low hurdle. As interpreted by Treasury Department regulations, an acceptable performance goal could be based on the company’s ‘stock price, market share, sales, earnings per share, return on equity, or costs,’ and the performance goal did not even have to require a ‘positive result.’11 The regulations said that an acceptable performance goal might require nothing more than ‘maintaining the status quo or limiting economic losses.’12 With so much flexibility, it was child’s play for companies to design performance-based compensation that rewarded mediocrity or even outright failure. Perhaps most importantly, the regulations gave a pass to stock options issued at or out of the money, as long as the company obtained advance shareholder approval of the plan under which the options were granted. The assumption was that an executive exercises an at-the-money or an out-of-the-money stock option only after the current stock price is greater than the strike price – that is, only if the stock price increases after the option is granted. That of course ignores the possibility that the stock price might increase with a generally rising stock market, as happened during the bubble in the technology sector between 1995 and 2000. Indeed, a generally rising stock market might pull up the stock of a particular company even as the company lags behind its competitors (Doran, 2017b). Also, it became clear during the middle of the 2000s that the tension between the need to grant at-the-money options and the desire to shield executives from risk encouraged many companies to backdate stock options, which had the effect of making options granted in-the-money look as though they had been granted at-the-money (Lie, 2005). Although it is impossible to know what would have happened to executive compensation if Congress had not enacted the $1 million cap in 1993, the cap does not seem to have led to a reduction in the level of executive pay (Murphy and Jensen, 2018). As of 2016, more than half of all companies in the S&P 500 paid base salaries of more than $1 million to their CEOs; in other words, those companies chose to give up tax deductions for at least some portion of CEO compensation (Doran, 2017b). Additionally, the average of total CEO compensation at the 350 largest companies in 2020, including both performance-based and other pay, was $24.2 million; this is far more than the average of such compensation in 1993 (Mishel and Kandra, 2021). And the ratio of CEO pay to average-worker pay in 2020 had risen to 351 to 1 – again, far in excess of what it had been in 1993 (Mishel and Kandra, 2021). Whether or not the $1 million cap affected the overall level of executive compensation, it likely did affect the types of executive compensation. Several scholars argue that the substantial increase in stock-option grants during the 1990s was a function of the relaxed treatment of 11 12

Treas. Reg. § 1.162-27(e)(2)(i). Id.

402  Research handbook on corporate taxation stock options under the exception for performance-based compensation (e.g., Murphy, 2012; Schizer, 2015), although there are other possible explanations for the increase in stock-option compensation (e.g., Shue and Townsend, 2017). The cap may also have resulted in a greater use of performance-based compensation more broadly (e.g., Balsam et al., 2019; Perry and Zenner, 2001; cf. Rose and Wolfram, 2002). Measured against congressional intent in 1993, that might have been considered a policy success. But Congress decided otherwise. In 2017, Congress declared that the shift in executive pay toward performance-based compensation had led companies and executives to give priority to short-term results over both long-term results and the interests of rank-and-file employees (Committee on Ways and Means, 2017). And so Congress radically revised the $1 million cap in the Tax Cuts and Jobs Act of 2017. First, Congress expanded both the class of corporations and the group of executives subject to the deduction cap. The cap now reaches corporations with publicly traded debt and all foreign corporations that are publicly traded in the U.S. through American depositary receipts, and it applies to the company’s CEO, chief financial officer (CFO), and three highest-paid executives other than the CEO and the CFO.13 Second, Congress repealed both the implicit exception for deferred compensation and the explicit exception for performance-based compensation. Now, any executive who is covered by the $1 million cap in any year after 2016 remains covered by the cap forever, even for compensation paid after the executive has left the company. Additionally, all compensation is subject to the $1 million cap, whether or not it is dependent on performance. As revised, section 162(m) is a pure penalty. Both in 1993 and 2017, legislators and others critical of executive compensation casually referred to the tax deduction for executive compensation as a ‘subsidy,’ but that is an analytic mistake. Compensation paid by a company to its employees, including the company’s executives, is part of the company’s cost of producing taxable income and, as such, is properly deductible under an income tax (Walker, 2011). The deduction is not a subsidy; it is necessary for the proper measurement of income. In certain cases, unreasonable or excessive compensation may be properly characterized as something else (disguised dividends, for example) and such compensation should not be deductible. But section 162(m) does not condition the deduction denial on unreasonableness or the excessiveness. It simply sets an arbitrary amount – an amount both well below average CEO compensation and not indexed for inflation – above which no deduction may be taken. The cap is punitive. This is not necessarily to say that section 162(m) represents bad policy. There are, perhaps, a few points that can be made in its favor. First, entirely apart from its effectiveness, the cap arguably has expressive value. Penalties define the limits of acceptable conduct (Doran, 2009), and by imposing a penalty on executive compensation in excess of $1 million, Congress in effect makes a statement that the payment of such compensation is not in the public interest. On the other hand, this statement, such as it is, lacks much meaning. In the three decades since the cap was enacted, most large companies have shown a strong inclination to ignore it. The failure to index the cap for inflation seems likely to reinforce that tendency. As more companies flout the $1 million cap, its expressive value will continue to erode. Second, the 2017 changes to section 162(m) should have the salutary effect of removing whatever distortions to executive pay the prior version of the cap may have induced. Again, 13 Under a further expansion made by the American Rescue Plan of 2021, the cap will also apply to the next five highest-paid executives (bringing the total to ten), starting in 2027.

Executive compensation and corporate governance  403 a number of scholars believe that section 162(m) changed the composition of executive compensation, especially by encouraging companies to issue stock options during the late 1990s; and again, the standard criticism of that practice was that, in a bull market, stock options reward executives without regard to corporate or individual performance. The elimination of the explicit statutory exception for performance-based compensation removes that distortion (Murphy and Jensen, 2018). That said, the exception for performance-based compensation had its roots in the widespread concern of the late 1980s and early 1990s that corporate pay was not dependent on performance (Crystal, 1991; Jensen and Murphy, 1990a; Jensen and Murphy, 1990b). It is possible, then, that the 2017 repeal of the exception for performance-based compensation will result in executives being paid more like bureaucrats. In any event, the objectionable aspects of revised section 162(m) outweigh whatever good there may be in the new provision. The broadened cap on deductible pay almost certainly will fail to limit the amounts that public companies pay their executives. Corporations paid non-deductible compensation even when section 162(m) included established exceptions for nonqualified deferred compensation and performance-based compensation (Doran, 2017b; Kastiel and Noked, 2018). There is no good reason to think that they will change that practice now that all compensation over $1 million is non-deductible. And in fact, initial empirical evidence suggests that companies are largely indifferent to the effects of the broadened penalty tax under section 162(m) (De Simone et al., 2022; Galle et al., 2021; cf. Luna et al., 2020).14 Granted, executive-compensation arrangements are somewhat sticky, and it may be that new executive-pay equilibria will emerge over time. But five years after the changes to the $1 million cap, there is no evidence to suggest that companies will be more responsive to the broader cap than they were to the narrower cap (De Simone et al., 2022).15 This points to a more serious problem. By definition, the disallowance of the deduction for compensation over the $1 million cap increases the corporation’s tax liability (or decreases the corporation’s net operating loss). Although the details remain uncertain, the burden of that increased tax liability falls on some combination of investors and workers. This of course is the familiar problem of the incidence of the corporate income tax (Toder, 2023). Although the corporation is the nominal taxpayer, the corporation is a legal fiction used to describe complicated contractual arrangements between and among natural persons such as investors, executives, directors, rank-and-file workers, consumers, and suppliers. As a legal fiction, the corporation cannot bear the burden of the corporate income tax; the tax necessarily is borne by natural persons (Auerbach, 2005; Nunns, 2012). Beyond this basic point, however, there is little consensus about the incidence of the corporate income tax, although it is reasonably clear that both capital and labor bear a substantial portion of it (Toder, 2023; see also Auerbach, 2018; Gale and Thorpe, 2022; Nunns, 2012). The tax reduces the returns to shareholders and other investors, and it reduces the compensation paid to employees, whether they are executives or rank-and-file workers.16 The important 14 One of the most pronounced effects of the 2017 change to section 162(m), at least in the short run, may have been to accelerate the payment of performance-based compensation to avoid the effective date of the change (Durrant et al., 2021). 15 One study suggests that, in response to the repeal of the exception for performance-based compensation, companies have not shifted away from performance-based compensation but have shifted the underlying performance criteria from objective to subjective measures (Fox, 2021). 16 To the extent that the corporate income tax is borne by investors, it is at least partly borne by investors in the non-corporate sector (Harberger, 1962).

404  Research handbook on corporate taxation point here is that the increase in the corporate income tax attributable to the $1 million cap falls on investors and workers (Doran, 2017b; Walker, 2018), but these are precisely the persons in whose interest the $1 million cap supposedly was enacted and then broadened. It is hard to see any policy justification for imposing a penalty tax on the very people said to be harmed by the penalized conduct. It is like giving a red card to a player who commits a foul and then ejecting the player against whom the foul was committed. Perhaps, however, section 162(m) operates as a wage tax on amounts over $1 million, rather than as an increase in the corporate income tax? And perhaps, as a consequence, section 162(m) operates not so much to increase the tax burden on investors and workers as to decrease the compensation that otherwise would be paid to executives?17 If so, that would offer a better policy justification for the $1 million deduction cap in general and for the 2017 broadening of the cap in particular. But the early empirical evidence indicates otherwise. Studies of executive pay after the 2017 reforms to section 162(m) (De Simone et al., 2022), earlier reforms to section 162(m) that targeted the health-insurance industry (Schieder and Baker, 2018), and legislation in Austria denying corporate deductions for executive compensation over €500,000 (Bornemann et al., 2023) generally find no meaningful effects on the level of executive pay. These results are suggestive rather than conclusive. Still, based on the evidence available today, it appears that the expanded $1 million cap is indeed nothing more than a punitive increase in the corporate income tax – one borne primarily by investors and workers – rather than an effective constraint on executive pay. In the end, section 162(m) must be put down as a policy failure. As enacted in 1993, section 162(m) distorted decisions about the components of executive compensation but had little or no discernible effect on the overall levels of executive compensation. As reformed in 2017, section 162(m) mitigates the distorting effects of the original statute. But the 2017 reform exacerbates the harsh effects on investors and workers who now must bear an even greater economic burden for executive-pay arrangements put into place by companies and executives.

CONCLUSION The two critical assumptions made by legislators over the past four decades when enacting tax rules directed at executive compensation are, first, that certain features of executive pay represent a failure of corporate governance and, second, that tax policy can correct that failure. The first assumption may or may not be correct; the theoretical and empirical arguments on this point remain unresolved. But the second assumption is increasingly untenable. Four decades of tax rules targeting executive compensation – the golden-parachute penalty taxes (section 280G), the $1 million deduction cap (section 162(m)), and the penalty taxes on nonqualified deferred compensation (section 409A) – have repeatedly undermined the assumption. The penalty taxes are largely ineffective in changing executive-compensation practices in the ways that legislators intend; in many instances, they actually exacerbate the features of executive pay that concern legislators in the first place. Most recently, the 2017 expansion of section 162(m) is a particularly misguided effort that likely will do little more than increase the economic burden of the corporate income tax on investors and rank-and-file workers. 17 After all, corporations appear to pay executives at least a portion of their super-normal returns (Gale and Thorpe, 2022).

Executive compensation and corporate governance  405

REFERENCES AFL-CIO, principal author. 2021. ‘Labor Unions, Anti-Poverty Groups, and Other Leading Economic Justice Organizations Urge Support for the “Tax Excessive CEO Pay Act.”’ Auerbach, Alan J. 2006. ‘Who Bears the Corporate Tax? A Review of What We Know.’ Tax Policy and the Economy 20:1–40. Auerbach, Alan J. 2018. ‘Measuring the Effects of Corporate Tax Cuts.’ Journal of Economic Perspectives 32:97–120. Baker, Dean, Josh Bivens, and Jessica Schieder. 2019. ‘Reining in CEO Compensation and Curbing the Rise of Inequality.’ Economic Policy Institute. Balsam, Steven, John H. Evans III, and Amy J.N. Yurko. 2019. ‘The Impact of Regulation on Executive Compensation: IRC Section 162(m) and the Unexpected Exclusion of CFOs.’ Journal of the American Taxation Association 41:59–81. Bebchuk, Lucian and Jesse Fried. 2004. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Cambridge: Harvard University Press. Berle, Adolf and Gardiner Means. 1932. The Modern Corporation and Private Property. New York: Harcourt, Brace & World, Inc. Bornemann, Tobias, Martin Jacob, and Mariana Sailer. 2023. ‘Do Corporate Taxes Affect Executive Compensation?’ Accounting Review 98:31–58. Brou, Daniel, Aroop Chatterjee, Jerry Coakley, Claudia Girardone, and Geoffrey Wood. 2021. ‘Corporate Governance and Wealth and Income Inequality.’ Corporate Governance: An International Review 29:612–29. Burak, Esra. 2018. ‘Is the Sky the Limit? Fair Executive Pay as Performance Rises.’ Social Problems, 65:211–30. CG Lytics. 2019. ‘Top 50 CEOs Earn More than 21 National Economies.’ Chapas, Benjamin and Virgile Chassagnon. 2021. ‘Reappraising the Problem of CEO Compensation: Modern and Old Theoretical Perspectives.’ Journal of Economic Issues 40:760–78. Committee on Ways and Means. 2017. Tax Cuts and Jobs Act: Report of the Committee on Ways and Means, House of Representatives, on H.R. 1, together with Dissenting and Additional Views. Washington, D.C.: Government Printing Office. Cremers, K.J. Martijn, Saura Mascanale, and Simone M. Sepe. 2017. ‘CEO Pay Redux.’ Texas Law Review 96:205–78. Crystal, Graef S. 1991. In Search of Excess: The Overcompensation of American Executives. New York and London: W.W. Norton & Co. De Simone, Lisa, Charles McClure, and Bridget Stomberg. 2022. ‘Examining the Effects of the TCJA on Executive Compensation.’ Contemporary Accounting Review 39:2376–408. Doran, Michael. 2004. ‘Executive Compensation Reform and the Limits of Tax Policy.’ Tax Policy Center Discussion Paper No. 18. Doran, Michael. 2008. ‘Time to Start Over on Deferred Compensation.’ Virginia Tax Review 28:223–35. Doran, Michael. 2009. ‘Tax Penalties and Tax Compliance.’ Harvard Journal on Legislation 46:111–61. Doran, Michael. 2017a. ‘The Puzzle of Nonqualified Retirement Pay.’ Tax Law Review 70:181–242. Doran, Michael. 2017b. ‘Uncapping Executive Pay.’ Southern California Law Review 90:815–78. Durrant, Jon, James Jianxin Gong, and Jennifer Howard. 2021. ‘In the Nick of Time: Performance-Based Compensation and Proactive Responses to the Tax Cuts and Jobs Act.’ Journal of Management Accounting Research 33:53–74. Edmans, Alex and Xavier Gabaix. 2016. ‘Executive Compensation: A Modern Primer.’ Journal of Economic Literature 56:1232–87. Edmans, Alex, Xavier Gabaix, and Dirk Jenter. 2017. ‘Executive Compensation: A Survey of Theory and Evidence.’ NBER Work Paper 23596. Erkan, Asligul and Trung Nguyen. 2021. ‘Does Inside Debt Help Mitigate Agency Problems? The Case with Investment Inefficiency and Payout Policies.’ Finance Research Letters 39:1–8. Fox, Zackery D. 2021. ‘Taxes and the Use of Subjectivity in Executive Bonus Plans.’ Accessed 18 April 2023 at https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​3678935. Frydman, Carola. 2019. ‘Rising through the Ranks: The Evolution of the Market for Corporate Executives, 1936–2003.’ Management Science 65:4951–79.

406  Research handbook on corporate taxation Frydman, Carola and Dimitris Papanikolaou. 2018. ‘In Search of Ideas: Technological Innovation and Executive Pay Inequality.’ Journal of Financial Economics 130:1–24. Frydman, Carola and Raven E. Saks. 2010. ‘Executive Compensation: A New View from a Long-Term Perspective, 1936–2005.’ Review of Financial Studies 23:2099–138. Gale, William G. and Samuel I. Thorpe. 2022. ‘Rethinking the Corporate Income Tax: The Role of Rent Sharing.’ Tax Policy Center. Galle, Brian, Andrew Lund, and Gregg Polsky. 2021. ‘Does Tax Matter? Evidence on Executive Compensation after 162(m)’s Repeal.’ Stanford Journal of Law, Business & Finance 26:1–34. Hall, Brian J. and Jeffrey B. Liebman. 1998. ‘Are CEOs really Paid like Bureaucrats?’ Quarterly Journal of Economics 113:653–91. Harberger, Arnold C. 1962. ‘The Incidence of the Corporation Income Tax.’ Journal of Political Economy 70:215–40. Hlaing, Khin Phyo and Andrea Stapleton. 2022. ‘A Literature Review on the Dual Effect of Corporate Tax Planning and Managerial Power on Executive Compensation Structure.’ Accounting Perspectives 21:387–423. Islam, Emdad, Lubna Raham, Rik Sen, and Jason Zein. 2022. ‘Eyes on the Prize: Do Industry Tournament Incentives Shape the Structure of Executive Compensation?’ Journal of Financial and Quantitative Analysis 57:1929–59. Jensen, Michael C. and William H. Meckling. 1976. ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.’ Journal of Financial Economics 3:305–60. Jensen, Michael C. and Kevin J. Murphy. 1990a. ‘CEO Incentives: It’s not How Much You Pay, but How.’ Harvard Business Review May–June 1990:138–53. Jensen, Michael C. and Kevin J. Murphy. 1990b. ‘Performance Pay and Top-Management Incentives.’ Journal of Political Economy 98:225–64. Joint Committee on Taxation. 1985. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Washington, D.C.: U.S. Government Printing Office. Joint Committee on Taxation. 2003. Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations. Washington, D.C.: U.S. Government Printing Office. Kaplan, Steven N. 2012. ‘Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges.’ NBER Working Paper 18395. Kastiel, Kobi and Noam Noked. 2018. ‘The “Hidden” Tax Cost of Executive Compensation.’ Stanford Law Review Online 70:179–91. Lazear, Edward P. and Sherwin Rosen. 1981. ‘Rank-Order Tournaments as Optimal Labor Contracts.’ Journal of Political Economy 89:841–64. Lie, Erik. 2005. ‘On the Timing of CEO Stock Option Awards.’ Management Science 51:802–12. Luna, LeAnn, Kathleen Schuchard, and Danielle Stanley. 2020. ‘The Impact of CEOs on Changes to Executive Compensation after the TCJA: Initial Evidence.’ Accessed 18 April 2023 at https://​papers​ .ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​3451998. Mishel, Lawrence and Jori Kandra. 2021. ‘CEO Pay has Skyrocketed 1,322% since 1978: CEOs were Paid 351 Times as Much as a Typical Worker in 2020.’ Economic Policy Institute. Murphy, Kevin J. 2012. ‘The Politics of Pay: A Legislative History of Executive Compensation.’ Randall S. Thomas and Jennifer G. Hill (eds), Research Handbook on Executive Pay. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 11–40. Murphy, Kevin J. 2013. ‘Executive Compensation: Where We Are, and How We Got There.’ George M. Constantinides, Milton Harris, and Rene M. Stulz (eds), Handbook of the Economics of Finance, vol. 2A. Amsterdam: Elsevier, 211–356. Murphy, Kevin J. and Michael C. Jensen. 2018. ‘The Politics of Pay: The Unintended Consequences of Regulating Executive Compensation.’ Journal of Law, Finance, and Accounting 3:189–242. Nunns, Jim. 2012. ‘How TPC Distributes the Corporate Income Tax.’ Tax Policy Center. Perry, Todd and Marc Zenner. 2001. ‘Pay for Performance? Government Regulation and the Structure of Compensation Contracts.’ Journal of Financial Economics 62:453–88. Piketty, Thomas. 2014. Capital in the Twenty-First Century. Cambridge: Harvard University Press. Ravenscraft, David J. 1987. ‘The 1980s Merger Wave: An Industrial Organization Perspective.’ Conference Series, Proceedings, Federal Reserve Bank of Boston, vol. 31, 17–51.

Executive compensation and corporate governance  407 Reid, Colin D. 2018. ‘CEO Retirement Compensation: Is Inside Debt Excess Compensation or a Risk Management Tool?’ Business Horizons 61:721–31. Reilly, Meegan M. 1994. ‘Former Treasury Official Discusses Executive Compensation Cap.’ Tax Notes 62:747. Rose, Nancy L. and Catherine Wolfram. 2002. ‘Regulating Executive Pay: Using the Tax Code to Influence Chief Executive Officer Compensation.’ Journal of Labor Economics 20:S138–S175. Schieder, Jessica and Dean Baker. 2018. ‘Does Tax Deductibility Affect CEO Pay? The Case of the Health Insurance Industry.’ Economic Policy Institute. Schizer, David M. 2015. ‘Tax and Corporate Governance: The Influence of Tax on Managerial Agency Costs.’ Jeffrey Gordon and Wolf-George Ringe (eds), The Oxford Handbook of Corporate Law and Governance. Oxford: Oxford University Press, 1128–62. Shrider, Emily A., Melissa Kollar, Frances Chen, and Jessica Smega. 2021. ‘Income and Poverty in the United States: 2020.’ United States Census Bureau, Current Population Reports. Shue, Kelly and Richard R. Townsend. 2017. ‘Growth through Rigidity: An Explanation for the Rise in CEO Pay.’ Journal of Financial Economics 123:1–21. Tingle, Bryce C. 2017. ‘How Good Are Our ‘Best Practices’ when It Comes to Executive Compensation? A Review of Forty Years of Skyrocketing Pay, Regulation, and the Forces of Good Governance.’ Saskatchewan Law Review 80:387-419. Toder, Eric. 2023. ‘The Incidence of the Corporate Tax.’ This volume, ch 4. Walker, David I. 2011. ‘Suitable for Framing: Business Deductions in a Net Income Tax System.’ William and Mary Law Review 52:1247–318. Walker, David I. 2012a. ‘The Law and Economics of Executive Compensation: Theory and Evidence.’ Claire A. Hill and Brett H. McDonnell (eds), Research Handbook on the Economics of Corporate Law. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 232–52. Walker, David I. 2012b. ‘Who Bears the Cost of Excessive Executive Compensation (and Other Corporate Agency Costs)?’ Villanova Law Review 57:653–73. Walker, David I. 2018. ‘Expanding and Effectively Repealing the Executive Pay Deductibility Limitations.’ Tax Notes 160:1819–32.

PART V CONCLUSION

25. The future of the corporate tax Daniel Shaviro

I. INTRODUCTION It seems like only yesterday that what one might call the ‘end of history’1 in corporate and international tax policy appeared to be at hand. Over time, global tax competition was driving down countries’ corporate income tax rates,2 with a predicted endpoint of zero that some experts favored reaching sooner, rather than later.3 Meanwhile, with regard to the taxation of multinational companies, the world was said to be marching inexorably towards the universal replacement of worldwide residence-based taxation with that which was purely territorial, or source-based.4 Proponents lauded this shift as both benign and ‘long overdue,’5 and tended not to emphasize the fact that existing, putatively territorial, systems generally were ‘hybrids’ that retained significant elements of residence-based taxation of home companies’ foreign source income (FSI).6 Also not always emphasized was the tension or complementarity – depending on one’s perspective – between the expected decline of entity-level corporate income taxation in general, and of residence-based taxation of FSI in particular. Discussions of the latter might suggest that residence-based taxation of multinationals was increasingly being supplanted by that which was source-based. But the broader decline of corporate income taxation suggested that source-based corporate taxation was likewise on a path to extinction. This in turn would imply that the global profits of, say, an Amazon, Apple, or Facebook might be expected to escape entity-level income taxation everywhere, without even continuing to require the sorts of tax planning gyrations that, by 2011 or so, had begun receiving widespread attention.7 Hence, the economic value that all these profits represented could only be taxed through other sorts of tax instruments – for example, through worldwide residence-based

See Francis Fukuyama, The End of History and the Last Man (Free Press 1992). See, e.g., U.S. Dep’t of the Treasury, The Made in America Tax Plan 11 (U.S. Dep’t of the Treasury 2021); OECD Secretary-General, Corporate Tax Statistics, at 9 (3d ed. 29 July 2021), accessed 7 April 2023 at https://​www​.oecd​.org/​tax/​tax​-policy/​corporate​-tax​-statistics​- third-edition.pdf. 3 See Daniel Shaviro, ‘Goodbye to All That? A Requiem for the Destination-Based Cash Flow Tax’, 72 Bull. for Int’l Tax’n, No. 4/5 (2018) (noting that the destination-based cash flow tax or DBCFT, widely discussed by experts and briefly considered for enactment by U.S. policymakers, would have effectively eliminated the existing origin-based corporate income tax, replacing it with a value-added tax plus a wage subsidy). 4 But see Daniel Shaviro, ‘The New Non-Territorial U.S. International Tax System’, 160 Tax Notes 57, 58 (2018) (criticizing the accuracy and usefulness of the worldwide versus territorial distinction). 5 Mihir A. Desai, ‘Tax Reform, Round One: Understanding the Real Consequences of the New Tax Law’, Harv. Mag., May/June 2018, at 57, 59. 6 See Shaviro, supra note 4, at 58. 7 See, e.g., Edward D. Kleinbard, ‘Stateless Income’s Challenge to Tax Policy’, 132 Tax Notes 1021 (2011). 1 2

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410  Research handbook on corporate taxation taxation of the companies’ shareholders, consumption taxation of the shareholders and/or customers, and/or certain types of destination-based taxes.8 But then this apparent ‘end of history’ – like so many others before it9 – ran into brisk headwinds. In the public policy realm, a rising focus on global tax avoidance by highly profitable, mainly American, multinationals led to extensive pushback efforts, such as those led by the Organization for Economic Cooperation and Development (OECD).10 These efforts focused not just on strengthening source-based corporate income taxation – already in tension with the maxim that tax-competitive pressures make this undesirable and unsustainable – but also on revivifying residence-based worldwide taxation as at least a significant backup.11 Meanwhile, when the U.S., in 2017, finally moved towards explicit territoriality by exempting U.S. companies’ receipt of dividends from their foreign subsidiaries, it also significantly expanded the current taxability of the companies’ FSI.12 The U.S. pendulum will swing even more decidedly back towards reliance on both source-based and residence-based corporate taxation if key elements of the Biden Administration’s April 2021 Made in America Tax Plan13 should become law. Under this plan, not only would half of the 2017 corporate rate cut be reversed,14 and source-based taxation strengthened in response to concerns about profit-shifting,15 but the U.S. would move closer to the pole of full worldwide residence-based corporate taxation than it has ever previously been.16

For example, the DBCFT, prominently proposed as a replacement for existing corporate income taxes, would effectively be a VAT. See Shaviro, supra note 3. By contrast, as I discuss below (see text accompanying notes [91–96]), proposals to employ sales-based formulary apportionment, or close variants thereof, within existing corporate income taxes might be viewed as merely changing the applicable source rules, and thereby as permitting corporate income taxation to survive after all. However, such proposals were long viewed by many as being of questionable compatibility with existing income tax institutions. 9 See Fukuyama, supra note 1. 10 See, e.g., Daniel Shaviro, ‘Mobile Intellectual Property and the Shift in International Tax Policy from Determining the Source of Income to Taxing Location-Specific Rents, Part One’, 2020 Sing. J. Legal Stud. 681, 691 (2020) (evaluating the challenges posed by the rise of mobile intellectual property for the traditional income tax concept of source, and for the OECD’s proposed focus on the site of ‘value creation’). 11 See, e.g., OECD, ‘OECD/G20 Base Erosion and Profit Shifting Project Tax Challenges Arising from Digitalisation: Report on Pillar Two Blueprint’ (14 October 2020). 12 See Shaviro, supra note 4, at 57–8. 13 See U.S. Dep’t of the Treasury, supra note 2. 14 The 2017 tax Act lowered the U.S. corporate rate by 14 percentage points, or from 35 percent to 21 percent. Under the Made in America Tax Plan, the rate would increase by seven percentage points, to 28 percent. See id. at 12. 15 In particular, the Made in America Tax Plan would replace certain current law rules known as the BEAT (for ‘Base Erosion and Anti-avoidance Tax’) with a new proposal dubbed the SHIELD (for ‘Stopping Harmful Inversions and Ending Low-tax Developments’) that is meant to address profit-shifting more rigorously. 16 Under the Made in America Tax Plan, U.S. companies’ FSI would be taxed mainly the same way as their domestic source income (DSI), except that (1) the tax rate for their FSI would be 21 percent, rather than 28 percent as with DSI, and (2) 80 percent foreign tax credits would generally be allowable against FSI from the same country. While it is true that, prior to 1918, the U.S. taxed resident companies’ FSI with no allowance of a foreign tax credit, at that time deferral generally applied to the earnings of foreign subsidiaries. See Michael J. Graetz and Michael M. O’Hear, ‘The Original Intent of U.S. International Taxation’, 46 Duke L.J. 1021 (1997). 8

The future of the corporate tax  411 Whether or not this pushback is well-advised, and whether or not it yields major, long-lasting policy changes, its main political impetus is easily discerned. The headline companies’ huge profits and low global taxes drew worldwide attention that was perhaps exacerbated, at least in some circles, by their being mainly American firms. The post-2008 emergence of austerity and budget deficits also mattered atmospherically, even before COVID further raised the fiscal stakes (along with many of these companies’ profits). Yet the new direction is rooted in more than just shifting public sentiment. The last ten years have also witnessed a complementary shift in the tenor of scholarly discourse regarding corporate and international taxation. In brief, the mainstream intellectual grounds (both empirical and theoretical) for supporting both entity-based corporate taxation in general, and worldwide residence-based corporate taxation in particular, have gained significant ground. Revised understandings of the economics, law, and politics of taxing multinational firms have all dramatically weakened the ‘end of history’ view, and provided new support for a change in direction. This shift could be viewed as representing either something old, or something new. On the one hand, it involves reviving tax policy views that were far more in vogue in, say, the era of the Tax Reform Act of 198617 than they have been more recently. It does so, however, on relatively novel grounds that rebut the grounds for the ‘end of history’ view, which had themselves rested on rebutting the prior main grounds for 1986-style views. As we will see, this kind of historical back-and-forth process has been taking place more broadly in recent legal and economic scholarship, extending well beyond corporate and international (or other) tax policy. Against that background, this chapter has two main aims. The narrower one is to explain the grounds underlying both the ‘end of history’ view and its proposed replacement, focusing as well on why each has seemed so persuasive at particular times. The broader aim is to place these shifts within a broader pattern of back-and-forth intellectual shifts in legal policy thinking, while at least posing the issue (without attempting to resolve it definitely) of how the pattern might be explained. To these ends, I proceed as follows. Section II discusses the broader intellectual wind shifts of recent decades, not just in tax policy but also in legal and economic scholarship more generally. Section III discusses recent economics scholarship that supports deploying corporate income taxation more vigorously. Section IV discusses new legal understandings that may facilitate imposing vigorous residence-based and source-based corporate income taxation. Section V notes possible reasons for hoping (although also doubting) that countries might cooperate in restraining tax competition between them. Section VI offers a brief conclusion.

Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085.

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II.

BACK-AND-FORTH IN CORPORATE AND INTERNATIONAL TAX POLICY (AND MORE GENERALLY)

A.

Bittker’s Pendulum

Back in 1979, Boris Bittker called the ‘tax theorists’ of his day a combination of ‘Old Turks’ and ‘Young Fogies.’18 (The joke was that one normally would have spoken of young Turks and old fogies.) More specifically, he noted that ‘a generation of idealists in their sunset years, still inspired by the ethics of compassion adopted in their youth,’ had recently been joined (and were apparently being supplanted) in academia by ‘a rising generation of skeptics insisting on the prudent calculation of costs.’19 Oddly, however, like a rooster crowing hours before sunrise, Bittker had espied his era’s generational transition well before it actually took place. The efficiency aficionados whom he invokes here had merely changed the primary rationale for an unchanged support of comprehensive Haig-Simons income taxation. For the Old Turks (such as Stanley Surrey20), the key issue had been horizontal equity. Tax-favoring, say, real estate over rival industries would unfairly benefit real estate investors relative to other taxpayers. Young Fogies, however (such as Martin Feldstein21), employed standard neoclassical economic models (such as those employing simple supply and demand curves) to argue that after-tax returns would re-equalize as between tax-favored and fully taxed activity or investment choices. Hence, tax preferences for a particular industry, rather than benefiting its investors after tax, would ‘shake out in competitive resource allocation and translate into misuse of resources.’22 In retrospect, this revised reasoning in support of unchanged normative conclusions proved to be no more than a prologue to the main event. As efficiency-based reasoning, rooted in neoclassical price theory models, spread and broadened in the tax policy field, its capacity to require affirmatively altering prior mainstream conclusions became clear. Views that gained widespread academic support in the decades after Bittker had identified the generational transition – each rooted in straightforward economic reasoning, but departing sharply from the ‘compassion’-driven consensus of his Old Turks – included the following: ● Marginal tax rates should be lower and far less graduated (if not, indeed, flat or even declining) than many had previously thought.23

18 Boris I. Bittker, ‘Equity, Efficiency, and Income Tax Theory: Do Misallocations Drive Out Inequities?’, 16 San Diego L. Rev. 735, 737 (1979). 19 Id. 20 Daniel Shaviro, ‘“Moralist” versus “Scientist”: Stanley Surrey and the Public Intellectual Practice of Tax Policy’ (2022), accessed 18 April 2023 at https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​ 4143601. 21 Martin Feldstein, ‘On the Theory of Tax Reform’, 6 Journal of Public Economics 77 (1976). 22 Id. 23 See, e.g., James A. Mirrlees, ‘An Exploration in the Theory of Optimal Income Taxation’, 38 Rev. Econ. Stud. 175 (1971); Efraim Sadka, ‘On Income Distribution, Incentive Effects and Optimal Income Taxation’, 43 Rev. Econ. Stud. 261 (1976); Jonathan Gruber and Emmanuel Saez, ‘The Elasticity of Taxable Income: Evidence and Implications’ (Nat’l Bureau of Econ. Rsch., Working Paper No. 7512, 2000); N. Gregory Mankiw, Matthew Weinzierl, and Danny Yagan, ‘Optimal Taxation in Theory and Practice’, 23 J. Econ. Persp. 147 (2009).

The future of the corporate tax  413 ● Capital income, or at least the normal risk-free return to waiting, should not be taxed.24 ● In light of international tax competition, entity-level corporate income taxation should be greatly reduced or even eliminated.25 ● The best achievable global regime for taxing multinational corporations would employ source-based, rather than residence-based, taxation, and thus would involve FSI’s being exempted, rather than taxed subject to the allowance of foreign tax credits.26 Bittker may not have seen any of this coming, but he atoned intellectually by hinting at an insightful ‘longer view’27 of academic debate. Noting that ‘today’s efficiency theorists differ from their parents but resemble their grandparents,’28 he implied that a broader back-and-forth process might be at work. Today, revived variants of the bygone Old Turks’ equity prescriptions are back in vogue, albeit standing on new foundations that move beyond, rather than failing to account for, the (formerly) Young Fogies’ grounding in neoclassical economics. Thus, once again today’s ‘children’ have broken with their ‘parents but resemble their grandparents.’29 A generational back-and-forth between placing equity versus efficiency in the foreground30 has been an important theme of recent decades’ scholarship in multiple realms – not just tax policy. Consider vigorous antitrust enforcement, disparaged by the ‘Chicago school’31 but renascent in modern analyses of the New Economy.32 Or consider the regained intellectual respectability of support for the minimum wage33 and robust consumer protections.34 Tax scholars are therefore in harmony with broader intellectual shifts when today they favor, for

24 See, e.g., Christophe Chamley, ‘Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives’, 54 Econometrica 607 (1986); Assaf Razin and Efraim Sadka, ‘The Status of Capital Income Taxation in the Open Economy’, 52 Finanzarchiv 21 (1995); Andrew Atkeson, V.V. Chari, and Patrick J. Kehoe, ‘Taxing Capital Income: A Bad Idea’, Fed. Rsrv. Bank Minneapolis Q. Rev., Summer 1999, at 3. 25 See, e.g., Alan J. Auerbach, ‘A Modern Corporate Tax’, The Ctr. for Am. Progress/The Hamilton Project (Dec. 2010), accessed 7 April 2023 at https://​www​.americanprogress​.org/​wp​-content/​uploads/​ issues/​2010/​12/​pdf/​auerbachpaper​.pdf. 26 See, e.g., Mihir A. Desai and James R. Hines Jr., ‘Old Rules and New Realities: Corporate Tax Policy in a Global Setting’, 57 Nat’l Tax J. 937 (2004). 27 Bittker, supra note 18, at 737. 28 Id. 29 Bittker recognized, however, that the transition’s strictly generational character could easily be exaggerated. See id. (‘There are, of course, some tax theorists who resist this bipolar classification; every taxonomy is a Procrustean bed’.) 30 I should note that these differences in emphasis reflect not only the relative importance assigned to equity versus efficiency in the abstract, but also how one’s analysis affects the degree of weight that each has in a given instance. 31 See, e.g., Robert Bork, The Antitrust Paradox (Basic Books 1978). 32 See, e.g., Marshall Steinbaum and Maurice E. Stucke, ‘The Effective Competition Standard: A New Standard for Antitrust’, 86 U. Chi. L. Rev. 595 (2020). 33 See David Card and Alan B. Krueger, ‘Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania’, 84 Am. Econ. Rev. 772 (1994). 34 See Oren Bar-Gill, Seduction by Contract (Oxford University Press 2012).

414  Research handbook on corporate taxation example, (1) steep rate graduation at the top,35 (2) expanding capital income taxation36 or even imposing a U.S. federal wealth tax,37 (3) strengthening or expanding wealth transfer taxes (such as through the enactment of a federal inheritance tax),38 (4) increasing entity-level corporate income tax rates (both statutory and effective),39 and (5) expanding worldwide residence-based taxation of multinationals.40 A common feature in today’s many pushbacks against the conclusions of the formerly Young Fogies is a rising appreciation of the problems with ‘Econ 101ism.’41 This term refers to views that are based on blithely assuming that, as a general or even universal matter, ‘[m]arkets are efficient. Firms are competitive. Partial-equilibrium supply and demand describes most things. Demand curves slope down and supply curves slope up … No curve is particularly inelastic or elastic; all are somewhere in the middle (straight lines with slopes of 1 and −1 on a blackboard).’42 Hence, under Econ 101ism, one ostensibly needs neither empirical research, nor any particular understanding of real-world labor markets, in order to conclude, with complete self-confidence, that, say, ‘a pair of supply and demand curves proves that a minimum wage increases unemployment and hurts exactly the low-wage workers it is supposed to help.’43 Equipped with a simple and indeed Panglossian model of perfect markets and pure rationality, one could purport to answer all questions through ‘appeal to the powers of pure logic … dispensing with messy and cooperative facts,’44 along with any need for empirical inquiry beyond the (it was assumed inevitably) confirmatory. In legal circles especially, Econ 101ism not only had its day, but actually – despite its defects – served good purposes, at least to a degree and for a time. The shift that Bittker espied took advantage of the fact that neoclassical Econ 101-style assumptions often have a great deal of force. Failing even to consider them – as where one simply assumes that differences in tax treatment lead straight to violations of horizontal equity – can be myopic and naïve. When one

See Peter Diamond and Emmanuel Saez, ‘The Case for a Progressive Tax: From Basic Research to Policy Recommendations’, 25 J. Econ. Persp. 165 (2011). 36 See Lily Batchelder and David Kamin, ‘Policy Options for Taxing the Rich’, in Maintaining the Strength of American Capitalism 200, 211 (Melissa Kearney and Amy Ganz eds., The Aspen Institute 2019). 37 See, e.g., David Gamage, ‘The Case for Taxing (All of) Labor Income, Consumption, Capital Income, and Wealth’, 68 Tax L. Rev. 355 (2015); Ari Glogower, ‘Taxing Inequality’, 93 NYU L. Rev 1421 (2018). 38 See Lily L. Batchelder, ‘What Should Society Expect from Heirs? The Case for a Comprehensive Inheritance Tax’, 63 Tax L. Rev. 1 (2009). 39 See, e.g., Edward Fox and Zachary Liscow, ‘A Case for Higher Corporate Tax Rates’, 167 Tax Notes 2021 (2020). 40 See, e.g., Robert J. Peroni, J. Clifton Fleming Jr., and Stephen E. Shay, ‘Getting Serious about Curtailing Deferral of U.S. Tax on Foreign Source Income’, 52 SMU L. Rev. 455 (1999); Edward D. Kleinbard, ‘The Lessons of Stateless Income’, 65 Tax L. Rev. 99 (2011); Reuven S. Avi-Yonah, ‘Hanging Together: A Multilateral Approach to Taxing Multinationals’, 5 Mich. Bus. & Entrepreneurial L. Rev. 137 (2016). 41 Noah Smith, ‘101ism’, Noahpinion (21 Jan. 2016), accessed 7 April 2023 at http://​noahpinionblog​ .blogspot​.com/​2016/​01/​101ism​.html. See also James Kwak, Economism (Pantheon Books 2017). 42 Smith, supra note 41. 43 James Kwak, ‘The Curse of Econ 101’, The Atlantic (14 Jan. 2017), accessed 7 April 2023 at https://​www​.theatlantic​.com/​business/​archive/​2017/​01/​economism​-and​-the​-minimum​-wage/​513155/​. 44 Kwak, supra note 41, at 12. 35

The future of the corporate tax  415 rejects the Econ 101 view, one should be able to explain why its core assumptions have failed to apply in a given setting. Just as the Coase theorem, properly understood, does not predict zero transaction costs, but rather shows what might happen were they absent – hence highlighting their central importance – so the precepts underlying Econ 101ism can very usefully remind us of the importance, where applicable, of such contrary conditions as market failure, monopoly power, and people’s ‘behavioral’ departures from neoclassical notions of rational optimization. Econ 101ism’s lessons needed to be fully absorbed (or perhaps reabsorbed)45 by legal scholars before its limitations could be sophisticatedly understood. B.

Accounting for Bittker’s Pendulum

The previous section suggested that Bittker’s pendulum has gone through at least four iterations: from the formerly Young Fogies’ ‘grandparents’ through (in more recent decades) their ‘children.’ In seeking to account for this back-and-forth, various types of explanation are possible. For example, one could posit a broader intellectual pattern, be it founded on eternal recurrence, Hegelian new syntheses, periodic generational muscle-flexing, or simply the recurring need for lagged course corrections. Today’s advancement past Econ 101ism is not, however, just a pristine march-of-science (or fashions) story. The most recent turn also reflects changing social and economic conditions over the last 20 years that have brought fresh (or, at least, greatly exacerbated) problems to public attention. These include, for example, the rise of high-end inequality, and of wildly profitable (yet largely tax-avoiding) global mega-corporations, often run by world-famous business titans. How fitting that, on the very day I started to write this chapter, the New York Times front page should feature two stories about feuds between rival tycoons: Tim Cook versus Mark Zuckerberg,46 and Jeff Bezos versus Elon Musk.47 One could hardly imagine a more overt throwback to America’s late-nineteenth-century First Gilded Age, obsessed with its towering Rockefellers, Carnegies, and J.P. Morgans,48 whose wealth and power neither the general public nor policymakers could ignore. More broadly speaking, the four iterations appear to reflect changing societal attitudes about unfettered free market capitalism as its apparent performance goes up and down. The formerly Young Fogies’ Old Turk progenitors had been swayed by the disastrous, seemingly unending, Great Depression, followed by the New Deal’s widely credited success in reviving both the macroeconomy and economic justice. This historical experience made credible the view that

45 Earlier legal realist scholars such as Robert Hale – arguably, the Old Turks’ grandparents – had earlier harshly criticized neoclassical economic reasoning, based on close familiarity with it. See, e.g., Barbara Fried, The Progressive Assault on Laissez Faire: Robert Hale and the First Law and Economics Movement (Harvard University Press 1998). 46 See Mike Isaac and Jack Nicas, ‘Breaking Point: How Mark Zuckerberg and Tim Cook Became Foes’, N.Y. Times (26 Apr. 2021), accessed 7 April 2023 at https://​www​.nytimes​.com/​2021/​04/​26/​ technology/​mark​-zuckerberg​-tim​-cook​-facebook​-apple​.html. 47 See Kenneth Chang, ‘Jeff Bezos’ Rocket Company Challenges NASA over SpaceX Moon Lander Deal’, N.Y. Times (26 Apr. 2021), accessed 7 April 2023 at https://​www​.nytimes​.com/​2021/​04/​26/​ science/​spacex​-moon​-blue​-origin​.html. 48 See, e.g., Daniel Shaviro, Literature and Inequality (Anthem Press 2020) at 186 (noting such ‘businessmen’s Gilded Age prominence’).

416  Research handbook on corporate taxation market failure (and indeed, inefficiency) was pervasive, and that well-advised governments could adopt policies that would markedly improve people’s lives. Then the era of the Vietnam War, Watergate, and 1970s stagflation helped prompt the rise of neoliberalism, support for lower taxes and deregulation, and other such expressions of the view that markets would richly reward us all, if only they were freed from obtuse legal and regulatory constraints. Government was the problem, Ronald Reagan asserted, and the age of big government was over, Bill Clinton agreed.49 More recent decades, however, have witnessed rising inequality, foundering economic growth, and repeated financial market scandals and downturns. Then came the nightmare of Trumpian nihilism, racism, deliberate government fecklessness amid a pandemic, and pseudo-libertarian looting and corruption that reflected a callous, sneering rejection of any interest in the public good even as an abstract concept. This era’s one major legislative product, the 2017 Tax Cuts and Jobs Act, not only vastly increased the long-term U.S. fiscal gap while concentrating its benefits at the very top, but drew ‘new and arbitrary lines dividing the tax system into winners and losers,’50 often with ‘no discernible policy rationale’51 other than rewarding politically, economically, or culturally favored groups.52 In response to all this, a broad rethinking of the prior era’s truisms has emerged. Luckily for those who are emotionally or intellectually inclined to favor such a rethinking, abundant grounds exist in its support. I next discuss the recent turns in economic research and thinking that stand behind the view that entity-level corporate taxation, both source-based and residence-based, can be used effectively as one of many tools towards promoting economic justice in a given country, while also being acceptable (or even a net positive) on efficiency grounds.

III.

NEW ECONOMIC GROUNDS FOR SUPPORTING ENTITY-LEVEL CORPORATE TAXATION

The Made in America Tax Plan is in some ways unusual within its genre. Reflecting Paul Krugman’s (slightly exaggerated!) statement that ‘it’s hard to find a tax expert who hasn’t joined the Biden team,’53 it augments such standard trappings as its flag-waving title with a surprising degree of reliance on, and citation to, recent academic research. Moreover, while its academic discussions are understandably brief, it does indeed lay out a picture of how recent scholarship amends the more neoclassical trappings of prior work to reverse many of the ‘end of history’ era’s core conclusions. As we will see, this picture jibes neatly with the Bittker pendulum story as carried forward to the present day. I will start, however, with the earlier rise of Bittker’s Young Fogies. See, e.g., Steve Fraser and Robert Gerstle, The Rise and Fall of the New Deal Order (Princeton University Press 1989). 50 David Kamin, principal author, ‘The Games They Will Play: Tax Games, Roadblocks, and Glitches under the 2017 Tax Legislation’, 103 Minn. L. Rev. 1439, 1442 (2019). 51 Daniel Shaviro, ‘Evaluating the New US Pass-Through Rules’, 1 Brit. Tax Rev. 49, 50–51 (2018) (citing an earlier version of Kamin et al., supra note 50). 52 Id. at 51. 53 Paul Krugman, ‘Biden, Yellen, and the War on Leprechauns’, N.Y. Times (8 Apr. 2021), accessed 7 April 2023 at https://​www​.nytimes​.com/​2021/​04/​08/​opinion/​biden​-corporate​-taxes​.html. 49

The future of the corporate tax  417 A.

Background: The Incidence of Tax Preferences

Recall the earlier example of real estate tax preferences, which Old Turks assumed would unfairly benefit real estate investors relative to other taxpayers. In illustration, suppose that investments generally earn 10 percent before tax, but that they all – apart from those in real estate, which are wholly tax-exempt – face a 30 percent income tax that applies uniformly to all investors. Hence, investments apart from real estate end up earning only 7 percent after tax. What about real estate? If – for whatever reason, despite its being tax-exempt – it earns the same 10 percent pre-tax return as everything else, then the benefit of the tax exemption accrues entirely to those investors. Indeed, they are ‘unfairly’ benefiting if, for example, one believes in horizontal equity, and interprets it as requiring that two investors who earn the same pre-tax returns also have the same after-tax returns. To modern, Econ-101-trained eyes, this scenario looks simplistic and question-begging. Why would some people invest in real estate, while others choose taxable assets, when the assumed equality in pre-tax returns assures that their after-tax returns will be very different? As Bittker noted, however, ‘equity-oriented theorists [typically assumed] (more often implicitly than explicitly) … that taxpayers [would] continue to do just what they would have done without the [special exemption].’54 With no net shift of investment capital to real estate from everything else, there would be no particular reason to expect pre-tax returns to adjust for the after-tax difference. Alternatively, as he further explains, the equity theorists might simply have been assuming that any ‘changes in economic conduct to take advantage of the … [exemption would] not significantly alter the pre-tax yield or other economic benefits produced by the tax-favored behavior.’55 Perhaps, for example, some unknown factor might cause investment choices to be inelastic. Or investors might be thought, for whatever reason, to focus myopically or irrationally on pre-tax returns, and thus to be oblivious to differences in tax treatment. While Bittker suggests a paucity of express argumentation as to why any of this should have been the case, the equity theorists’ view was not necessarily as benighted and simply ignorant as it can easily look today. For example, they presumably noticed that, in real-world cases, for whatever reason (and there are many possibilities), the ‘implicit taxes’ that respond to particular tax benefits often appear to be quite low.56 A very partial market adjustment might reasonably seem not to require the equity theorists to alter their conclusions about horizontal inequity. In addition, insofar as they had lived through the Great Depression and New Deal eras, and thereby had acquired a pronounced skepticism regarding market efficiency and neoclassical assumptions, the claim that, in Bittker’s terms, resource misallocations do not drive

Bittker, supra note 18, at 738. Id. 56 See, e.g., Calvin H. Johnson, ‘Repeal Tax Exemption for Municipal Bonds’, 17 Tax Notes 1259, 1261 (2007) (estimating that between 72 and 93 percent of the benefit from the federal tax exemption for municipal bond interest is enjoyed by investors, rather than accruing to issuers via reductions in the pre-tax interest rates that they need to offer). Among the explanations for this that Johnson mentions are (1) graduated marginal rates, implying windfalls to higher-bracket taxpayers if the marginal purchaser is in a lower bracket, and (2) ‘competing tax-favored investments [that] swamp the market.’ Id. at 1262. 54 55

418  Research handbook on corporate taxation out inequities may not have seemed surprising enough to require much attention or explicit defense.57 With the arrival of the Young Fogies and Econ 101ism, this soft spot in the Old Turks’ explicit reasoning proved highly damaging to their scholarly sway. In an era of renewed intellectual ascendancy for the belief in well-functioning markets that were presumed to be guided by investors’ rational quest to maximize risk-adjusted expected after-tax returns, it seemed not only inevitable but almost childishly obvious that, at least in the ordinary case, as Bittker put it, there would be an ‘increase of tax-favored behavior at the expense of its unfavored alternative until the after-tax benefits of the two are equalized.’58 From now on – as remains the case today – any exceptions to what was now deemed the general rule would need to be more rigorously supported than previous convention had required. For present purposes, however, the case of especial interest is in some respects opposite to that discussed just above. It concerns a posited income tax dispreference for a particular type of investment. This is the case of uniquely subjecting profits that are earned through a corporation to the corporate income tax, in addition to eventually taxing corporate income at the shareholder level. However, corporate income taxation has enough special features to merit further elaboration in a separate section. B.

Corporate Income Taxation in the ‘Old Turk’ and ‘Young Fogey’ Eras

In theory, a ‘classical’ corporate income tax system disfavors corporate investment, relative to all other, by taxing corporate income twice: first at the entity level, and then again at the shareholder level upon distribution. To be sure, this picture ignores the possible impact of tax avoidance at either or both levels, and of rate differences between the two levels. Yet it provides a basic structure for analysis that tax experts have fruitfully (if, at times, without due caution regarding its degree of descriptive accuracy) used for many decades. 1. Harberger, part 1 (closed economy) The classic early (1962) analysis of corporate income taxation, by Arnold Harberger,59 posits an economy with two sectors, the corporate and the noncorporate, which differ in that only the former is taxed. Harberger concluded that the corporate income tax is borne by holders of all capital, both corporate and noncorporate. In part, this reflected his applying standard neoclassical Econ 101-style assumptions to the choice between corporate and noncorporate investment. Self-evidently, within that framework, capital would respond to the tax by leaving

57 From my own adolescent and early-adulthood discussions with my parents, who had received economics training and PhDs during the post-World War II era, I well remember how readily they would dismiss Econ 101-style arguments that I might make on one topic or another. At least as I then saw it, they would assert, for example, that the absence of perfect markets and complete rationality meant that such arguments could simply be dismissed out of hand. 58 Bittker, supra note 18, at 738. 59 See Arnold C. Harberger, ‘The Incidence of the Corporate Income Tax’, 70 J. Pol. Econ. 215 (1962). In spirit, Harberger is perhaps best viewed as more ‘Young Fogey’ than ‘Old Turk,’ given his focus on efficiency (along with his view of the relationship between corporate and noncorporate business taxation). As we will see, however, what I call his Part 1 analysis was in some respects more encouraging to legal ‘Old Turks,’ and his Part 2 analysis more encouraging to ‘Young Fogies’ – reflecting, in each case, his empirical assumptions, rather than any evident political agenda.

The future of the corporate tax  419 the corporate sector and flowing into the noncorporate sector, thus raising pre-tax returns in the former and lowering them in the latter, until the two had been equalized after tax. Within the economics profession – legal ‘Old Turks’ notwithstanding – this was too obvious a move to give his analysis the renown that it rightly drew. That resulted instead from his applying a very sophisticated general equilibrium analysis – in contrast to the partial equilibrium analysis that the above equalization argument embodies60 – to conclude that, almost by happenstance, the burden of the corporate income tax would not, within his model, be shifted from capital to labor. An obvious general equilibrium mechanism for shifting the burden of the corporate income tax from capital to labor would have been its reducing the rate of saving and investment in the economy as a whole.61 Harberger, however, assumed that the saving rate was fixed (based on evidence suggesting its inelasticity). His general equilibrium analysis rested instead on his positing observed (but theoretically unexplained) differences between the corporate and noncorporate sectors. In his model, both sectors use capital plus labor to generate income. However, the corporate sector is more able than the noncorporate sector (e.g., real estate and agriculture) to substitute between capital and labor as productive inputs. Thus, when the corporate income tax drives capital from the corporate to the noncorporate sector, the demand for labor increases more in the former than it declines in the latter. Hence, in equilibrium wage-setting, workers win, and the business owners who now must pay them higher market wages lose, when the corporate income tax drives capital from the corporate to the noncorporate sector.62 In sum, Harberger deployed his brilliant analytical and modeling gifts to reach a familiar and easily accepted ‘dog bites man’ conclusion.63 As a matter of economic incidence, the corporate income tax would not be shifted, other than within the business realm as between its corporate and noncorporate sectors. The fact that this happened for a seemingly arbitrary reason – that is, theoretically unexplained differences between the two sectors’ ease of substitution between labor and capital as productive inputs – did not prevent it from gaining wide acceptance. Harberger’s conclusion caused the corporate income tax to look, in a key respect, quite appealing from a Young Fogey perspective. True, it would have a needless efficiency cost, by reason of its causing capital to shift from the corporate to the noncorporate sector at a loss of pre-tax profitability. (This helped to motivate corporate integration proposals that aimed to treat corporate and noncorporate investment more neutrally.) Yet, because Harberger assumed that overall saving and investment were inelastic, his model helped to make the broader enter60 A partial equilibrium analysis only considers the effects of a given policy action in the market(s) that are directly affected – in the above case, corporate versus noncorporate investment. By contrast, a general equilibrium analysis considers broader economic interactions between the various markets in a given economy. 61 In theory, if increased taxation of capital income (through the corporate income tax or otherwise) causes saving and investment to decline, the reduced stock of capital, relative to the counterfactual, might reduce workers’ productivity, along with their wages if these tend to reflect productivity. See, e.g., Daniel Shaviro, ‘Taxing Multinationals’, Econofact (10 July 2021), accessed 7 April 2023 at https://​ econofact​.org/​taxing​-multinational​-corporations. 62 Under this model, the reverse would presumably happen – i.e., a shift of the tax burden from capital to labor – if a special tax applied solely to the noncorporate (rather than the corporate) business sector. 63 See Daniel N. Shaviro, Decoding the U.S. Corporate Tax 61–5 (Roman and Littlefield Publishers 2009).

420  Research handbook on corporate taxation prise of taxing capital seem quite appealing. For example, investors, who presumably for the most part were rich people, would bear both the short-term and the long-term incidence of the tax.64 It would thus be highly progressive. Moreover, given the assumption of fixed savings and investment rates, it would not reduce productivity or economic growth, apart from via the adverse effects of the capital shift from the corporate to the noncorporate sector. Subsequent decades, however, would make it clear (not least to Harberger himself) that the analysis needed revision. Reasonably for the time, his 1962 analysis presumed a closed economy, in which there were no cross-border capital flows. The rise in subsequent decades of integrated global capital markets suggested replacing that model with one in which each country, even the U.S., has a relatively small, open economy, from which capital can readily flow both in and out. Hence, even if savings everywhere remain fixed, a given country’s investment stock may prove highly tax-elastic. As I discuss next, this single change caused the dominant economic view of corporate income taxation to shift in a way that (despite its distinct analytics) paralleled the transition in legal scholarship from Old Turks to Young Fogies. 2. Harberger, part 2 (open economy) As Harberger himself noted in 1995,65 once the savers in one country can invest in other countries, and effectively be taxed only on a source basis,66 the model’s conclusions effectively reverse. Thus, suppose all capital can go wherever it ‘likes’ in quest of the highest available after-tax return. Moreover, suppose that, at the margin, investors demand and can get (but cannot exceed) the ‘normal’ global rate of return, whatever it happens to be at a given moment. All countries are merely price-takers, unable to lure (or retain) capital unless it earns the requisite global after-tax return. To make a strong version of this model more explicit, suppose the following. Each country has valuable, locally owned resources, including not just land with varying site values, and other natural resources, but also people who can supply their own labor. The local resource-owners need investment capital in order to develop these resources’ commercial potential. They obtain it on global capital markets by paying the going after-tax expected world rate of return – nothing more, and nothing less. Suppose that the suppliers of capital are just providing money – as distinct from the modern case where we might think of a distinctive multinational firm (such as Amazon, Apple, or Facebook) that commands particular intellectual property (IP) and expertise. This explains why both (1) to their benefit, they can simply pack up and go somewhere else if not offered the requisite rate, and (2) to their detriment, they cannot demand more than that rate. The locals who are dealing with these capital suppliers therefore face a horizontal supply curve. At the global rate, they can get as much investment capital as they like. There is no need to pay more, and they cannot raise any capital if they offer less.

64 The short-term incidence would fall on corporate shareholders, but it would then shift to investors generally as markets adjusted. 65 See Arnold C. Harberger, ‘The ABCs of Corporation Tax Incidence: Insights into the Open-Economy Case’, in Tax Policy and Economic Growth 51 (Am. Council for Cap. Formation ed., Am. Council for Cap. Formation 1995). 66 Presumably, the mechanism for being taxed only on a source basis is funneling the investment through a corporation that, for tax purposes, both resides in the source country and earns all its income there.

The future of the corporate tax  421 Suppose that the global after-tax expected world rate of return is 6 percent. All local investments that would earn at least this much are made, with 6 percent going to the investors and the surplus going to the locals.67 In this scenario, if the country exempts the income earned locally by those investors, they will indeed charge just 6 percent. But if the source country taxes the investors at, say, a 25 percent rate, they will demand an 8 percent pre-tax return. Local investments that would have earned between 6 and 8 percent are no longer made, resulting in a loss of surplus by domestic resource-owners. However, the investors are just as well-off as they were before (transition aside), since they can earn the same 6 percent return by shifting their funds elsewhere. Moreover, while the investors who earn 8 percent pre-tax are observably paying domestic income tax on their inbound investments, they do not bear the incidence of the tax, as they would have cleared 6 percent after tax either way. Instead, the incidence is borne locally by the resource-owners (including workers whose wages bear the impact of the reduced after-tax profitability). In sum, if we fully accept this model, capital bears none of the incidence of the corporate tax (short-term transition aside). Investors need not care about the corporate or other business income taxes in a given country, as they can simply move their capital elsewhere and earn the same after-tax returns as before. By contrast, the workers and other resource-owners in a given country will lose out as demand shrinks for what they have to offer. Thus, the corporate income tax is no longer progressive (at least, if we define the better-off as those with more savings). Moreover, it may substantially reduce national income, along with economic growth if it is a byproduct of inbound investment. In this model, even the one respect in which a corporate income tax can achieve progressive aims – via the transition effect when it is newly announced – is severely limited by what became known as the time-consistency problem. If you fool investors once by imposing a one-time high tax on their capital once it has entered a given jurisdiction, then they will anticipate its being imposed again, thereby constraining the ability to fool them twice. Models like this support the ‘end of history’ view that both source-based and residence-based corporate income taxes are doomed to wither away (and indeed should do so, the sooner the better). The application to source-based corporate income taxation is more straightforward, but a similar analysis may apply to residence-based taxation of multinationals’ FSI. As I further discuss below, insofar as corporate residence is effectively elective – whether this represents entity-level choices or investors’ decisions regarding which firms to give their capital – the tax ‘price’ for corporate residence that a given country can charge should be limited to its value, which is zero (transition aside) in the pure electivity/interchangeability case.68 Consistent with a Young Fogies-style view of the world, concerns of efficiency, not distribution, are all that should matter in this setting. The advancement of distributional concerns requires different sorts of tax instruments, such as worldwide residence-based income taxation of individuals (with corporate earnings being flowed through to them), and/or the use of progressive consumption taxes.

As a matter of formal legal labels, however, suppose that the return to investors could be denominated either interest or a return to equity, and that the two are taxed the same way, reflecting that the choice of labels is highly elective. 68 See Daniel Shaviro, ‘The Rising Tax-Electivity of U.S. Corporate Residence’, 64 Tax L. Rev. 377 (2011). 67

422  Research handbook on corporate taxation C.

Corporate Income Taxation Today: Market Power and Excess Profits

1. New evidence The above open economy model of corporate income taxation has compelling internal logic. Its conclusions follow from its premises – which, even if not completely true, also are surely not completely false. However, its persuasive power regarding actual real-world institutions depends on its assumptions’ degree of accuracy, or at least adequacy. There is good reason to believe that this has declined in recent decades. The aftermath of the 2017 tax Act has provided an important flashpoint for debate about the model’s continued pertinence. The model would appear unambiguously to predict that the 2017 Act, by reason of such changes as its lowering the U.S. corporate rate from 35 percent to 21 percent, should have triggered a flood of inbound investment (all else equal). Instead, according to a study released by the widely respected International Monetary Fund – pertaining to data from before the COVID pandemic – while ‘U.S. business investment grew strongly compared to pre-TCJA forecasts and outperformed investment growth in other major advanced economies … the overriding factor supporting that growth has been the strength of U.S. aggregate demand.’69 Any positive investment response that was due to the Act itself fell short, not just of theoretical predictions, but also of those ‘based on the historical relation between tax cuts and investment as identified by a range of studies in the empirical literature.’70 The main reason that the International Monetary Fund (IMF) paper identifies for this was ‘stronger corporate market power compared to previous postwar episodes of tax policy changes.’71 As the Made in America Tax Plan notes, other studies have reached similar conclusions – finding, for example, ‘no evidence that the 2017 tax law has made a substantial contribution to investment or longer-term economic growth.’72 The report finds this ‘unsurprising’ given that ‘much of the corporate tax falls on “excess profits,” not normal returns.’73 As excess profits are the fruit of corporate market power, this repeats the IMF paper’s explanation for the 2017 Act’s disappointing upshot. As we will see, assuming excess profits or corporate market power transforms the theoretical analysis of corporate tax policy every bit as much as the shift in earlier decades from positing a closed to an open economy. Only, it does so in the opposite direction, back towards the views of the Old Turks, in keeping with Bittker’s pendulum. The impact of excess profits on corporate tax policy analysis 2. Recall Bittker’s Old Turks’ view that disparities in tax treatment will not affect resource allocation because taxpayers will just keep on doing the same things anyway. If one accepts the full open economy model as discussed above, this is clearly false. However, that conclu Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunleertchai, ‘U.S. Investment since the Tax Cuts and Jobs Act of 2017’, at 17 (Int’l Monetary Fund, Working Paper, WP/19/120, 2019). 70 Id. 71 Id. For pushback against the widely held view that U.S. firms have in recent decades enjoyed rising market power and excess profits, see Susanto Basu, ‘Are Price-Cost Markups Rising in the United States? A Discussion of the Evidence’, 33 J. Econ. Persp. 3 (2019). 72 See U.S. Dep’t of the Treasury, supra note 2, at 4. 73 Id. 69

The future of the corporate tax  423 sion reflects the model’s assuming, not just investor rationality in the service of risk-adjusted after-tax profit maximization, but also that companies, at least at the margin, are only earning normal returns that they can readily replicate elsewhere. That assumption drives, for example, capital’s rapid departure from a given country when an increase in the corporate tax rate means that investments there can no longer match the after-tax rate of return that is generally available elsewhere. By contrast, if comparable after-tax returns are not available elsewhere, or if particular profits simply cannot be earned anywhere else, the Old Turks’ expectation may come true after all. The Made in America Tax Plan mentions substantial evidence in the literature suggesting that ‘[t]axing … excess profits can generate revenue without undue distortion.’74 Intuitively, this reflects that excess profits can resemble free money, which is still worth having even if a tax reduces its amount.75 The report also notes evidence that ‘a rising share of the corporate tax base, over three-quarters by 2013, consists of excess returns.’76 Moreover, recent changes to U.S. corporate income taxation, such as the greater allowability of expensing for capital investments, have reduced the extent to which it reaches normal returns to begin with.77 A fuller analysis of this point would add an international component that further, and more directly, supports modifying the open economy model’s assumptions in order to reach very different conclusions. The extra component pertains to multinationals’ ability to use their IP to earn location-specific rents.78 To illustrate this aspect, consider a firm such as AirBnB, Amazon, Apple, Facebook, Google, Netflix, or Starbucks – to name just a few – that uses one or more of a globally prominent brand, valuable IP, a web platform, and/or a broad user network to make itself a profitable New Economy player in multiple countries. Suppose that such a firm is deciding how active it should be in seeking profits via interactions with the residents of a given country. In an Old Economy version of the open economy model, this might mean that it was considering, say, placing a factory there – involving tangible local capital investment that will result (it hopes) in its earning more global income.79 The firm needs only so many factories, so this particular one will go either here or elsewhere, presumably depending on its marginal risk-adjusted after-tax expected profitability. Now suppose instead that Facebook is considering seeking profits through interactions with the residents of a given country.80 Neither its employees nor any of its tangible assets Id. The analogy between excess profits and free money is imperfect, however, especially over the long run, if the former are created through labor supply that can potentially be tax-deterred. 76 U.S. Dep’t of the Treasury, supra note 2, at 4. The Made in America Tax Plan adds that this ‘fraction is likely to be even higher now, due to the rising market power of large companies, as well as special provisions that exempt most normal returns from taxation.’ Id. (footnote omitted). 77 Id. Recent years have also seen uncommonly low real risk-free interest rates. See, e.g., Rachel Lukasz and Lawrence H. Summers, ‘On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation’ (Brookings Papers on Economic Activity, BPEA Conference Drafts, 2019). This may reduce the extent to which it matters whether the U.S. corporate income tax system is taxing ordinary returns, in addition to rents. 78 See Daniel Shaviro, supra note 10. 79 However, as I further discuss in section IV, infra, the question of where income is actually earned lacks a clear economic answer, and depends legally on the details of the source rule that one adopts. 80 The arguments set forth herein can also apply to a firm such as Starbucks that, unlike Facebook, operates through actual bricks-and-mortar stores within a given country, if it is using its global brand and 74 75

424  Research handbook on corporate taxation need actually enter the country’s physical territory. Facebook may expect to incur very low marginal costs of adding these interactions to those in which it is already engaged with people in other countries, and yet it may enjoy substantial added profits by reason of its adding this set of interactions to all the others. Finally, unlike an Old Economy company that wants to add a single factory, Facebook is not deciding where to be active as between competing choices. It can operate, in this remote way, in as many countries as it likes, with no need to choose between them. Its profits from engagement in each country may be largely non-rival with its profits from such engagement in other countries.81 Under these circumstances, a country in which Facebook operates may find itself, at least up to a point, in the Old Turks’ world of responding through tax instruments to fixed investment choices. Insofar as Facebook can earn profits that are non-rival to its operations elsewhere from interacting with a given country’s residents, it should not be expected to adjust its activity and investment choices in response even to a 99 percent tax on those profits. In a model featuring excess profits, shareholders really do bear the incidence of unexpected corporate tax changes. Moreover, the tax is likely to be highly progressive, and may avoid being (at least directly) distortionary. In the international setting, the model allows source-based corporate income taxes (other than those falling on the normal return) to raise significant revenue from the companies’ owners without inducing a reduction in domestic investment or activity. The corporate income tax thereby shifts from being a very bad tax instrument in a global economy to being one with great advantages. 3. Extending the analysis to residence-based corporate taxation of FSI The above analysis concerns source-based corporate income taxation, although it leaves open (pending section IV below) the question of what ‘source-based’ means – for example, in the Facebook case, where the company acts purely from afar. For residence-based taxation of companies’ FSI (as defined from a home country perspective), one has to consider the separate margin of corporate residence. Whatever attributes a country uses to define resident companies will be tax-discouraged, insofar as having them increases expected tax liability. Again, if being a corporate resident were completely elective, as in the case where having those attributes or not was a matter of complete indifference (taxes aside), one would expect residence-based taxation of FSI to yield little or no revenue. This conclusion changes, however, if the relevant attributes are hard to avoid or have positive value of some kind to a given company or its owners. This, in turn, gives rise to empirical questions regarding the degree of corporate tax residence electivity. U.S. federal income tax law generally defines U.S. companies as those incorporated in the U.S., whereas other countries typically rely on some measure of where one’s headquarters, central management, and/or main weight of operations are to be found.82 Either way, one might reasonably fear that corporate residence electivity has been ineluctably rising and will

IP to generate profits. See Daniel Shaviro, ‘Mobile Intellectual Property and the Shift in International Tax Policy from Determining the Source of Income to Taxing Location-Specific Rents, Part Two’, 2021 Sing. J. Legal Stud. 128, 136 (2021). 81 See Wei Cui, ‘The Digital Services Tax: A Conceptual Defense’, 73 Tax L. Rev. 69 (2019). 82 See Mitchell A. Kane and Edward B. Rock, ‘Corporate Taxation and International Charter Competition’, 106 Mich. L. Rev. 1229 (2008).

The future of the corporate tax  425 continue to do so, what with decades of increasing cross-border shareholding, along with declining cross-border travel and communication costs. The Made in America Tax Plan appears to be influenced by such pessimism, at least as to new companies. While it advocates expanding anti-inversion rules that impede exit by existing U.S. companies it also appears to count on increased global cooperation between countries, such as via a strengthened global minimum tax regime that would make it hard for new companies to escape being significantly taxable somewhere.83 However, as I will discuss in section IV, even in the face of greater global economic integration, corporate residence electivity strongly depends on the legal question of how such residence is defined. 4. Summing up the new turn in corporate tax policy analysis As an analytical matter, market power that yields extra-normal returns greatly shifts the analysis of corporate income taxation. In a closed-economy model with fixed savings rates, it means that corporate income taxes may be largely non-distortionary and borne by suppliers of capital (such as shareholders), rather than by workers or consumers. In an open economy analysis, if multinationals earn location-specific rents through non-rival activity or investment choices that address consumers in particular countries, those countries can in principle tax the companies without inducing any reduction in this inbound focus. Purely on efficiency grounds, this may greatly increase the appeal, not just of source-based corporate income taxation, but also of that which is residence-based if concerns about residence electivity (and hence elasticity) can sufficiently be addressed. Yet today’s Young (or New?) Turk proponents of increased corporate income taxation resemble their ‘grandparents’ in giving high priority to distributional considerations. These relate in particular to concern about apparently rising high-end wealth and income inequality, and their arguably broad-ranging ill effects.84 Research supporting the Made in America Tax Plan’s proposed greater focus by the tax system on high-end inequality, both inside and outside the corporate income tax system, has multiple dimensions, not all of which are focused on the economics of corporate enterprise.85

IV.

NEW LEGAL UNDERSTANDINGS OF WHAT ‘SOURCE’ AND ‘RESIDENCE’ MIGHT MEAN

A.

The Important and Flexibility of Legal Language

When a theory of international corporate tax incidence, such as that underlying the ‘end of history’ view, prominently foregrounds an economic model, such as the Old Economy version of the small open economy, one might think that only its economic analysis needs careful See U.S. Dep’t of the Treasury, supra note 2, at 12–13. See, e.g., Daniel Shaviro, ‘The Mapmaker’s Dilemma in Evaluating High-End Inequality’, 71 U. Miami L. Rev. 83 (2016). 85 For example, the Made in America Tax Plan, supra note 2, at 5, also adduces evidence regarding the broader recent shift of U.S. tax liability from capital to labor. It also notes recent research suggesting that, when corporate income taxes are changed, a significant portion of the short-term incidence will fall on foreign shareholders. See id. at 5 n.6 (citing Steven Rosenthal and Theo Burke, Who’s Left to Tax? US Taxation of Corporations and Their Shareholders (Tax Policy Center 2020)). 83 84

426  Research handbook on corporate taxation scrutiny. This is incorrect, however. Even if one accepts the ‘end of history’ view’s premises regarding capital markets and investment, its conclusions regarding source-based corporate income taxation rest also on an implicit legal theory regarding what domestic source income (DSI), from a given country’s perspective, can or does mean. In this regard, recall the earlier example in which a multinational is deciding where to place a factory, conditioned on the expected marginal after-tax return that it would earn by choosing one country as compared to another. The tax part of the analysis rests not only on countries’ tax rate schedules, but also on how they would measure DSI from the factory. An ‘end of history’ analysis seems to presuppose that this is basically an economic question. The factory would earn so much pre-tax DSI from the contemplated factory – reflecting such real-world economic factors as local labor supply, other resource availability, and transportation costs – and then the local government would take its percentage cut. One can thus view DSI as basically an economic concept without being wholly oblivious to the various amorphous legal issues that notoriously surround it, such as those pertaining to transfer pricing, or to the allocation of interest expense between a multinational’s affiliates in different countries. Yet the ‘end of history’ view cannot withstand the absence of a sufficiently strong link between (1) the actual economic payoff to placing investment capital in a given location, and (2) the DSI that the investment would yield under the source country’s tax rules. At the extreme, if the two are completely unrelated, choices of factory location will have no effect whatever on how much DSI a given jurisdiction will find, and how much tax liability it will consequently impose – thus suggesting that it will not affect locational investment choices. The disappointing investment response to the 2017 Act reflected a pro-taxpayer version of this disconnect. While, as noted in section III, the Act’s failure to meet proponents’ expectations partly reflected the impact of extra-normal returns and location-specific rents, it also had a legal terminological side. These days, when companies shift profits in response to tax rate changes, ‘we’re mainly looking at accounting tricks rather than real capital flight.’86 Tax rates on DSI are evidently not having the impact that one might have expected on companies’ real locational choices when ‘most — most! — overseas profits reported by U.S. corporations are in tiny tax havens that can’t realistically be major profit centers.’87 There also is a potentially pro-government version of the disconnect between the operative DSI measure and real locational choices. Suppose that countries followed what I call a Humpty Dumpty approach to measuring DSI. In Lewis Carroll’s Alice Through the Looking Glass, Humpty asserts that a word means ‘just what I choose it to mean – neither more nor less.’ When Alice asks ‘whether you can make words mean so many different things,’ he replies that the only question is ‘which is to be master’ – him or the word – and ‘that’s all.’88 In this spirit, a country that could define DSI absolutely however it liked, and then enforce its liability determinations without facing any practical or legal constraints, truly would be the ‘master’ like Humpty. For example, if it based the tax on immutable characteristics of some

Paul Krugman, ‘Krugman Wonks Out: Why Was Trump’s Signature Policy Such a Flop?’, N.Y. Times (9 April 2021), accessed 7 April 2023 at https://​www​.nytimes​.com/​2021/​04/​09/​opinion/​trump​ -corporate​-tax​-reform​.html. 87 Id. 88 Lewis Carroll, Through the Looking Glass, and What Alice Found There (Macmillan 1871). 86

The future of the corporate tax  427 kind (whether or not they had anything to do with the physical location of anything), then by definition there would be no taxpayer exit option in response to the tax being too high. In practice, countries may not have quite so much linguistic freedom in defining DSI as that which Humpty Dumpty claimed over speech generally. Whether for reasons of comity, enforceability, or preserving one’s broader global credibility as a reasonably good-faith actor, they may need to draw on some sort of local connection to something. Yet this may still leave them the flexibility to choose, for example, indicia that are highly inelastic, rather than elastic. Indeed, recent years have made it increasingly clear that, in defining the source of income – and also corporate residence – they stand closer to Humpty’s side of the continuum, and further from the side where the legal concepts have fixed economic meanings that countries simply must accept and apply, than proponents of the ‘end of history’ view seem to have presumed. Perhaps fittingly, the very taxpayers whom this shift in understanding might end up disadvantaging played an active role in bringing it to public view. Multinationals’ aggressive profit-shifting helped to undermine acceptance of both the fixity and the economic meaningfulness of existing source rules. Likewise, their pursuit, in certain eras, of corporate inversions, removing companies from the U.S. tax net while (at least, in first-generation transactions) little of substance was actually changing, helped to do the same for residence rules. Over time, however, the source and residence concepts’ high degree of artificiality, which decades of corporate tax planning have so vividly demonstrated, may turn, from the companies’ standpoint, from friend to foe. Specifically, it may help empower governments to design what they call source-based and/or residence-based entity-level corporate income taxes, without requiring that they rely on factors that taxpayers can readily modify in response to the burdens imposed. Countries may also – and the distinction here may end up being more formal than substantive – increasingly find that they can rely on inelastic factors via tax instruments that are not labeled as corporate income taxes. B.

New Thinking about Defining the Source of Income

A simple example that I have used elsewhere can help to illustrate the boundaries of the source concept’s significant, but not unlimited, measurement flexibility and indeterminacy. Suppose that, while never leaving New York City, I write novels in Tagalog that I sell directly to people in the Philippines (and no place else). In these transactions, reflecting relevant people’s physical locations, the U.S. is the production country (where I do all the work), and the Philippines is the market country (where people buy and read the books). My income therefore unambiguously arose in the U.S. under what I call a production-based view of source, and in the Philippines under what I call a market-based view. However, barring more facts to complicate the story, it cannot plausibly be said to have arisen anyplace else.89 Unfortunately, both the production-based and market-placed views of source may prove ambiguous in practice under more complicated fact patterns. U.S. multinationals’ success in claiming that so large a share of their profits arose in tax havens where little is actually happening reflects their exploitation of formalistic and highly manipulable rules that appear to reflect a poorly implemented production-based view. Market-based views may also be

See Shaviro, supra note 10, at 684.

89

428  Research handbook on corporate taxation manipulable in practice,90 although they are widely believed to be less so.91 Moreover, while the two views yield rival, inconsistent answers when there is cross-border activity – as in the hypothetical case where both the U.S. and the Philippines seek to tax my book profits as DSI – neither abstract theoretical inquiry, nor existing practice, offers clear grounds for choosing between them.92 These problems have long inspired expert frustration and criticism regarding source as a core international tax concept. They undermine the search for clearly ‘correct’ answers to source questions, stimulate rule complexity and formalism that multinationals can then exploit, and offer ammunition to both sides when production and market countries want either to claim tax jurisdiction for themselves, or to dispute such claims by the other side. Yet, from a Humpty Dumpty perspective, they also can empower governments to sift through a wide range of plausible instantiations of DSI, using whichever might prove the most convenient, whether from the standpoint of minimizing behavioral responses or maximizing revenue. Recent years have witnessed significant progress, in both the scholarly and policymaking communities, towards leaving behind prior eras’ angels-on-the-head-of-a-pin fuss regarding both what the source concept ‘really’ means, and whether physical presence is a sine qua non for taxability. Instead, the modern focus – favoring today’s Young Turks against their formerly Young Fogey precursors – has increasingly been on how national governments might be able to tax a given multinational’s derivation of profit from its direct and indirect interactions with their own residents, without being readily defeated by tax planning. Consider, for example, recent scholarly proposals to replace the existing regime of transfer pricing and separate entity accounting with global sales-based formulary apportionment within multinational groups,93 or with a revised version thereof that is more planning-resistant as well as formally more compatible with existing practice.94 Likewise, the recent adoption by many countries of digital services taxes, while formally not involving corporate income taxation or the measurement of net profit as such, can reasonably be viewed as functioning in lieu of such taxes in order to address practical challenges in DSI measurement,95 much as gross withholding taxes on passive income have been so described.96 In sum, more flexible thinking about measuring DSI – and about devising formally distinct measures that likewise target multinational corporations’ (MNCs’) efforts to reach domestic consumers – has helped to revive the credibility of taxing multinationals’ profits on what can plausibly be called a source basis. To be sure, for the incidence of taxes on particular sales in a given country to fall on the companies’ owners, rather than on consumers, it may be necessary that the companies have market power, such that they are earning excess profits, rather

90 See Shaviro, supra note 80, at 143 n.47 (noting an example of how sales-based formulary apportionment can be manipulated). 91 See, e.g., Reuven S. Avi-Yonah, Kimberly A. Clausing, and Michael C. Durst, ‘Allocating Business Profits for Tax Purposes: A Proposal to Adopt a Formulary Profit Split’, 9 Fla. Tax Rev. 497 (2009); Michael P. Devereux, Alan J. Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schon, and John Vella, Taxing Profit in a Global Economy (Oxford University Press 2020). 92 See Shaviro, supra note 10, at 693–5. 93 See Reuven Avi-Yonah et al., supra note 91. 94 See Michael P. Devereux, Alan J. Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schon, and John Vella, ‘Residual Profit Allocation by Income’ (U. of Oxford, Working Paper No. 19/01, 2019). 95 See, e.g., Shaviro, supra note 10; Shaviro, supra note 80. 96 See Cui, supra note 81; I.R.C § 903.

The future of the corporate tax  429 than normal returns.97 However, the rise of powerful and hyper-valuable New Economy firms suggests that this precondition can frequently be met. C.

Potential Legal Evolution with Respect to Corporate Residence

When it comes to defining residence for U.S. corporate income tax purposes, economic reasoning that is based on real-world phenomena offers even less aid than with regard to source. For the residence of individuals, one can at least observe where they physically spend time, have dwellings that they regard as their homes, and/or have strong family or business connections.98 For an abstract legal entity such as a corporation – a mere ‘nexus of contracts,’ as corporate law theorists sometimes put it99 – residence is even harder to theorize satisfyingly. As I noted briefly above, the U.S. bases corporate residence on the taxpayer’s place of incorporation (POI). Other countries generally rely on the location of what one might call its ‘real seat’ (RS).100 However, the RS standard varies between countries, not just in its particular details, but also in the extent to which the inquiry is more formalistic (e.g., where are annual shareholder meetings held) or more substantive (e.g., where is the true center, if any, for active management). Other suggested approaches to defining corporate residence would look at such factors as (1) the percentage of a company’s ultimate beneficial shareholders who are domestic residents, and/or (2) whether it is publicly listed on domestic capital markets, or even just actively marketed to residents.101 The Made in America Tax Plan does not discuss changing the U.S. corporate residence standard, other than by expanding the anti-inversion rules. This may reflect its relying on the prospect of multilateral cooperation in imposing residence-based global minimum taxes to reduce the relative tax-disadvantageousness of U.S. corporate resident status. Despite this reticence, however, it is plausible that the report’s proposed tax increases for U.S. companies’ FSI would strongly motivate, at a later stage, domestic legal changes aimed at making domestic residence harder to avoid. This would require stepping onto ground that is even less well-trodden than that concerning the definition of source. Questions that are relevant to how one might want to define corporate residence, but that, at present, are neither theoretically nor empirically well-understood, include at least the following: (1) How companies’ founders make corporate residence choices under alternative legal regimes for determining residence, (2) What factors affect midstream residence changeability under any particular set of anti-inversion rules, and

97 See Joseph Bankman, Mitchell A. Kane, and Alan O. Sykes, ‘Collecting the Rent: The Global Battle to Capture MNE Profits’, 72 Tax L. Rev. 197 (2019). 98 See Daniel Shaviro, ‘Taxing Potential Community Members’ Foreign Source Income’, 70 Tax L. Rev. 75 (2016). 99 See, e.g., Stephen M. Bainbridge, ‘The Board of Directors as Nexus of Contracts’, 88 Iowa L. Rev. 1, 9 (2002) (tracing this view to Ronald Coase’s classic The Nature of the Firm (Economica, Blackwell Publishing 1937)). 100 See Kane and Rock, supra note 82, at 1235. 101 See Clifton Fleming, Jr., Robert A. Peroni, and Stephen E. Shay, ‘Defending Worldwide Taxation with a Shareholder-Based Definition of Corporate Residence’, 2016 BYU L. Rev. 168.

430  Research handbook on corporate taxation (3)

How investors factor corporate residence status into their demand for particular equities.

In considering the prospects for unilaterally maintaining the feasibility of significant residence-based tax burdens, while the rise of cross-border shareholding is clearly adverse, the Humpty Dumpty spirit may support a degree of optimism. After all, one’s rules need not aim at the unavailing ‘truth’ of what it really means to be a resident company. Instead, in the pure Humpty sense they might be driven purely by the aim of making corporate residence, in a wide swath of relevant cases, costly to avoid. More specifically, the aim would be to raise significant revenue, relative to the deadweight loss imposed on domestic individuals.102 Adding in concern for global comity and credibility might suggest requiring as well that one’s approach bear some plausible relationship to factors indicating a meaningful local connection of some kind. Unfortunately, while (as noted above) a number of different approaches have been tried or at least suggested, to my knowledge there has been little empirical research to date that sheds much light on the relevant parameters. One type of approach clearly worth considering, however, would involve disjunctive application of multiple metrics, such that qualification under any of them would cause a company to be deemed a resident. Suppose, for example, that either being domestically incorporated or having a domestic headquarters – and perhaps also, as a third alternative standard, being listed or actively marketed domestically – would suffice. The use of such multiple criteria might result, not only in casting a broader net than otherwise, but also in reducing avoidance behavior directed at any one of the criteria. For example, whereas the use of a standalone RS standard might induce companies to move their headquarters out of the would-be residence jurisdiction, this would be unavailing (and hence not worth doing) in cases where the companies would also qualify as domestic residents based on active domestic marketing.103 Moreover, needing to defeat all of the criteria might tend to raise its nontax costliness, thereby reducing take-up. The use of multiple residence criteria would presumably increase the frequency with which companies would duplicatively qualify as residents of more than one country, without having deliberately planned any such outcome. This might unduly tax-penalize companies that found themselves in such a position. The answer, presumably, is for putative residence countries either to enact statutory rules providing circumstances under which they will recede and/or to coordinate such responses with each other through multilateral agreements. In sum, actual practice regarding corporate residence has not much evolved as yet, other than through the enactment of anti-inversion rules that target attempted midstream changes in a given company’s residence status. However, increased scholarly focus on corporate residence’s fundamental artificiality implies flexibility in how countries might reasonably define it. This, in turn, may end up empowering greater use of residence-based taxation of FSI than would have been feasible were it a single fixed thing. U.S. proponents of increased residence-based taxation of FSI would be well-advised to consider efforts of this kind, especially (but not only) if they succeed in enacting changes like those in the Made in America Tax Plan.

102 See Daniel N. Shaviro, ‘Economic Substance, Corporate Tax Shelters, and the Compaq Case’, 88 Tax Notes 221 (2000). 103 One might loosely analogize this to combating infection through the simultaneous use of multiple antibiotics, thus making unavailing the evolution of mutations that create immunity against just one.

The future of the corporate tax  431

V.

POLITICS AND THE FEASIBILITY (OR NOT) OF MULTILATERAL COOPERATION

The Made in America Tax Plan’s silence on changing U.S. corporate residence rules, other than with respect to midstream inversions, leaves it all the more reliant on multilateral cooperation to address residence electivity. As it notes, a global minimum tax might help substantially in this regard, insofar as it ensured that non-U.S. MNCs would face comparable residence-based tax liability on their tax haven FSI. Since the Plan’s issuance, there has indeed been diplomatic progress on this front. In June 2021, the G7 Finance Ministers and Central Bank Governors issued a joint communique in which they ‘commit[ted] to a global minimum tax of at least 15% on a country by country basis,’ to be further pursued at the next G20 meeting.104 Yet it remains too early to tell what fruit these efforts will ultimately bear, and the grounds for skepticism are clear. As Peter Barnes recently argued, a global minimum tax ‘requires all countries in the world to hold hands … Unless they can get 90 percent of the world’s countries to adopt it, countries will view exempting themselves from the system as a great way to create a potentially significant competitive advantage.’105 This view is sufficiently well-grounded and widely accepted that the Made in America Tax Plan itself echoes it to a degree, noting that countries face ‘a collective action problem. When [they] compete against each other to attract multinationals’ profits and activities … the result is a race to the bottom … [as they] try to gain a competitive edge by undercutting each other’s tax systems.’106 More specifically, the collective action problem identified here is a prisoner’s dilemma. It rests on the view that, even if all countries would be better-off if all cooperated, each individual country might benefit from defecting, no matter what any other country might do. Presumably, since the main issue here is residence-based taxation of tax haven FSI, the claim is that countries would benefit from offering residence status without such taxes being imposed. In addition, defector residence status might prove tax-advantageous on other grounds, such as its making the holders thereof useful counterparties in profit-shifting transactions. In any event, would-be defector countries might either charge a modest fee to companies that wished to claim residence status, or else require some kind of local physical connection (such as an office or annual meeting site that would provide local benefits). As in other areas discussed above, the internal logic behind this view is sound. Once again, however, the completeness and accuracy of its premises can be challenged. In particular: (1) The crucial legal question, with respect to avoiding U.S. corporate residence, is not what any other country does, but what U.S. law does. No matter how many tax havens, or for that matter peer countries, are willing to recognize a given MNC as their resident for tax purposes, this will prove unavailing if the U.S. decides to make the same claim. 104 G7 Fin. Ministers and Cent. Bank Governors, ‘G7 Finance Ministers and Central Bank Governors Renewed Effort towards Deeper Multilateral Economic Cooperation’ Press Release (5 June 2021), accessed 7 April 2023 at https://​www​.gov​.uk/​government/​publications/​g7​-finance​-ministers​-meeting​ -june​-2021​-communique/​g7​-finance​- ministers-and-central-bank-governors-communique. 105 Quoted in Jim Tankersley and Alan Rappaport, ‘Biden and Democrats Detail Plans to Raise Taxes on Multinational Firms’, N.Y. Times (5 Apr. 2021), accessed 7 April 2023 at https://​www​.nytimes​.com/​ 2021/​04/​05/​business/​raising​-taxes​-corporations​.html. 106 See U.S. Dep’t of the Treasury, supra note 2, at 11–12.

432  Research handbook on corporate taxation Even if a tax treaty between the U.S. and the other residence claimant has implications for resolving the dispute, this can be overridden in the U.S. by statute, since we use last-in-time rules to resolve conflicts between tax (and other) laws and treaties. (2) Even insofar as the U.S. needs cooperation from other countries in order to curb profit-shifting (or, for that matter, real activity-shifting), whether by resident or nonresident MNCs, it is not without means to encourage this. Some years ago, when the U.S. enacted the Foreign Account Tax Compliance Act (FATCA), demanding cooperation from foreign banks in identifying accounts held by U.S. residents, skeptics called the effort ‘insane’ and bound to fail.107 It soon became clear that FATCA was attracting enough global buy-in from non-U.S. players (both governments and financial institutions) for even early critics to start conceding that it had achieved significant success. With respect to profit-shifting, the Made in America Tax Plan seeks to leverage foreign cooperation in resisting the ‘race to the bottom’ through a proposed new international tax rule called SHIELD (for ‘Stopping Harmful Inversions and Ending Low-tax Developments’) that would ‘den[y MNCs] … U.S. tax deductions by reference to payments made to related parties that are subject to a low effective rate of tax.’108 Such a provision, if enacted, not only would directly address profit-shifting, but might place pressure on other countries to cooperate so that MNCs would not have reason to avoid including them in global planning structures. (3) More broadly speaking, the traditional national self-interest model that underlies the standard view of tax competition is perhaps too simple. While often not made explicit, the most straightforward version of it might rest on a rational choice model in which nations, like individuals in the neoclassical setup, are pursuing their financial self-interest. Thus, in the prisoner’s dilemma described above, defection may be motivated by its generating modest tax revenues or fees, or from its attracting inbound investment that yields positive local externalities. While this is by no means a frivolous way to think about countries’ choice metrics, one should recognize that – even insofar as the neoclassical framework works adequately with respect to individuals – by its own terms it does not apply to the fruits of collective political choice. In a political system, be it democratic or not, where many different people can exert degrees of influence, individual actors have an incentive to favor what is best for them, not for the country as a whole. Moreover, those with only minimal influence, like individual voters in a mass society, have almost no reason even to try to determine what policies would be best for themselves individually, given the unlikelihood that they can alter the outcome. Even for powerful actors, political preferences frequently are driven by ideological or symbolic issues, as distinct from narrow economic calculation about overall national welfare. In addition, there is often great disagreement about where national self-interest, broadly considered, actually lies – a problem that is acute in the international tax field, even just among leading scholars.109 107 See, e.g., David Jolly and Brian Knowlton, ‘Law to Find Tax Evaders Denounced’, N.Y. Times (26 Dec. 2011), accessed 7 April 2023 at https://​www​.nytimes​.com/​2011/​12/​27/​business/​law​-to​-find​-tax​ -evaders​-denounced​.html (quoting David Rosenbloom, ‘Congress came in with a sledgehammer … The Fatca story is really kind of insane’). 108 See U.S. Dep’t of the Treasury, supra note 2, at 12. 109 See, e.g., Daniel Shaviro, ‘Ten Observations Concerning International Tax Policy’, 151 Tax Notes 1705 (2016) (‘International tax policy is an ongoing N-person game in which no one agrees about the underlying payoff structure’).

The future of the corporate tax  433 Consider how fundamentally American policymaking objectives have changed, both internationally and in the domestic tax arena, as between the Trump and Biden (or, before that, Obama and Trump) Administrations. These head-snapping changes in direction, in addition to rebutting any presumption that national policymakers should be expected to follow consistent aims across time, also help to show the linkage between (1) more progressive versus more conservative domestic political ascendancy and (2) attitudes towards global interaction. For example, the Trump Administration’s evident distaste for liberal democratic countries and leaders such as those in western Europe, and its eagerness to ally with repressive authoritarians and plutocrats, inevitably correlated with a very different stance towards both global tax cooperation and highly profitable MNCs’ tax avoidance than that of the Biden Administration.110 More generally, even in the absence of national leaders as appalling as the recently departed U.S. president,111 the prospects for widespread multilateral cooperation in addressing MNCs’ tax avoidance will clearly be greater insofar as parties that are more on the left, rather than the right, side of the political spectrum do well in national power struggles over the next few years.

VI. CONCLUSION Recent calls for increased entity-level corporate income taxation of multinationals, on both a source and a residence basis, have a distinctly back-to-the-future cast. At least as to the bottom line, they have far more in common with 1986-era thinking than with that which has often prevailed in more recent decades. This historical back-and-forth has ample parallels in other areas, and precedents from earlier eras. In corporate and international tax policy, as well as with regard to taxing capital income and addressing high-end inequality more generally, the intellectual back-and-forth has reflected, first, the rise of standard neoclassical Econ 101 precepts that, in the preceding period, had been underappreciated, and then a growing awareness of what those precepts leave out. Meanwhile, the popular back-and-forth has reflected fluctuating public perceptions of unfettered free market capitalism’s merits and performance. As Mark Twain reportedly said: ‘History may not repeat itself, but it often rhymes.’ Among other things, this helps to show that the current era, with its rising intellectual support for entity-level corporate income taxation (on both a source and a residence basis), may not be the end of history either. However, even Boris Bittker might find it difficult to forecast today the next ensuing turn in the road.

The gulf is narrower, though still visible, if one compares the tax policies of the Republican and Democratic Congressional leaderships. For example, the Republican-driven 2017 tax Act made some effort to address MNCs’ profit-shifting, but aimed (for reasons that can be defended in principled terms) to impose significantly lower burdens on their tax haven income than those contemplated by the Democrats. 111 ‘Appalling’ is not an excessive term to describe a U.S. president who, as detailed in a recent book about the COVID pandemic, acted throughout as a ‘saboteur’ deliberately undermining efforts to reduce the U.S. death toll. See Lawrence Wright, The Plague Year: America in the Time of COVID (Knopf 2021). 110

26. A new corporate tax? Reuven S. Avi-Yonah

1.

INTRODUCTION: WHY TAX CORPORATIONS?

Should the US tax corporations? For many academic and political observers, the answer is no.1 The corporate tax is a strange tax because by definition it is not borne by the corporate taxpayer, since corporations are legal entities and cannot economically bear the burden of taxation. Moreover, unlike other indirect taxes (e.g., consumption taxes that are passed on to consumers or the employer’s portion of the payroll tax that is passed on to employees), economists after over 50 years of debate are not sure who bears the burden of the corporate tax: shareholders, all capital providers, corporate employees or consumers. The most likely answer is all of the above in varying ratios depending on the current elasticities of capital, labor and demand in the global economy, and on the degree to which the US economy is open.2 The broad public, on the other hand, is convinced that the corporate tax is borne by large corporations, and politicians respond by maintaining the corporate tax as a tax paid by someone else than the voters. But this fiscal illusion, the opponents of the tax pronounce, is hardly a valid reason to maintain a very complicated tax that is the cause of significant deadweight loss (changes in behavior caused by the tax) and transaction costs (tax compliance and avoidance costs).3

1 See, e.g., Yariv Brauner, ‘The Non-Sense Tax: A Reply to New Corporate Income Tax Advocacy,’ 2008 Mich. St. L. Rev. 591; Edwin G. Dolan, ‘The Progressive Case for Abolishing the Corporate Income Tax,’ Milken Institute Review, 12 January 2017; Simon Constable, ‘Six Reasons Trump Should Abolish Corporate Income Tax’, Forbes, 19 December 2016; Nathan Boidman, ‘Is Corporate Tax Abolition Unrealistic?,’ Tax Notes Int’l, 4 Nov. 2019; Nathan Boidman, ‘Boidman Offers Pillar 4: Abolish Corporate Taxes!,’ Tax Notes Int’l, 8 June 2020. 2 In recent estimates, most of the burden of the corporate tax falls on capital and on rents. See Kimberly Clausing, ‘Who Pays the Corporate Tax in a Global Economy?’ 2013 National Tax Journal 66, 151 and ‘In Search of Corporate Tax Incidence’ 2012 Tax Law Review 65, 433; Edward Fox, ‘Does Capital Bear the U.S. Corporate Tax after All? New Evidence from Corporate Tax Returns,’ 2020 J. Empirical Legal Stud. 17, 71. 3 Austan Goolsbee, ‘Taxes, Organizational Form, and the Deadweight Loss of the Corporate Income Tax,’ NBER Working Paper No. 6173 (September 1997); Christopher Charles Evans, Philip Lignier, and Binh Tran-Nam, ‘The Tax Compliance Costs of Large Corporations: An Empirical Inquiry and Comparative Analysis,’ 2016 Canadian Tax Journal/Revue Fiscale Canadienne 64, 751; UNSW Law Research Paper No. 17-26. Accessed 18 April 2023 at SSRN: https://​ssrn​.com/​abstract​=​2909028. All taxes except head taxes (assuming no interjurisdictional mobility) and Pigouvian taxes have some deadweight loss, but the corporate tax has more transaction costs than most. There is an entire industry of tax lawyers and accountants devoted to helping large corporations minimize their tax burden, and it employs some of the brightest minds who could have been contributing in more socially useful ways. On the corporate tax and economic growth see OECD, ‘Tax Policy Reform and Economic Growth,’ 3 Nov. 2010, describing the corporate tax as the most destructive form of taxation.

434

A new corporate tax?  435 This chapter will argue that we do need a corporate tax, but not for the traditional reason, which is that if we do not tax corporations, rich shareholders will be able to defer tax on their income. Instead, the chapter will argue that we should tax corporations for the same reason we originally adopted the corporate tax in 1909: To limit the power and regulate the behavior of our largest corporations, which are monopolies or quasi-monopolies that dominate their respective fields and drive their competitors out of business (the best example being Big Tech, i.e. Amazon, Apple, Facebook, Google and Microsoft). But if that is the reason to have a corporate tax, it should have a different structure from the current flat corporate tax of 21 percent. Instead, the tax should be set at zero for normal returns by allowing the expensing of physical capital, but at a sharply progressive rate for super-normal returns (rents), culminating at a rate of 80 percent for income above $10 billion a year.4 After this introduction, section 2 of the chapter discusses and rejects the traditional reason given for taxing corporations. Section 3 argues that the only reason to maintain a corporate tax is as a tax on monopolistic rents. Section 4 develops this proposal in some detail. Section 5 concludes.

2.

THE CORPORATE TAX AS AN INDIRECT TAX ON SHAREHOLDERS

The traditional reason for taxing corporations is that, if we did not tax corporations, rich shareholders would be able to earn their income through corporations and defer the tax until there is a dividend distribution or they sell the shares, or even avoid the tax altogether by holding their shares until death and having their heirs sell at a stepped-up basis. That is not a valid reason for keeping alive a tax as complicated and costly as the corporate tax, which is why many academic observers have called for its abolition. Given that the corporate tax rate has been cut sharply to 21 percent and that the revenue from the corporate tax is at $230 billion (in 2019) only a small fraction (below 7 percent) of total federal revenues of $3.4 trillion, it does not appear impossible that some future president could successfully argue for abolishing the corporate tax, despite its public popularity. There are three reasons why the corporate tax is not a valid way of taxing shareholders. First, despite over 50 years of economic research, economists are still unsure who bears the burden of the corporate tax.5 Plausible candidates are (a) the shareholders, if the corporate tax reduces corporate profits available to them as dividends or reflected in the price of their

4 See below for more on the rate structure. Edward Fox and Zachary Liscow, ‘A Case for Higher Corporate Tax Rates,’ Tax Notes, 22 June 2020, support a higher corporate tax rate for similar reasons but believe the rate should be limited by international considerations, which are addressed below. 5 For recent studies on the incidence issue see Edward Fox, ‘Does Capital Bear the U.S. Corporate Tax after All? New Evidence from Corporate Tax Returns,’ 2020 J. Empirical Legal Stud. 17, 71; see also Clemens Fuest, Andreas Peichl, and Sebastian Siegloch, ‘The Incidence of Corporate Taxation and Its Implications for Tax Progressivity’ CEPR, 10 October 2017; Stephen J. Entin, ‘Labor Bears Much of the Cost of the Corporate Tax,’ The Tax Foundation, 24 October 2017; Laura Power and Austin Frerick, ‘Have Excess Returns to Corporations been Increasing over Time?’ 2016 National Tax Journal 69, 831; Kimberly A. Clausing, ‘Who Pays the Corporate Tax in a Global Economy?’ 2013 National Tax Journal 66, 151; Benjamin H. Harris, ‘Corporate Tax Incidence and Its Implications for Progressivity’ (Tax Policy Center, November 2009).

436  Research handbook on corporate taxation shares (although even that assumes that the tax was not priced in when they bought the shares, in which case only the original shareholders in an initial public offering bear the burden); (b) all capital providers, if the tax causes capital to flow from the corporate to the non-corporate sector, which is influenced by the ever changing relative tax rates on corporate versus pass-through businesses; (c) employees, if the corporations can effectively reduce wages in response to the tax by, for example, threatening to move production overseas; or (d) consumers, if corporations enjoy a monopolistic or quasi-monopolistic position and therefore can raise prices to include the tax without fear of being undercut by competition. The true answer is probably all of the above in different ratios over time depending on the elasticities (response to the tax) of capital, labor and demand. Second, as economists have recently emphasized, many shareholders are tax exempt. In fact, a recent study has shown that 70 percent of US equities are held by tax-exempt institutions or individuals (e.g., through retirement accounts).6 The authors of the study argue that this is a reason to tax corporations because otherwise capital would not be taxed at all, but it seems to me that if we believe in the reason that we exempt these individuals and institutions from tax, there is no reason to tax them indirectly through a corporate tax (assuming that they do in fact bear the tax burden). Third, even for taxable shareholders, there are better ways of taxing the shareholders directly, thereby eliminating the incidence issue. For closely held corporations, the answer is to tax the shareholders currently on their income earned through the corporation, that is, to make pass-through treatment mandatory, since there are no administrability issues for such corporations and most of them are pass-throughs in any case. For publicly traded corporations and partnerships, pass-through taxation is not administratively feasible. Instead, the shareholders should be taxed on the changing value of their shares, since liquidity and valuation are not issues for publicly traded shares, and the same tax can be collected on a withholding basis on foreign shareholders and if necessary on tax-exempt domestic shareholders (the government can impose a lien on some of the shares and sell them if the tax is not paid by foreign shareholders).7 Pre-enactment unrealized appreciation can be reached by applying the tax in the year of enactment to the difference between end of year share value and original basis. For these reasons, if the only rationale for having a corporate tax is to indirectly tax shareholders, it is not clear that it is worth fighting for against the many voices calling for its abolition. But that is in fact not the only rationale, as the next section explains.

3.

THE CORPORATE TAX AS A TAX ON MONOPOLISTIC RENTS

When the corporate tax was enacted in 1909, taxing shareholders was not the reason. In fact, taxing shareholders would in 1909 have been unconstitutional under the Supreme Court’s Pollock decision (1895), which both President Taft and Senate Majority Leader Nelson

Leonard E. Burman, Kimberly A. Clausing, and Lydia Austin, ‘Is U.S. Corporate Income Double-Taxed?’ 2017 National Tax Journal 70, 675. 7 Alternatively, the tax can be collected only upon the payment of a dividend or a sale of the shares with an interest charge added to eliminate deferral, but that raises administrability issues for sales of shares between foreign shareholders. 6

A new corporate tax?  437 Aldrich (R-R.I.) believed precluded a tax on shareholders, although to placate the Progressives they also introduced a constitutional amendment to allow Congress to tax individual income, which neither expected to pass. Instead, the corporate tax was designated as an excise tax on the privilege of conducting business through the corporate form, since the Supreme Court had held such excise taxes on corporations to be constitutional in 1898; but neither Taft nor Aldrich thought that was a good reason to impose a federal tax on corporations, since the privileges of the corporate form derived from state, not federal, law. Instead, as I have shown elsewhere by examining the legislative history, the corporate tax of 1909 was primarily seen as a vehicle for limiting the power of and regulating the great trusts such as John D. Rockefeller’s Standard Oil Company or J.P. Morgan’s U.S. Steel Corporation.8 The Taft administration was at the same time litigating against Standard Oil and American Tobacco (among many other trusts) in order to break them up under the Sherman Act of 1890, but the prospects of the litigation were uncertain (the government had lost the E.C. Knight case in the Supreme Court in 1895 and only narrowly won the Northern Securities case in 1904). Thus, as President Taft said in his message to Congress, we should have a corporate tax in order to curb the trusts: Another merit of this tax is the federal supervision which must be exercised in order to make the law effective over the annual accounts and business transactions of all corporations. While the faculty of assuming a corporate form has been of the utmost utility in the business world, it is also true that substantially all of the abuses and all of the evils which have aroused the public to the necessity of reform were made possible by the use of this very faculty. If now, by a perfectly legitimate and effective system of taxation, we are incidentally able to possess the Government and the stockholders and the public of the knowledge of the real business transactions and the gains and profits of every corporation in the country, we have made a long step toward that supervisory control of corporations which may prevent a further abuse of power.9

The corporate tax of 1909 had several features that were considered potentially effective as antitrust measures. First, even though the tax rate was only 1 percent, both supporters and opponents knew the rate could be increased (as it was ultimately, reaching 52.8 percent in 1968) and the threat of such changes might deter the trusts. Second, the tax returns were to be made public, thus alerting the press and the voters to which corporations were the most profitable and therefore the likeliest targets for antitrust enforcement actions. Third, while intercorporate dividends were exempt (a controversial feature, because the trusts were holding corporations) there were no tax-free reorganizations and no consolidated returns. Unfortunately, all of these antitrust features of the corporate tax were eliminated by 1928. The publicity feature was eliminated in 1910, tax-exempt reorganizations were adopted in 1919, and consolidated returns were made elective in 1928. In addition, various pro-corporate provisions like accelerated depreciation, percentage depletion and the foreign tax credit were adopted in the same period. While the Roosevelt administration limited the dividends received deduction and tax-exempt reorganizations in the 1930s, it never eliminated them, and subsequent enactments like investment tax credits reduced the corporate tax even further. As for the rate, it never exceeded 52.8 percent (as opposed to the individual rate, which reached

Reuven S. Avi-Yonah, ‘Corporations, Society and the State: A Defense of the Corporate Tax,’ 2004 Va. L. Rev. 90, 119. 9 44 Cong. Rec. 3344 (1909). 8

438  Research handbook on corporate taxation 94 percent during World War II and was still as high as 70 percent when Ronald Reagan was elected president). The effective corporate tax rate was much lower because of interest and depreciation deductions and investment tax credits. In 1986, the corporate rate was reduced from 46 percent to 34 percent (later raised to 35 percent), and despite various base broadening measures, the effective corporate tax remained low. Corporate tax revenues consequently declined from 25 percent of total federal revenues in the 1960s to less than 10 percent in the 2000s. Finally, in 2017 the corporate tax rate was reduced to 21 percent, and it was a flat rate – all the previous progressivity, which only applied to small corporations with revenues below $15 million, was eliminated. Other than the rates, we are unlikely to reverse these pro-trust features of the corporate tax, since they are old, well established and benefit small as well as large corporations, which are not the proper subject of a corporate tax aimed at limiting the power of monopolies and quasi-monopolies. Recent research by Ed Fox has shown, however, that most of the existing corporate tax falls on super-normal returns.10 Fox shows this by demonstrating from corporate tax returns for the period 1995–2013 that if expensing of capital expenditures were allowed before 2017, corporate tax revenues would have been almost identical to actual revenues. Since (as discussed below) expensing is equivalent to exempting the normal return, that means that the corporate tax has historically fallen primarily on super-normal returns, or rents. This finding is consistent with Power and Frerick’s evidence from 2016 that excess returns to corporations have been increasing over time.11 In the current environment, since expensing is in fact allowed until 2022, that finding is even more likely to be true. In that case, and if the main reason to have a corporate tax is to tax rents and limit monopolies, then the tax should have a different rate structure than we have now. I would suggest that the effective tax rate on normal corporate profits should be zero. On super-normal returns, since the main concern is monopolies and quasi-monopolies, the tax should be progressive, with a very high tax rate (e.g., 80 percent) for profits above a very high threshold (e.g., $10 billion). In between, there should be a series of graduated tax rates, similar to the individual rate schedule before 1980. Normal Returns

a.

There is no reason to tax corporations on normal returns. Normal returns are the risk-free return from investing in, for example, US Treasuries. In recent years, these returns have been quite low, but they have historically been higher. However, from the point of view of only applying the corporate tax to rents, these returns should be exempt. In addition, there is the uncertainty about the incidence, which suggests that a tax on normal returns is less likely to contribute to the progressivity of the system. Finally, the deadweight loss from the corporate tax arises from the tax on normal returns, since a tax on pure rents does not generate deadweight loss (i.e., does not change taxpayer behavior, since taxpayers not subject to any competition would derive net profit from rents even if 99 percent of them were taxed away). Since from a political perspective a zero tax rate on normal returns is unlikely to pass, and since it is hard to determine what normal returns are, I would suggest that we keep the current Fox, supra. Power, supra.

10 11

A new corporate tax?  439 flat rate of 21 percent on corporations (with no de minimis exception, since small corporations are likely to be pass-throughs), but allow for permanent expensing of capital expenditures. Under the Cary Brown theorem, as explained below, such expensing is equivalent to an exemption for the normal return to capital.12 As elaborated below, however, we should not allow expensing for research and development (R&D), since that typically generates rents, nor a deduction for interest, since combining it with expensing generates negative tax rates. The Cary Brown theorem demonstrates the theoretical equivalence, under certain assumptions, of expensing and exempting the normal return to capital. To take a common example, suppose the taxpayer earns 100 subject to a tax of 50 percent and can invest the after-tax income in a machine generating a return of 10 percent per year. Under an income tax, the 100 of earnings are subject to tax of 50, and the remaining 50 are invested in the machine, yielding 55 after 1 year; the 5 of income is subject to income tax, leaving the taxpayer with only 52.5. In an exemption regime that exempts the normal return to capital from tax, the 100 of income is subject to tax of 50 when earned. The remaining 50 are invested in the machine, but when the additional 5 of income is earned, they are exempt from tax, so that the taxpayer is left with 55. In an expensing regime, the 100 of income are expensed, and the resulting deduction eliminates the tax on the 100, so that the taxpayer can invest the entire 100 in the machine. However, when the machine is sold for 110 a year later, since the basis is zero, the sale is subject to tax at 50 percent, leaving the taxpayer with the same 55 as in the previous example. Hence, the Cary Brown theorem demonstrates that expensing the 100 is equivalent to exempting the normal return from tax. The Cary Brown theorem makes two important assumptions. The first is that tax rates do not change between the time the income is expensed and the time the machine is sold. If the tax rate changes, the equivalence does not hold, since exemption applies the rate at the beginning of the investment and expensing the rate at the end. However, this assumption may not matter too much since rates can either increase or decrease over time, so that it is unclear which form of the tax is more beneficial to the taxpayer. The other assumption, however, has clear implications. That is the assumption that the taxpayer can invest the savings from exempting at the same rate as the underlying investment. This holds true when the investment is a commonly available one, yielding what the economists call marginal (normal) returns. However, suppose the underlying investment is in a unique business opportunity, yielding what the economists call infra-marginal (extraordinary) returns, or rents. In that case, the investor may not be able to invest the tax savings from expensing at the same rate as the underlying investment because the size of the unique investment opportunity is limited, and the Cary Brown equivalence does not hold. For example, suppose in the example above the underlying investment yields a 50 percent return but the tax savings can only be invested in a bond earning 10 percent. In a regime that exempts the normal return, the taxpayer earns 100, pays 50 in tax, and invests the other 50 in the high-yielding opportunity, resulting after a year in a 25 return exempt from tax, for a net after-tax of 75. In an expensing regime, the investor earns 100 and does not pay tax because of expensing; however, of the 100, only 50 can be invested at a return of 50 percent, and the 12 The following is based on Reuven S. Avi-Yonah, ‘Risk, Rents and Regressivity: Why the United States Needs Both an Income Tax and a VAT,’ Tax Notes, 20 Dec. 2004.

440  Research handbook on corporate taxation other 50 (the tax savings) are invested at 10 percent. The result is a yield after a year of 75 from the underlying investment and 55 from the tax saving, for a total of 130, and when these are sold and are subject to tax at 50 percent, the taxpayer nets only 65. To put it another way, in an expensing regime, only the normal yield is exempt from tax; the extraordinary yield is fully taxable. So how should those extraordinary yields (rents) be taxed? b.

Super-Normal Returns (Rents)

Economists are unanimous in supporting a tax on rents since (a) it does not create deadweight loss and is therefore efficient and (b) it falls on the above normal return to capital and is therefore progressive. Above the de facto exemption resulting from expensing, the corporate tax should be sharply progressive. In order not to create ‘notches’ (sudden jumps in the marginal tax rate) progressivity should be gradual, similarly to the way the individual tax was structured when it was more progressive (before 1980). The reason to have a progressive tax on rents is that, in addition to targeting rents, we also want to discourage bigness, which is equivalent to monopoly or quasi-monopoly status. The less competition a business firm faces, the more profitable it is likely to be, because competition generally drives down prices. That is why our most monopolistic firms are also the most profitable, and why they engage in behaviors like ‘killer acquisitions’ designed to eliminate competition.13 At the top, the corporate tax rate should be 80 percent for income above $10 billion.14 In 2019, this rate would have applied to the Big Tech: Amazon ($10.1 billion), Apple ($59.5 billion), Facebook ($22.1 billion), Google ($30.7 billion) and Microsoft ($16.6 billion). Other corporations that had profits over $10 billion in 2019 include other major tech companies (Intel, Micron), Big Banks (Chase, Bank of America, Wells Fargo, Citi, Goldman Sachs, Visa), Big Pharma (Pfizer), Big Oil (Exxon, Chevron), Big Telecomm (AT&T, Verizon, Broadcom), United Health, Boeing and some major consumer brands (Johnson & Johnson, Home Depot, Disney, Pepsi). All of those enjoy some degree of monopolistic or quasi-monopolistic status.15 Such a high tax rate would make corporate regulation through the tax highly effective. It should enable Congress to grant deductions for activities it deems desirable, such as job creation during the current recession or in underdeveloped areas of the country, and impose high rates on activities it deems undesirable, such as invading consumer privacy.

See, e.g., Naomi R. Lamoreaux, ‘The Problem of Bigness: From Standard Oil to Google,’ 2019 J. Econ. Persp. 33, 94; Kenneth A. Bamberger and Orly Lobel, ‘Platform Market Power,’ 2017 Berkeley Tech. L.J. 32, 1051; Axel Gautier and Joe Lamesch, ‘Mergers in the Digital Economy,’ CESifo Working Paper No. 8056 (3 Feb. 2020); Colleen Cunningham, Florian Ederer, and Song Ma, ‘Killer Acquisitions’ 2021 J. Political Econ. 129, 649; Marc Bourreau and Alexandre de Streel, ‘Big Tech Acquisitions,’ Issue paper, Centre on Regulation in Europe (2020). 14 While we never had a corporate tax rate above 53 percent, the World War II excess profits tax, which applied to rents resulting from the war, was capped at 80 percent. See Reuven S. Avi-Yonah, ‘Taxes in the Time of Coronavirus: Is It Time to Revive the Excess Profits Tax?’ (19 May 2020) U of Michigan Public Law Research Paper No. 671; U of Michigan Law & Econ Research Paper No. 20-008. Accessed 18 April 2023 at SSRN: https://​ssrn​.com/​abstract​=​3560806 or http://​dx​.doi​.org/​10​.2139/​ssrn​ .3560806. 15 See https://​fortune​.com/​fortune500/​2019/​search/​?profits​=​desc. 13

A new corporate tax?  441 In addition, the high rate may persuade the corporations subject to it to split up. Splitting up corporations to reduce their profits and therefore escape the 80 percent tax rate is actually a feature of the proposal and not a bug: As Lina Khan and others have proposed, we should ideally want to induce Big Tech to divest their anti-competitive acquisitions (e.g., Facebook’s acquisitions of Instagram and WhatsApp). And if the tax structure also motivates an actual break-up of the core business (e.g., along geographic or business segment lines), any loss in efficiency would be more than compensated by the removal of the threat to democracy posed by Big Tech.16

4.

A NEW CORPORATE TAX

Besides the rate structure, the new corporate tax should have several other features missing from the current corporate tax. a.

The Tax Base

The problem with using current definitions of the corporate tax base is that it allows large corporations like the Big Tech to pay low effective tax rates because of three factors: Profit shifting to offshore jurisdictions with low tax rates, expensing R&D and deducting stock option compensation. Profit shifting can be dealt with relatively simply by mandating consolidated returns (at the 50 percent level by vote or value, to prevent tax-motivated deconsolidation without giving up control) and including foreign corporations in the consolidation. The standard objection that this will impede competitiveness does not apply since rents are not subject to competition by definition. R&D should not be expensed because unlike physical capital expenditures it does not just generate future profits but specifically future rents.17 Thus, it should be amortized over a 15-year term like acquired intangibles. Unsuccessful R&D can be deducted when it becomes clear that it will not result in future profits. Stock options should be valued and deducted as wages when granted, as is done for book purposes. There is no reason to pretend that stock options have no value when granted. The same goes for restricted stock and other forms of stock-based compensation. Interest should not be deductible because combining an interest deduction with expensing results in negative tax rates. In addition, under current conditions much interest is effectively guaranteed by the government so it should not receive a tax subsidy as well.

On Big Tech and Democracy see Barry C. Lynn, Cornered (John Wiley & Sons 2010); Tim Wu, The Curse of Bigness (Columbia Global Reports 2018); Lina M. Khan, ‘Amazon’s Antitrust Paradox,’ 2017 Yale L.J. 127, 710. 17 See Calvin H. Johnson, ‘The Effective Tax Ratio and the Undertaxation of Intangibles,’ Tax Notes, 15 Dec. 2008, 1289. Arguably, R&D generates positive externalities (mostly in the form of ideas that can migrate to other firms) but (a) there is less human capital migration than there used to be because of the above market rate salaries offered by Big Tech and (b) there are significant negative externalities imposed by Big Tech. R&D should be treated like any other expense, i.e., matched to the income stream it generates. 16

442  Research handbook on corporate taxation b.

Anti-Avoidance Provisions

The most important anti-avoidance provisions for public companies controlled by their founders are already in the Code: Section 367 imposes tax on all large shareholders in an inversion, and section 877A prevents the controlling owners of Big Tech from expatriating and selling their shares with no tax. However, if the mark to market proposal raised above is adopted, this will be irrelevant if it is applied to the entire unrealized appreciation. If that move is not politically feasible, a high tax rate (discussed below) of 50 percent should be applied upon expatriation. In addition, inversion transactions can be prevented, as the Obama administration proposed, by (a) reducing the section 7874 threshold to 50 percent and (b) redefining corporate residence as location of the headquarters. If that is not enough, the US can follow EU countries by treating a move of the headquarters as a realization event and taxing both the shareholders and the corporation on a deemed sale of stock and assets. Such ‘exit taxes’ are the reason no EU countries have experienced inversions despite having similar effective tax rates to the US rate before 2017.18 c.

Shareholder Taxation

Ideally, shareholders in public corporations should be taxed on a mark to market basis, including on past unrealized appreciation. In addition, accrual taxation should be applied to non-publicly traded property as well by adding an interest charge when the property is sold and abolishing the section 1014 step-up. Those steps should enable the US to adopt a significantly more progressive system of individual taxation, up to, for example, 50 percent, for all income (including dividends).19 Capital gains will not be taxed to domestic US shareholders, but stock buybacks as well as dividends should be subject to withholding tax for foreign shareholders not subject to the mark to market regime. Taxing actual dividends in addition to mark to market may seem like double taxation, but in practice it is not because the market value of stock is not a good proxy for underlying corporate earnings, and the receipt of dividends increases ability to pay as much as capital gains (which will be taxable under either mark to market and/or the higher tax rates). Dividends as well as interest should not be deductible.

Reuven S. Avi-Yonah and Yaron Lahav, ‘The Effective Tax Rates of the Largest US and EU Multinationals,’ 2012 Tax L. Rev. 65, 375. 19 Rates above 50 percent may induce the rich to work less, and we have never (except during World War II) had effective rates of over 50 percent on the rich (top 1 percent) even though nominal rates were much higher. That is why the corporate tax on rents should be higher than the top individual tax rate, which will also encourage moving businesses out of subchapter C and distribution of dividends, both of which make it easier to tax the rich on business profits. See Reuven S. Avi-Yonah, ‘Why Tax the Rich? Efficiency, Equity, and Progressive Taxation (Review of Slemrod, Does Atlas Shrug? The Economic Consequences of Taxing the Rich),’ 2002 Yale L.J. 111, 1391. 18

A new corporate tax?  443

5. CONCLUSION This chapter has sought to develop a new corporate tax that is appropriate for targeting rents earned by large, monopolistic or quasi-monopolistic enterprises like the Big Tech. Its main recommendations are that normal corporate returns should be functionally exempt by allowing permanent expensing for capital expenditures, but that super-normal returns should be taxable on a progressive basis (up to 80 percent above $10 billion in profit) and on a broad base that (a) includes foreign subsidiaries, (b) disallows current R&D and interest deductions and (c) limits deductions for stock-based compensation to value on date of grant. In addition, I recommend a mark to market regime for shareholders as well as full taxation of dividends at a progressive rate of 50 percent, but would allow for tax-free split-ups. These steps should complement antitrust enforcement to bring our large monopolies down to a normal size, without creating deadweight loss.

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Index

ability-to-pay principle 9–10, 39–40, 172, 188 development of 171 abuse, of corporate tax 351–2 abusive tax planning 362 accelerated depreciation (AD) 310 accounting losses 341, 342 accounting period, definition of 155 accounting profits 169, 312, 319, 335, 341 accounting scandals 394 acquisition corporation 246 active business income, tax jurisdiction for 245 actual profits 341 adjusted gross income (AGI) 39 Administrative Procedure Act (APA) 350 advance pricing agreements 265 after-tax profit maximization, risk-adjusted 423 after-tax returns 412, 426 allocation of capital 14 Alternative Carbon Resources v. United States 366 American Jobs Creation Act of 2004 398 American Law Institute (ALI) 109 anti-abuse rules, for tax-free corporate divisions 101–2 anti-avoidance provisions, for public companies 442 anti-competitive acquisitions 441 anti-corporate taxation 232 Anti-injunction Act (1867) 62–3, 359 Anti-Tax Avoidance Directive (ATAD) 134, 137 arguments, in support of taxing corporations policy 9–11 political 11–13 technical 9 weakness of 13 arm’s length price (ALP) 264 arm’s length principle 187, 264, 344 artificial entity 2 asset acquisitions 87, 316 associated enterprise 141, 322 attribution of powers, principle of 130 avoidance, of corporate tax 27–9 Avoir Fiscal case 135 bank loans, write-off of 290 bankruptcy 398–9 Barnes, Peter 431 base erosion 11

Base Erosion and Profit Shifting (BEPS) project 4, 10–11, 299 Beacham case 284 Bebchuk, Lucian 394 benchmark dividend 278 Berle, Adolf 30 Bezos, Jeff 415 Biden Administration 360, 433 Big Tech 441, 443 bilateral income tax treaties 112, 121, 122 Bill of Rights 6 ‘binding commitment’ test 106 Bird, Richard 231 Bittker, Boris 412, 422, 433 Bittker’s pendulum 412–15 accounting for 415–16 body corporate 150–51, 178 bond and options sales strategies (BOSS) 348, 356 bonus depreciation 50 book-tax adjustments 312 Borsa Istanbul Equity Market 262 Bowen, William 382 Bradford’s X-Tax 289 branch equivalent tax account (BETA) 273 branch profits tax 8, 118, 119 Brazil, corporate taxation in actual profit regime deductibility rules 340–41 interest on net equity 343–4 tax losses 341–3 thin cap rules 345–6 transfer pricing rules 344–5 complementary law (lei complementar) 330 Direct Action of Unconstitutionality No. 2,588 339 exclusion dividends method for 332–3 Federal Constitution, Law No. 7,689/1988 331 Generality Principle 333 Imposto de Renda Pessoas Jurídicas (IRPJ) 329 notion of income for 329–31 tax base of 335 integration between legal entities and individuals 332–3 Memorandum of Explanation 332 methods concerning the import of goods, services or rights 344–5

451

452  Research handbook on corporate taxation National Tax Code (Código Tributário Nacional (CTN)) 329 notion of legal entity for CIT 333–4 of profits and dividends 332 Realization Principle 331 ‘revenue minus expenses’ formula 336 Social Contribution on Profits (CSL) 329 rise of 331–2 tax base of 331 sociedades de economia mista 333 tax regimes for CIT actual profit regime 335–6 deemed profit tax regime 336–7 tax regime for micro and small enterprises 337–8 transfer pricing rules 344–5 anti-avoidance scope of 344 Worldwide Taxation rules 338–40, 346 Brazilian Income Tax, creation of 329 Brazilian Revenue Service (RFB) 332 British East India Company 5 burden of the tax 9, 13, 15–16, 342, 434 in China 304 corporate 45 in Germany 171 implications for estimating agencies 50–52 income group (tax policy center) 52 to labor 50 business cash flow 179 business connection, meaning of 327 business management 31 Business Roundtable 377, 382, 390 Canada–United States Income Tax Convention 227 Canadian tax system anti-corporate taxation 232, 247 Business Corporations Act 226 for business income 239–40 business, investment and personal services income 236–7 for Canadian controlled private corporations (CCPCs) 234–5, 236, 245 business income of 240 top-up tax on investment income of 238 corporate distributions 240 corporate surplus and the taxation of corporate income 241–4 corporate taxations 229–30, 249 for corporations 226–7 corporations as taxpayers 233–4 ‘double taxation’ on distributions of the previously taxed income 237 economic and social implications 231

‘foreign affiliate’ regime 245 for foreign corporations owned by Canadian shareholders 244–5 general corporations 236 income tax law 225 Income Tax Regulations (ITR) 228 Income War Tax Act (1917) 229, 238 incorporation, tax aspects of 245–8 for acquiring a business 246 acquisition of control and tax attributes 246–7 divisive reorganizations 248 reorganizing a corporation and its business 247–8 integration of the taxation of corporations and their shareholders 232 intercorporate dividends and ‘paid-up capital’ 241–4 investment (and personal services) income 237–9 for loss making subsidiary 233 Minister of National Revenue 229 objective of 225 Ontario Business Corporations Act 227 preferred share rules 226 for ‘public’ and ‘private’ corporations 234–5 refundable tax on investment 232 for residents and non-residents 228–9 surplus stripping 232 for taxation of income 230 tax corporations 231–3 tax jurisdiction 227–8 tax rates 235–6 tracking low and general rate income 240–41 cancellation of debt (CODI) 312 capital distributions, upon liquidation 280 capital dividend account 238 capital gains stripping 240, 241 transformation 243 capital income taxation 414 capital investment, returns to 39 capital losses, on participations 214 capital plus labor, for generating income 419 capital recovery over time, rules of 49 capital taxation, in China 302 Cary Brown theorem 439 cash distribution 277 cash-equivalence doctrine 398 cash flow, tax on 15 chief executive officers (CEOs) 364, 391, 397, 402 chief financial officer (CFO) 402 China, corporate taxation in accounting rules 310

Index  453 burden for corporate taxpayers 304 capital taxation 302 debt restructuring 312 Enterprise Income Tax (EIT) 302 application to cross-border transactions 305 exceptions from 305 statute and formal regulations 309 Enterprise Income Tax Law (EITL) 302 basic depreciation rules 310 implementational regulations (EITLIR) 306, 311 headquarter (HQ) jurisdiction 317 HNTE regime 308–9 huazhuan 316 legal foundations of 303 Ministry of Finance (MOF) 302, 306 personal income tax (PIT) and 304, 313, 317 rate and base determinants of effective tax rate graduated average rates 306–7 income tax accounting 312–13 local tax rebates as rate reductions 309 loss carryovers 311–12 modifications of the income tax base 310–11 preferential tax exemptions and rate reductions 308–9 ‘SMPE’ income threshold 307 stages of evolution of 302 State Taxation Administration (STA) 303, 306 taxable corporate sector and 305–6 tax-administrator-to-taxpayer ratio 310 tax incentives through rate reductions 309 tax lawmaking and 303 tax revenue, composition of 303 transactions between corporation and shareholders 313–17 contributions, distributions and reorganizations 314–16 ‘de-consolidation’ among group members and branches 316–17 shareholder benefits and loans 314 transition to a market economy 315 CIC Services v. IRS 358–9 citizenship, duties of 378 civil war tax (US) 6 ‘close’ company, definition of 158–9 closed economy, corporate income tax in 46–7 cloud-computing 157 Coase theorem 415 Code of Federal Regulations, Title 26 of 112 Coltec v. United States 369 commencement of business 255

Commissioner v. Newman 378 Common Consolidated Corporate Tax Base (CCCTB) 140 ‘common law’ doctrines 367, 372 company definition of 273 limited by guarantee 150 meaning of 150–52 company value, transfer of 277 compensation deferred 394, 398–400 equity-based 395 non-deductible 403 of non-executive employees 393 performance-based 392, 394, 400–403 compensatory stock options, taxation of 81 congressional tax 29 consolidation covenants 217 consolidation fees 217 consortium relief 214, 217–18 constructive-receipt doctrine 398 content of disclosure 357 control and tax attributes, acquisition of 246–7 Controlled Foreign Company (CFC) 124–5, 134, 160, 164–6, 179, 206, 266–7 Cook, Tim 415 corporate acquisitions, tax treatment of 95–6, 109 in general 87 in sum 95–6 taxable acquisitions 87 tax-free acquisitions 90–95 judicially developed requirements for reorganizations 92–4 statutory requirements for reorganizations 91–2 structuring acquisitive reorganizations 94–5 when the target is not a controlled subsidiary 87–8 subsidiary of another corporation 88–90 corporate debt financing 70 corporate divisions, tax treatment of pro rata distribution 99 taxable corporate divisions 97–8 tax-free corporate divisions 98–102 anti-abuse rules for 101–2 judicially developed requirements for 100–101 statutory requirements under section 355 99–100 in sum 102 corporate earnings strategies 356 corporate equity investments, cross-border ownership of 48 corporate financing 66

454  Research handbook on corporate taxation corporate governance 3, 12, 29, 31, 391, 392–6, 397, 398–400, 404 corporate hoarding 30 corporate income tax 4 adoption in US 2 burden of 4, 13, 15–16 classical 22, 32 enactment of 436 Harberger’s model of 14 impact on economy 9 incidence of 13–16, 38–41 as an indirect tax on shareholders 435–6 legal liability for payment of 41–2 open economy model of 422 opposition to 8 proponents of 30 residence-based 421 resilience in 16–20 source-based 421, 424 as a tax on monopolistic rents 436–41 corporate intermediation 225, 237, 239, 245, 249 corporate inversions, issue of 383–5 corporate investments 24, 43, 44, 47–8, 53, 418–19 corporate liquidations 110, 315 tax treatment of 84–7 in general 85 in sum 86–7 for taxable corporate liquidations 85 for tax-free liquidations of controlled subsidiaries 85–6 corporate management 2, 12 corporate net income, direct tax on 24 corporate ownership 10, 61, 344, 395 corporate profits, sources of 42 corporate residence 274–5 legal evolution with respect to 429–30 corporate revenues, extraction of rents from 394 corporate shareholders 44–6 corporate–shareholder tax integration 182–7 current shareholder relief system 184–7 historical developments in 182–4 corporate social responsibility (CSR) 3 background of 376–7 best practices 377 changes in restructuring of corporate value chains 379–81 tax shelters 381–2 corporate inversions, issue of 383–5 definition of 376 Duke of Westminster doctrine 379 goals of 390 versus individuals 386–7 Learned Hand standard 379

non-tax business decisions 377 Pillar Two initiative 388–9 with regards to international developments 387–9 global minimum tax 388–9 harmful tax practices 388 with respect to tax planning 382–3 and social constraints on taxpayer behavior 390 on tax incentives 385–6 view of a taxpayer’s obligation to society 378–9 corporate tax enforcement 349 corporate taxpayer, definition of 289 corporate tax restructuring programs 382 corporate tax shelters abusive 350–52, 356 administrative law challenges 358–9 approach to tax enforcement against 349 badges of 351–2 basis-shifting 357 boom of 349 characteristic of 348 definitions of 354 disclosure reform options for reportable transactions affirmative disclosure duty for positions conflicting with regulations 360–61 non-tax documentation 363–4 tax advice 361–3 economic substance doctrine 352 intermediary 357 limitations of targeting 355–9 listed transaction 353 mass-marketed 381–2 nondisclosure and underdisclosure transactions 357–8 non-tax documentation 363–4 other reportable transactions 353 overdisclose information regarding transactions 358 penalties 353–4, 357 reasons for targeting 354–5 designation 354 detection 354–5 deterrence 355 related and tax-indifferent parties 352 ‘reportable transaction’ disclosure rules 349 reportable transaction regime 352–4 targeted approach to 350–55 tax losses due to 352 transactions of interest 353 ‘Whac-A-Mole’ game 356

Index  455 corporate tax to shareholders, imputation of 277–8 corporation distributed property 83 corporations as taxpayers, legal personification of 5–6 corporation tax ‘grouping’ 166–7 country-by-country minimum tax 223 Country by Country Reporting (CbCR) 265 Covid-19 pandemic 179, 274, 422 cross-border dividends 221 EU system of 213 cross-border ownership, of corporate equity investments 48 cross-border shareholdings 45 rise of 430 cross-crediting, opportunities for 123 crypto-assets 133 currency options bring reward alternatives (COBRA) 348 custom adjustable rate debt structure (CARDS) 356 debt-equity bias problem 148 debt financing 48, 210, 384 debt obligation 114 debtor, liquidation of 159 debt restructurings 315 in China 312 debt-to-equity recapitalizations 315 deductibility of expenses, general rule for 340–41 deductibility of interest for corporate income tax purposes (DEBRA) 148 limitation on 110 deferral principle, significance of deemed dividend out of accumulated earnings 124 global intangible low-taxed income (GILTI) regime 125–6 with respect to US domestic corporations 126 section 245A dividends-received deduction 126 Subpart F regime 124–5 deferred compensation 394, 398–400 Deficit Reduction Act of 1984 (USA) 396 de minimis harmonisation 130 derivative contracts 167 Destination Based Corporate Cash Flow Tax 289 destination-based taxes 410 digital service tax (DST) 143, 250, 428 disguised capital 265 distributed corporate income 60 Distributing’s shareholders 97 distribution, of corporate income tax 52

dividends anti-avoidance rules on dividend stripping 287 benchmark 278 codified rules relating to 276 concept of 276, 295 credit 292 definition of 277 distribution tax 323 exemption of foreign dividends 298–9 inter-company 280 relevant exclusions from 279 dividend tax credit 213, 237, 240–41 for individual shareholders 237 domestic income tax 421 domestic source income (DSI) 426 double declining balance (DDB) 310 double taxation 31–3, 36, 58, 195 ban on 213 of distributed profits 182, 213 on distributions of the previously taxed income 237 in Germany 182 imputation credits to avoid 276 of inter-company dividends 186 in Italy 213 in New Zealand 276 prevention of 59, 266 in Turkey 266 Duke of Westminster doctrine 379 Dutch East India Company 5 earnings and profits (E&P) 159 Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) 148, 211–12, 266 E.C. Knight case (1895) 437 e-commerce 328 Economic and Financial Affairs Council (ECOFIN) 143, 147 economic-benefit doctrine 398 economic burden, of the tax economic rents or ‘excess returns’ 42 normal returns to equity capital 42 economic depreciation 310 economic double taxation 250, 323 in Turkey 256 economic enterprises 255 economic liberalization 168 economic ownership 167, 284 economic rents 42 burden of 43 corporate tax on 49–50 sources of 43 tax on

456  Research handbook on corporate taxation corporate investment in low-tax countries in response to 44 stakeholders paying 44 economic substance doctrine 3, 105, 352 judicial approaches to 367–9 operation of 367 relevance standard 370–71 defined 371–4 extrastatutory approach 372–3 statutory approach 373–4 standards for invoking under section 7701(o) 366, 370, 373–4 emissions trading (ETS) 131 e-money 133 Enron, collapse of (2001) 394, 399 Enterprise Income Tax Law (EITL), in China 302 entity-level corporate taxation, economic grounds for supporting 416–25 market power and excess profits impact on corporate tax policy analysis 422–4 new evidence 422 residence-based corporate taxation of FSI 424–5 in the ‘Old Turk’ and ‘Young Fogey’ eras Harberger, part 1 (closed economy) 418–20 Harberger, part 2 (open economy) 420–21 tax preferences, incidence of 417–18 equalisation levy 328 equity capital 322 normal returns to 42 EU law 130 European Civil Law 289 European Commission 143 Communication on Business Taxation 148 European Court of Justice (CJEU) 174, 184, 213 European Parliament 130 European Union (EU), corporate taxation in allocation of taxing powers between Member States 139 Anti-Tax Avoidance Directive 2016 159 automatic exchange of financial account information 133 Avoir Fiscal case 135 Base Erosion and Profit Shifting (BEPS) project 140 ‘Business in Europe: Framework for Income Taxation’ 142 Cadbury Schweppes case 135–6 CLT-UFA SA case 135 Commerzbank case 135 Common Consolidated Corporate Tax Base (CCCTB) 140

corporate tax base and tax rate 140–47 corporate tax rates 142 on cross-border payment of profit distributions 132 de minimis harmonisation 130, 146 Directive on Administrative Cooperation (DAC) 133 Financial Transaction Tax (FTT) 142 Halliburton case 135 impact on member state corporate tax systems 134–40 Income Inclusion Rule (IIR) 144 Interest and Royalties Directives 148 legislations regarding 131–4 Marks & Spencer case 138 of Member States 131 Merger Directive 132, 149 National Grid Indus case 139 Parent-Subsidiary Directive 132, 137, 148–9 Royal Bank of Scotland case 135 Tax Dispute Resolution Mechanisms Directive 134 Undertaxed Profits Rule (UTPR) 144 excess parachute payments 396–7 excess profits, impact on corporate tax policy analysis 422–4 excess profits tax’ (EPT), on income 64 executive compensation 3 analysis of policy failure 400–404 components of 395 as corporate-governance failure 392–6 excessive pay levels 392 inappropriate types of pay 393–4 theory of executive power and executive pay 394–6 criticisms about the level of 393 ‘managerial-power’ theory of 391, 394–6 ‘optimal-contracting’ theory of 391, 395–6 penalty taxes for 391, 396 $1 million deduction cap 400–404 deferred compensation 398–400 golden parachutes payments 396–7 executive pay, theory of 394–6 executive power, theory of 394–6 extrastatutory-statutory conflict 369 Facebook 423–4 acquisitions of Instagram and WhatsApp 441 fair market value (FMV) 72, 84, 85, 101, 315 of controlled stock 97 for restricted stock 79 ‘family’ corporation 239–40 family-owned businesses 176 Federal Central Tax Office, Germany 173 Federal income tax, evasion of 350

Index  457 federal inheritance tax 414 federal wealth tax 414 financial income for individual taxpayers, taxation of 294 financial leasing 218, 261–2, 265 financial statements summary 275 Financial Transaction Tax (FTT) 142, 377 financing of investment 8 First Gilded Age 415 force of attraction principle 122 Foreign Account Tax Compliance Act (FATCA) 432 foreign accrual property income 245 foreign derived intangible income (FDII) 126 foreign direct investment (FDI) 283 foreign portfolio investment 283 foreign resources, concept of 266 foreign-source income (FSI) 112, 409, 429 residence-based taxation of 424 foreign tax credits 340 allowance of 413 Fortune 500 companies 348 France, corporate taxation in anti-abuse rule 206 Anti-Tax Avoidance Directive (ATAD) 206 Base Erosion and Profit Shifting (BEPS) 205 capital tax 194 controlled foreign company (CFC) rules 206 determination of the taxable income for global income or a profit 198–201 specific tax rules for groups of companies 201–4 Group Steria SCA case 202 Merger Directive (1990) 204 ‘mini abuse of law’ (mini abus de droit) 206 normality of taxable results 205–7 correction of the income or profit 207 extension of control tools 205–6 Papillon case 203 Principal purpose test clause (PPT) 206 scope of personal 195–6 territorial 196–7 sui generis 194 Tax Procedure Code (TPC) 205 tax reform 194 free market capitalism 415, 433 free-trade zones 309 Fried, Jesse 394 G20 meeting 431 General Anti-Abuse Rule (GAAR) 134, 137 General Anti-Avoidance Rule (GAAR) 325, 327 generally accepted accounting principles (GAAP) 290

General Tax Code (‘Abgabenordnung’) 178 General Utilities doctrine 83–4, 98–9 German Empire 169 German fiscal federalism 172–3 Germany, corporation tax in ability-to-pay of 171–2 Allied Control Council 183 business taxation, system of 171 ‘check-the-box’ system key features and issues 191–3 overview of 190–91 Commission for Business Tax Reform 190 constitutional framework of fiscal federalism 172–3 fundamental rights 173–4 controlled foreign company (CFC) regime 179 corporate-shareholder integration 169 corporate/shareholder relationship corporate-shareholder tax integration 182–7 dealing at arm’s length principle 187 separate entity principle 181–2 economic double taxation 169 emergence of 168 Federal Corporation Tax Act (CTA) 173 Federal Council 173 group taxation 188–9 half-income method 185 historical roots of 168–9 Investment Tax Act 177 justifications of 169–72 municipal tax 169 overview of interaction with other taxes 174–6 personal scope 176–8 taxable income and loss treatment 179–81 territorial scope 178–9 ‘partial income’ system 185 profit transfer agreement (Gewinnabführungsvertrag) 188 real seat theory 178 tax treaty law 189 gift tax 387 global after-tax return 420 global intangible low-taxed income (GILTI) 125–6 global minimum tax 17, 144, 146, 388–9, 429, 431 ‘global taxation system’ of multinationals 223 GloBE rules 144 government bonds 42 Graetz, Michael 350 Granite Trust Co. v. U.S. 86

458  Research handbook on corporate taxation Gravelle, J.C. 48 Great Depression of 1930s 30, 415 ‘gross-up’ payments 395 group relief 166–7 group taxation 188–9, 288 GU repeal see General Utilities doctrine Haig-Simons income taxation 412 Hall and Rabushka’s Flat Tax 289 Harberger, Arnold 14, 418–19 harmful tax practices 388 hidden profit distributions doctrine 210 high and new technology enterprises (HNTEs) 308–10 high-end inequality, rise of 415 high-tax countries, tax imposed by 123 ‘horizontal double dummy’ transaction 76–7 household well-being 39–40 House Ways and Means Committee 58, 60 huazhuan 316 human capital 39 impermissible avoidance arrangement 327 imputation credit account (ICA) 278 imputation credits 276 carry forward of 278–9 resident withholding tax (RWT) and 279 imputation ratio 278 inbound investments 422 incentive stock option (ISO) 80 incidence, of corporate income tax 13–16, 425 analysis of 38–40 ability to pay 39–40 differences among households 40 distribution of income among income groups 40 corporate shareholders 44–6 economic burden 40, 42 economic rent burden of 43 sources of 43 stakeholders paying tax on 44 meaning of 38–41 on normal returns 46–9 in closed economy 46–7 in open economy 47–9 theory of 40–41 income from capital assets 185 versus capital gain 155–6 concept of 256–7 corporate-source 66–7 definition of 39, 274 distribution of 40, 45 excess profits tax (EPT) on 64

FDAP 114, 119, 121–2 foreign derived intangible income (FDII) 126 foreign-source 112, 114 fully-taxed 68 net accretion theory of 330 penalty tax on 65 rental 275 Schanz-Haig-Simons model 330 sources of see sources of income tainted 218 undistributed profits tax (UPT) on 66 US-source 113–14 Income Inclusion Rule (IIR) 144 income tax accounting, in China 312–13 Income Tax Act (1961), India 319 Income Tax Act (1803), UK 34 Income Tax Act (1913), USA 16th Amendment 6, 25, 28 concept of progressivity 25 enactment of 25 section 117 of 23 income taxes 23 civil 6 Civil War-era 24 growth of 6–7 income taxpayers 45 India, corporate taxation in anti-abuse provisions 326–7 general anti-avoidance rule (GAAR) 327 place of effective management (POEM) 326–7 significant economic presence 327 Companies Act (2013) 319 constitutional scheme for 319 corporate groups mergers and demergers 325–6 as separate personality 324–5 tax neutrality in intra-group transactions 325 in corporate restructurings 325 equalisation levy 328 financing and taxation of distributions debt versus equity 321–2 dividends 323–4 share issues 322–3 thin capitalisation rule 322 General Anti-Avoidance Rule (GAAR) 325 implementation of 327 Income Computation and Disclosure Standards (ICDS) 320 Income Tax Act (1961) 319 Chapter X-A of 327 section 14A of 323 legislative scheme for 319

Index  459 minimum alternate tax (MAT) 320 ‘piercing the corporate veil’ test 324 on ‘related party’ transactions 325 residential status on the basis of ‘place of effective management’ (POEM) 326–7 ‘substance over form’ principle 324 tax and accounting 319–20 on transactions with third parties 325 Vodafone judgment 324 indirect tax, on shareholders 435–6 individual proprietorship enterprises 305 Individual Retirement Account 379 industrial property rights 267 Inflation Reduction Act of 2022 (IRA) 110 information technology 43 initial public offering (IPO) 379 Inland Revenue Commissioners v. Duke of Westminster 378 insolvency 398 institutional know-how 43 insurance brokerage 338 intangible fixed assets 167 intellectual property (IP) 44, 383, 420 inter-corporate dividend exemption 284 inter-corporate dividends 31, 316 interest payments on debt 119–20 limitation on the deduction of 265–6 inter-group transfers, of assets 325 Internal Revenue Code (IRC) 41, 120, 123, 396 of 1986 112 amendments to 113 corporate tax preferences authorized in 350 IRC § 482 adjustment 127 penalties for noncompliance 353 section 163(j) of 384 section 409A of 398 section 7874 of 383 on tax penalties 349 Title 26 of the United States Code 112 Internal Revenue Service (IRS) 86, 348, 381 on abusive tax activities 360 advance pricing agreement 128 approach to section 7701(o) 366 Cumulative Bulletin 112 Form 8275 (Disclosure Statement) 362 Form 8275-R (Regulation Disclosure Statement) 360–61 Form 8886 (Reportable Transaction Disclosure Statement) 357, 362 Notice 2010-62 370 notice-and-comment process 358–9 Office of Tax Shelter Analysis 349, 353 private letter ruling 76

reactions to existing tax avoidance strategies 356, 360 reportable transaction rules 360 Revenue Ruling 84-71 76, 112 transfer pricing methods 128 international business, collection of taxes on 388 international capital movements 46 international corporate tax incidence, theory of 425 International Financial Reporting Standards (IFRS) 209 International Monetary Fund (IMF) 422 investment business 245 investment tax credits 32, 437–8 Italian Civil Code 211 Italy, corporate taxation in Anti-Tax Avoidance Directive (2016/1164) (ATAD) 212 design of 208–10 double track system 209 Earning Before Interest Tax and Amortization (EBITDA) ratio 211–12, 220 endogenous changes in 222–3 exogenous changes in 220–22 of foreign controlled companies CFC rules 218 worldwide tax consolidation 219–20 group consolidation and 214–18 consortium relief 217–18 domestic tax consolidation 215–17 introduction of 208 IRAP taxable base 208–9 Legislative Decrees 220 limitation of interest deductions 210–12 Parent Subsidiary Directive (PSD) 213 participation exemption system for inter-corporate dividends 212 Presidential Decree for 208, 220 profit distributions, tax treatment of 212–14 thin cap rules for 210–11, 220 Japan, corporate taxation in anti-abuse provision in 291 basic structure of general 288–9 tax administration 291 tax base 290 taxpayer 289–90 tax rate 291 Company Act of 2005 295, 300 Controlled Foreign Corporation (CFC) legislation 296 corporate tax data 297 corporate tax revenue 289

460  Research handbook on corporate taxation Corporation Tax Act (CTA, Law No.23 of 1965) 289 design of 288 economic reasonableness test 291 foreign income, taxing of exemption of foreign dividends 298–9 halfway territorial system 299–300 generally accepted accounting principles (GAAP) 290 Income Tax Act (ITA, Law No.33 of 1965) 289 integration with shareholder taxes dividends, concept of 295 historical overview of 294–5 rough and ready relief 292–3 during Japan-Russo War 294 Local Tax Act (Law No.226 of 1950) 289 Mandatory Disclosure Rule (MDR) 291 Marginal Reimbursement Rate (MRR) 299 Ministry of Finance (MOF) 297 national and local taxes 289 National Tax Agency (NTA) 289 reforms Recommendation by the Shoup Mission (1949) 294–5 under self-assessment system 291 Special Tax Measures Act (STMA) Law No.26 of 1957 289 special regime for taxing individuals’ financial income 292 split rate system 295 tax expenditure analysis Special Tax Measures (STMA) 296–7 Transparency Act 297–8 Universal Music case 291 write-off of bank loans 290 Yahoo case 291 Japan Industrial Bank 290 Joint Committee on Taxation (JCT) 45 joint stock company 254, 257, 289 joint ventures 165, 254–5 Kleinbard’s Business Enterprise Income Tax (BEIT) 289 Korean War 32 labor compensation 40, 313 labor markets 414 legal language, importance and flexibility of 425–7 levy tax, on the market value 139 liability for payment, of the corporate income tax 41–2 limited liability companies (LLCs) 41, 74, 169, 254, 257, 306 M&A deal structures using 104

partnership tax rules 104 limited liability partnership (LLP) 151 limited partnership companies 254 ‘limited-recourse’ debt 158 liquidation income 294, 315 listed transactions 349 nondisclosure of 353 loan relationships 156, 159, 166–7 loss trading, risk of 275 low-tax foreign countries 123 macroeconomy and economic justice 415 Made in America Tax Plan (2010) 410, 423, 425, 429 Mandatory Disclosure Rule (MDR) 291 Marginal Reimbursement Rate (MRR) 299 mergers and acquisitions (M&A) transactions anti-abuse provisions applicable to 106 complex corporations with multiple goals 103 corporate acquisitions, tax treatment of in general 87 in sum 95–6 taxable acquisitions 87 tax-free acquisitions 90–95 when the target is a subsidiary of another corporation 88–90 when the target is not a controlled subsidiary 87–8 corporate divisions, tax treatment of taxable corporate divisions 97–8 tax-free corporate divisions 98–102 corporate liquidations, tax treatment of 84–7 in general 85 in sum 86–7 for taxable corporate liquidations 85 for tax-free liquidations of controlled subsidiaries 85–6 corporate M&A transactions 84 changes to the tax rules governing 109–10 creative deal structures 103–4 deal structures using LLCs 104 future of 108–11 General Utilities doctrine 83–4 history of 83–4 judicial doctrines, relevance of economic substance doctrine 105 step transaction doctrine 105–6 substance over form 104–5 tax (quasi-)electivity for the well-advised taxpayers 107–8 special rules for 145 tax rules governing broader tax changes 110–11

Index  461 changes to 109–10 Up-C structures of 104 micro and small enterprises tax regime, in Brazil 337–8 micro-captive insurance strategies 358 minimum alternate tax (MAT) 320 misrepresentation, of financial results 394 modern corporation, ascent of 5–6 modified accelerated cost recovery system (MACRS) 50 monopolies 435 government-sanctioned 43 multilateral cooperation, politics and the feasibility of 431–3 multinational corporations (MNCs) 428, 432 tax avoidance 433 municipal trade tax (‘Gewerbesteuer’) 175–6, 178, 182, 186–8 Musk, Elon 415 ‘mutual interdependence’ test 106 natural person, private corporation as 6 neoclassical economics 412–13 net-basis tax 120 net deemed tangible income return (NDTIR) 126 net income, determination of 259–61 net profit margin, transaction-based 264 new corporate tax anti-avoidance provisions 442 shareholder taxation 442 tax base 441 new corporation (Newco) 73, 95 equal-value properties 74 formation of 72 transactions to M&A device 74–7 New Economy firms 429 New York Times 415 New Zealand tax system anti-avoidance provisions 283 anti-dividend stripping rules 284 assessment of 281–6 differentials between the corporate and individual tax rates 282–3 horizontal equity and dividend integrity 283–5 horizontal equity and wealth and tax distribution 285–6 Beacham case 284 branch equivalent tax account (BETA) 273 Companies Act (1993) 279 corporate entity tax 271–2 corporate income tax 33–4 imputation system 273 fair dividend regime 286–7 features of

company 273 company regime 273 corporate residence 274–5 income 274 losses 275 returns 275–6 separate taxable entity and shareholders 273 Income Tax Act 275 Policy and Regulatory Stewardship of Inland Revenue 282 Select Committee of Parliament 283 shareholder transactions dividends and imputation 276–9 return of capital 279–80 Vinelight Nominees decision 275 ‘non-business-related’ transactions 377 non-controlling corporate shareholders 291 non-profit organizations 334 non-qualified stock options 80 non-recourse debt, abusive use of 356 non-resident associated enterprise 322 non-resident withholding tax (NRWT) 276 non-taxable income 305 non-tax documentation 363–4 regarding reportable transactions 360 non-US income taxes 388 Obama Administration 433, 442 Obama, Barak 384 Old Economy company 424 Omnibus Budget Reconciliation Act of 1993 (USA) 400 open economy, corporate income tax in 47–9 ordinary share capital 160–61, 166 of the investee company 161 Organisation for Economic Co-operation and Development (OECD) countries 3, 344, 410 Action Plan 4 of 322 Base Erosion and Profit Shifting (BEPS) project 153, 322 Common Reporting Standard 133 initiative to limit ‘harmful tax competition’ between and among countries 387 Model Tax Convention 137, 164 Multilateral Instrument 164 Pillar One of 131 Subject to Tax Rule (STTR) of 145 Organschaft 188 origins, of corporate income tax debate on 7–9 modern corporation 5–6 parallel growth of income taxation 6–7

462  Research handbook on corporate taxation paid-up capital (PUC) 241–4 reductions of 243–4 partnership enterprises 305 partnership, meaning of 151 pass-through tax 23–4, 32, 436 penalty taxes 353–4 accuracy-related 362 on deferred compensation 398–400 due to abusive tax planning 362 due to nondisclosure 357, 361 for executive compensation 391, 396 $1 million deduction cap 400–404 on golden-parachute payments 396–7 on wages 41 permanent establishment (PE) 254 personal holding companies (PHCs) 65 personal income tax (PIT) in China 304 in Japan 288 in Turkey 250, 252 personal services business 237 personal services business income, taxes on 235 ‘piercing the corporate veil’ test 324 Pillar Two initiative 388–9 place of effective management (POEM) 326–7 place of incorporation (POI) 429 Pollock decision (1895) 436 portfolio investments 186 ‘portfolio’ shareholdings 162 pre-tax profitability, loss of 419 principal tax accountability 240 privately-owned businesses, ownership shares in 39 pro-business tax reforms 30 profit distributions, tax treatment of 212–14, 221 profit-shifting 299, 410, 432, 441 profits tax 31 in United Kingdom (UK) 34 profit transfer agreement 188–9, 192 property-for-stock exchanges 73 property, tax issues relating to contributions of section 351 72–3 evolution of 74–7 legislative purpose behind 73–4 proxy tax 7 public economic enterprises 253–4, 256 public partnerships 177 public–private partnership 239 qualified non-profit organizations (QNPOs) 306 qualified shareholders 211, 220 qualified stock distribution 89, 107 qualifying loan relationships (QLRs) 166 quasi-monopolies 435, 438

Reagan, Ronald 416, 438 real estate bubble 290 Realization Principle 331 real seat (RS) 429 recapturing income, rules for 313 recharacterization doctrine 210 regulation and mitigation, of corporate tax 29–32 related party 211 ‘related party’ transactions 325 rental income 275 ‘rent a star company’ schemes (France) 206 rent-sharing 44 research and development (R&D) 156–7, 308, 439 residence-based taxation burden of 430 global minimum taxes 429 of home companies’ FSI 409, 411, 424–5 of multinationals 414 of tax haven FSI 431 resident and non-resident corporations, definitions of 113 resident withholding tax (RWT) 228, 276, 279 resilience, in corporate income tax 16–20 abolition of corporate tax 18–19 distractions 17–18 political convenience and 19–20 ‘results-dependent’ debt 158, 164 retirement saving plans, ownership of assets in 45 returns to capital 40, 279, 283 Revenue Act (USA) of 1921 29 of 1924 29 of 1936 31 revenue, sources of 23–5 decline of 23 ‘risk-adjusted’ normal return 42 Roman Empire 5 Roosevelt administration 437 Roosevelt, Franklin Delano 30 Santa Clara County vs. Southern Pacific Railroad Company 6 Schedule M-3 (Net Income (Loss) Reconciliation) 360 Schedule UTP (Uncertain Tax Positions) 360–61 services, tax issues relating to contributions of stock grants 77–9 stock options 80–81 share acquisitions 315 share buyback transactions 70 shareholder credit 59–61 shareholder’s tax rate 59 shareholder taxation 33, 442 shareholder transactions

Index  463 dividends and imputation 276–9 carry forward of imputation credits 278–9 of corporate tax to shareholders 277–8 imputation credit account (ICA) 278 imputation credits 279 imputation ratio 278 resident withholding tax (RWT) 279 transfers of value and cooperative companies 277 return of capital 279–80 capital distributions upon liquidation 280 inter-company dividends 280 off-market share repurchase 279–80 on-market share repurchase 279 relevant exclusions from dividends 279 treasury stock 280 shareholding relationship 277 Sherman Act of 1890 (USA) 437 shielding, from corporate taxation 25–7 significant economic presence (SEP) 327 silent partnership contracts 214 Simples Nacional 337 small and medium-sized enterprises (SMEs) 176, 199 small and micro-profit enterprises (SMPEs) 306 social equalization 171 social redistribution 171 social security 40, 154, 198, 200, 209, 272, 337 social welfare 393 Societas Europaea 176–7 sole-proprietor business income, taxation of 304 sole proprietors 293 sole proprietorship, incorporation into a corporation 74 solidarity, principle of 171 solidarity surcharge 175–6 Son-of-BOSS (option position transfers) 348 sources of income definition of 427–9 market-placed 427 production-based 427 Spanish-American War (1898) 24 special economic zones 309 special excise tax 63 special levy on corporations 28 Special Tax Measures (STMA) in Japan 296–7 objective of 296 origin of 296 policy guidance to control 297 use of 297 specified investment business 237

‘Specified Investment Flow Through’ (SIFT) trusts and partnerships 233 spinoff transactions 108, 110 Springer v. U.S. 62 Statement on the Purpose of a Corporation (2019) 377 state-owned enterprises (SOEs) 315 stealth compensation 395 Steinberg, Lewis 105 step transaction doctrine 105–6 stock acquisition 87 stock grants 77–9 stock market crash 30 stock options 80–81 Stopping Harmful Inversions and Ending Low-tax Developments (SHIELD) 432 straddle transactions 368 substantial risk of forfeiture (SRF) 77 substantial shareholdings exemption (SSE) 160 Summa Holdings v. Commissioner 374 sum-of-the-year’s-digits (SYD) depreciation 310 super-tax 34 Supplemental Nutrition Assistance Program 40 surplus stripping 232, 240, 241, 243, 249 Surrey, Stanley S. 296 surtax, on corporate earnings 6, 25–6, 28, 64, 66, 194 Taft administration 436–7 Taft, William Howard 24–5, 30 ‘tainted’ income 218 taxable corporate income, design of 222 taxable income, determination of 195 global income or a profit 198–201 specific tax rules for groups of companies 201–4 tax advice 361–3 disclosure of 360 taxation of corporations 31 in New Zealand 33–4 in United Kingdom 34–6 tax audits 195, 332 tax avoidance strategies 356 IRS reactions to 356 tax bases, division of 11 tax collection, decentralization of 304 tax consolidation domestic 214, 215–17 worldwide 214, 219–20 tax corporations 434–5 tax credits 209, 213, 222 Tax Cuts and Jobs Act (2017) 124–5, 384, 400, 416, 422, 426 tax-deductible, in the tax return 209 tax deferrals 296

464  Research handbook on corporate taxation tax-exempt investors 45 tax-free acquisitions 90–95 judicially developed requirements for reorganizations 92–4 statutory requirements for reorganizations 91–2 structuring acquisitive reorganizations 94–5 tax-free capital profit 286 tax-free corporate liquidation 86 tax-free reorganization, requirements in order to qualify as 75–6 tax-free spin-off transactions 362 tax incentives 20, 343, 385–6 tax integration, between corporate/shareholder between 1862 and 1865 60 ‘corporate exclusion’ approach to 58 tax rates 59 U.S. approaches to 57–68 tax losses, due to abusive tax shelter 352 tax-motivated transactions 363, 369 tax neutrality in intra-group transactions 325 principle of 268 in Turkey 268 tax on monopolistic rents corporate tax as 436–41 de minimis exception 439 on normal returns 438–40 on super-normal returns (rents) 440–41 taxpayers, corporations as 233–4 taxpayer’s obligation, traditional view of 378–9 tax planning aggressive 390 benefits of 389 for a business entity 382 techniques for 387 Tax Policy Center Microsimulation Model 52 tax reforms corporate governance-related 31 Tax Reform Act of 1986 (USA) 65, 67, 84, 411 tax subsidy 441 tax system, in United States 65 Technology Zones Development Law (Turkey) 267 territorial tax, on profits 47 ‘top up’ tax 144 ‘traitor’ corporations 387 transactional elections 107 transactions in securities 159 transactions of interest 349 ‘transfer’ of shares 322 transfer pricing 322, 348 enforcement of 128

IRS’s methods for 127–8 OECD Transfer Pricing Guidelines 128 rules for 344–5 Treaty on the Functioning of the European Union (TFEU) 130 ‘triple L’ partnerships 227 Trump Administration 433 Turkey, corporate taxation in ashar tax (tributum mukasem) 251 Base Erosion Profit Shifting (BEPS) 253 characteristics of income 256–7 taxable event 257–8 tax base/taxable income 258–61 taxpayers 253–6 tax rate and tax liability 261–2 Controlled Foreign Company (CFC) rules for 266–7 Corporate Income Tax Law (CITL) 250 digital service tax (DST) 250 dividend tax 251 dual system 252 earnings tax 251 ex officio principle 263 industrial property rights 267 jizya (tributum capitis) 251 measures against aggressive tax planning general anti-avoidance rules 264 special anti-avoidance rules 264–8 numerus clausus principle 260 payment of 263 personal income tax (PIT) 250, 252 Personal Income Tax Law (PITL) 250 prevention of double taxation 266 procedure for 263 profit distribution by transfer pricing 264–5 Tahrir-i Umumi Regulation 251 tax-exempt income 259 Technology Zones Development Law 267 thin capitalization rules disguised capital 265 limitation on the deduction for interest 265–6 withholding tax 267–8 Ultimate Parent Company 219–20 Ultimate Parent Entity (UPE) 145 Undertaxed Profits Rule (UTPR) 144 undistributed earnings, taxation of 6 undistributed profits tax (UPT), on undistributed income loss of revenue from reduction of 67 repeal of 67 Roosevelt proposal on 66

Index  465 as substitution for surtax 66 unincorporated association 150 unitary taxation, system of 188 United Kingdom (UK) anti-avoidance rule 163 ‘controlled foreign company’ rules 160 corporate culture in 34 corporate income tax in 34–6 corporate taxation in income versus capital gain 155–6 meaning of a ‘company’ for 150–52 non-resident chargeable gains 154 for permanent establishments 153 property dealing or developing 153 property rental business 153–4 for resident company 152–3 territorial links for 152–4 Corporation Tax Act 2010 (‘CTA 2010’) 150 corporation tax ‘grouping’ 166–7 Finance Act of 1910 34 1965 35 holding company jurisdiction 160 ‘controlled foreign company’ (‘CFC’) rules 164–6 dividend exemption 162–3 ‘QAHC’ regime 163–4 substantial shareholdings exemption (SSE) 160–62 Income Tax Act of 1803 34 Individual Savings Account 158 non-UK real property 164 non-UK tax (‘underlying tax’) 162 ‘partial imputation’ system of dividend taxation 158 participation exemption for chargeable gains 160 dividends 162 Partnership Act 1890 (PA) 150 profits tax 34 real estate investment trusts 157 ‘results-dependent’ debt 158 Retail Prices Index of inflation 155 Royal Commission on the Taxation of Profits and Income 35 ‘securitisation’ companies 164 taxation of shareholders and other economic stakeholders 157–60 tax incentives 156–7 tax rates and procedure 154–5 Universal Music case 291 unlimited liability corporations 151, 227 US corporate taxation

‘check-the-box’ system 152 on income from trade or business conducted in the US 120–22 effectively connected 122 engaged in a trade or business 121 four requirements 121 laws governing 112 for nonresident corporations (inbound taxation) 113, 114–22 branch profits tax 118 business income 120–22 earnings stripping, base erosion and anti-abuse tax (BEAT) 120 earnings stripping, interest payments 119–20 gains from sales or exchanges of US real property interests 119 interest on certain accounts in US banks 118 interest payments 119–20 limitation of benefits provision 118 non-business income 114–20 portfolio interest exemption 114–18 property sale exception 119 treaty shopping 118 for resident corporations (outbound taxation) 122–6 creditable foreign taxes 123 credit for foreign taxes on gross income 123 deferral principle 124–6 foreign derived intangible income 126 foreign-source income 122 limitations on the foreign tax credit 123 significance of separate taxpayer treatment 124 source rules 115–17 sources of income and 113–14 transfer pricing 127–8 US Treasuries 381, 438 Comprehensive Business Income Tax (CBIT) 289 regulations governing reportable transactions 352 value added tax (VAT) 131, 166, 288 Vodafone judgment 324 voting rights and profits 219 Watergate scandal 416 wealth and generation of profits 22

466  Research handbook on corporate taxation wealth transfer taxes 414 William Pitt the Younger 6 Winn-Dixie Stores, Inc. v. Commissioner 366 worldwide income, principle of taxing 178, 299

Yahoo case 291 zero-tax companies 320 Zuckerberg, Mark 415