Restructuring Foreign Tax Credits, Increasing Efficiency and Eliminating the Entity Residency Electivity Problem

Abstract

The traditional approach to international taxation policy focus on two tax models, the worldwide taxation with foreign tax credit model, and the exemption model. Each of the two is aimed to maximize a different efficiency margin – the first aims to encourage the residence to maximize the pre-tax based return on capital, while the second aims to maximize the tax payer after-tax return on capital. In this regard, it is well accepted that the two policies cannot co-exist. Therefore, from a worldwide perspective the efficient international tax policy is a tradeoff between the total value generated and value lost under to two tax model. From a national perspective only value which is captured by the domestic investors and tax authorities and the cost allocated to the domestic market is taken into account. Therefore, different countries will have a different efficient international tax policy, dependent on the availability of capital and the availability of investments in the domestic market. The international tax policy therefore has nothing to do with "true" income measurement, but rather it is a matter of investment subsidy, and the tax policy should depend on the surplus created and captured by the domestic market versus the costs allocated to it. While the literature has started to develop the notion that foreign tax policy is just a subsidy policy and should be designed based on the return of the investment versus the cost of the subsidy, it remains focused on entity level taxation alone. In other words, it continues to focus on the efficient tax rate, while ignoring the question of the efficient subsidy mechanism. The contribution of this paper to the literature, besides of reframing the relevant debate and identifying the relevant consideration in regard to the treatment of foreign income, will be in examining the efficient subsidy mechanism. I will ask, even if a subsidy is desirable, is the current mechanism an efficient one. I will argue that the current mechanism, which allows the entity to enjoy the tax benefits (either the credit of the exemption), is poorly designed in regard to its own goal. If the goal is the increase the competitiveness of domestic individual capital owners, the current system creates additional cost in the form of subsidizing foreign capital owners. Furthermore, both the credit and the exemption systems distort the decision making of the domestic capital owner, thus reducing the efficient use of the domestic capital. Even if the goal is to increase the competitiveness of domestic corporations, for example because the country collects only entity level tax from domestic corporations, there is still no reason the equally subsidize domestic and foreign capital owners invested in the domestic entity. As an alternative, I will offer to allocate the tax benefits, if a country wishes to grant such benefits, directly to the individual capital owner. I will argue that such a mechanism will reduce eliminate the undesirable cost (from a domestic perspective at least) of subsidizing foreign investor. Furthermore, even if the country wishes to encourage investment in domestic corporations, due to the ability to collect entity level tax only from domestic corporations (in a residency based tax system), a subsidy in higher rates granted to domestic capital owners alone will lead to the same competitive advantage of the domestic entity, while allocating the entire subsidy only to domestic capital owners.