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Proposals for the reform of corporate income taxes are in high demand. Global firms can, if they want, avoid paying their taxes and the ‘trillion dollar question’ is how we can change that.

One proposal was recently put forward in the Journal of International Business Studies. The authors argued in favour of a zero rate corporate income tax and a positive tax on dividends and consumption. They asserted that our current system of separate accounting, which gives governments the right to tax the national incomes of firms operating within their borders, failed because it was built by “practitioners trained in international economics and international finance” (p.4), implying that such practitioners have no understanding of how international businesses actually work.

Well, we disagreed and wrote a counterpoint article – others did too.

We did not just disagree – we went back in history and found all the relevant League of Nations documents (with the help of our University librarians) that describe what happened between 1920 and 1935.

Guess what?

It was the international businesses – dominated by the United States – that wanted to have the separate accounting system in the first place while the academic experts had proposed a unitary taxation system with a formula apportionment rule.

For the full historical account, including the references and quotations, please see our JIBS paper.

What happened at the League of Nations?

International tax was discussed at the League of Nations after the end of World War I, when the world was trying to stand on its own feet again. The emergence of international institutions was on the rise, as international cooperation was seen as a way of stopping new wars. The International Chamber of Commerce (ICC), newly formed in June 1920 to represent the interests of the business community, brought the issue of double taxation of the profits of international firms (which was argued to be over-taxation of those profits) to the doorstep of the equally young League of Nations.

The League of Nations appointed four experts, all economists, – Professor Bruins (Commercial University, Rotterdam), Professor Senator Einaudi (Turin University), Professor Seligman (Columbia University, New York) and Sir Josiah Stamp K.B.E. (London University) – to analyse how to tax firms that operate in many countries.

The experts concluded that ‘… the ideal solution is that the individual’s whole faculty should be taxed, but that it should be taxed only once, and that the liability should be divided among the tax districts according to… the doctrine of economic allegiance’. Their report specifically addressed the ‘allocation of earnings where the whole of the economic stages are not conducted within one area’ and showed clear preference for activity-based taxation in recognising the potentially different locations and activities of value creation. The academic experts offered to look further into the matter if desired by the League; the offer was not taken up.

The League referred the work to technical experts made up of tax administrators from several countries. The April 1927 report of the technical expert committee was the first that implied a preference for separate accounting, under the condition that it is accompanied by a set of bilateral treaties. However, the ‘rules for the apportionment of profits or capital of undertakings operating in several countries’ was identified as a topic for further study, along with an investigation of methods to prevent double taxation of income derived from patents and authors’ rights.

The League’s deliberations were not divorced from business. The ICC – whose leadership included prominent businessmen from, for example, General Electric, Standard Oil Company and Deere and Company – exerted influence throughout the League’s work on double taxation and tax evasion. From its earliest interest in double taxation, the ICC had ‘maintained close contact with the League of Nations’, with ‘harmony existing between the [ICC and League] in pursuit of the same aim’.

Consistent with the League’s expert committees, the ICC emphasised that ‘the conclusion of bilateral agreements may be regarded as a step towards a more general agreement completely abolishing double taxation’. Double taxation was seen to generate incentives for tax avoidance: ‘any excessive taxation, by its very burden, brings in its train tax evasion… The suppression of double taxation [is…] closely connected with the measures for the systemic prevention or checking of such evasion’. Hence, tax evasion continued to take a back seat, with double taxation prioritised in the League’s deliberations.

Moreover, the new League of Nations Fiscal Committee, which first met in 1929, included direct and ongoing representation from the International Chamber of Commerce to help secure the views of business enterprises.

 [The Congress of the ICC] Calls the attention of the League of Nations to the necessity of avoiding anything that might hamper the free play of competition and of economic laws, especially the free movement of capital and the freedom of the exchange market, or that might violate the secrecy of bankers’ relations with their customers or of income-tax returns.

The League’s Fiscal Committee endorsed the ICC’s and the prior technical experts’ preference for a multilateral convention on double taxation once agreement, even on a limited scale, seemed possible. A questionnaire was sent to the Governments of ‘important commercial countries’. A summary of replies by T.S. Adams – a professor at Yale University who had been a member of the expanded Technical Committee and advisor to the U.S. Treasury – revealed ‘great diversity of law and practice’ and a need for further ‘systematic and continuous study’ of approaches of different countries.

It was then that the Fiscal Committee received a grant from the Rockefeller Foundation of $90,000 to prepare a study that would analyse and settle the issue of how to tax international firms. The study was led by Dr Mitchell B. Carroll, who had for some years been connected with the work of the Fiscal Committee as an assistant to Dr Adams in the US.

The Carroll Report identified two primary methods of profit allocation between countries for taxation of international businesses: separate accounting and formulary apportionment.

No country followed exclusively one method or the other. Formulary apportionment was the primary method for business taxation in Spain, in Swiss cantons, in Austria, Czechoslovakia and Hungary (under joint treaties) and in various states in the United States, and widely used elsewhere as a secondary method. In Spain, fractional apportionment had in law and practice replaced separate accounting for business enterprises since 1920, and was declared by the Spanish government the only system that

  • assures enterprises are taxed according to their real capacity to pay and precludes overlapping assessments that result in taxation of more than 100 per cent; and
  • permits the taxation of a subsidiary in accordance with their real importance in the enterprise as a whole.

Dr Agustin Vinuales, who authored the Spanish report, was eloquent in asserting its virtues:

Taken as a whole, the Spanish system of apportioning profits [based on the principle of economic unity of the multi-establishment enterprise] deserves the honour in which it is held by business men in Spain. They cannot understand how anybody can be in doubt, at the present time, which is the better—a system so solidly constructed as the Spanish system, or a system so primitive as that of separate accounts, with which it must be admitted a priori that, although the operation of one undertaking may be completely controlled by another, yet the former is independent of the latter, or that the ideal of taxation is to make a concern running at a loss pay the tax on profits. The pious Spaniard has no longer a faith so profound.

In his report, Carroll observed:

In view of the ever-growing complexity of the structure of international enterprises and the apparent difficulties encountered by many in maintaining an accounting system which will reflect the true profits of each establishment, whether conducted as a branch or a subsidiary company, there is a tendency on the part of tax officials to resort more and more to fractional [i.e. formula] apportionment.

Yet, despite this observation, the Carroll report advocated a separate accounting approach and presented a multilateral convention drafted on this basis that was sent for comment to Governments. The provisions and language of the Carroll report ultimately became part of the 1943 Mexico and 1946 London Model Conventions, which were forerunners to the modern United Nations (UN) and Organisation for Economic Co-operation and Development (OECD) Models.

It is worth remembering that Carroll wrote his report in a post-WWI era of heightened US influence, when there were fewer possibilities for profit shifting than today. There was less global capital mobility; less functional integration within groups; lower profits in affiliates; less importance of intangible property (although still recognised as vital); and less risk allocation (for instance, uncertain outcomes from research and development).

These are not the times in which we live today. There are now over 3,000 bilateral tax treaties that seek to govern an impregnable system of multinational corporate structures. The pervasive digitalisation of the world economy only complicates matters and makes the need for reform even more urgent. Even the ICC now calls for a reform of the international taxation system toward something more transparent, that reduces uncertainty and compliance costs.

Might formulary apportionment present a better solution to the problems of taxing MNEs?

We think so.

In our JIBS paper we provide a detailed explanation of the theory and the empirics around the benefits and costs of formula apportionment. We argue that a carefully designed formula apportionment system can reconcile tax competition, double taxation and tax sovereignty.

Taxing an activity-based share of a firm’s global profit is long overdue.

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