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Tax treaties with developing countries and the allocation of taxing rights

Abstract

Worldwide income taxation in the country of residence is a legal dogma of international taxation. We question this dogma from the perspective of relations between developed and developing countries from legal and economic perspectives, and make a modern and fair proposal for tax treaties. We show under which conditions a developing and a developed country will voluntarily sign a tax treaty where the developing country is more inclined to share the information with the developed country and whether they should share revenues. Moreover, we demonstrate how the conclusion of a tax treaty can assist in the implementation of a tax audit system in the developing country.

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Notes

  1. 1.

    I.e. relief for juridical double taxation by the so-called foreign tax credit method.

  2. 2.

    To be defined below.

  3. 3.

    See EU Council Directive 2003/48/EC of 3 June 2003 on taxation of savings income in the form of interest payments, OJ L 157 of 26 June 2003, p. 38 and ff. The global shift towards fiscal transparency has affected the scope of this directive, which is in force since 1 July 2005 and is being replaced by the EU Council Directive 2014/48/EU, due to be implemented by 1 January 2016.

  4. 4.

    By referring to tax treaties, the authors intend to refer to exchange of information clauses included in general treaties, the multilateral convention of the Council of Europe on mutual assistance in tax matters, currently being signed by 67 countries, and tax information exchange agreements (TIEAs), which are being concluded in a growing number of countries over the past few years. Another option currently in discussion is the OECD Global Initiative for Fiscal Transparency. For more detailed information see Dourado (2013). It is beyond the scope of the paper to include these types of treaties, but we presume that the main result, revenue sharing for information transfer, would still hold.

  5. 5.

    The exchange of information is currently a hot topic in the policy debate. We would like to stress that in our case, information will be provided by one partner and received by the other, and hence information sharing is unidirectional. This is due to the fact that we assume capital to flow in one direction only, and hence only one country needs to procure information.

  6. 6.

    To give an example, even though both the US and Mexico are OECD countries, there is a much stronger flow of capital from the US to Mexico than the other way around. In this case, the US would be the developed country and Mexico the developing country.

  7. 7.

    A good example of this is the predetermined mechanism currently applicable on a unilateral basis for determining transfer pricing in the Brazilian tax system, regulated mostly by the Law n. 9.430 from 27 December 1996, and the Normative Instruction SRF n. 243 from 11 November 2002. Schoueri and Silva (2010) provide details on the Brazilian system.

  8. 8.

    USA and Canada are two of the OECD countries which use such a method. Chisik and Davies (2004b) present reasons for preferring this method over others.

  9. 9.

    This scenario covers the vast majority of all potential international tax cases.

  10. 10.

    We assume that consumers in \(D\) are immobile.

  11. 11.

    with \(0<c_{l}<c_{h}< p_d = 1\).

  12. 12.

    In our case, firms can claim at most costs of \(c_{h}\).

  13. 13.

    For the sake of simplicity we assume that \(D\) can levy a corporate income tax on revenues in \(D\) even in the absence of a subsidiary.

  14. 14.

    See European Court of Justice, decision of 18 December 2007, case C-101/05, A.

  15. 15.

    We have presented empirical evidence for this above.

  16. 16.

    Under the foreign tax deduction method, global tax revenues would equal \(T^{na}_{deduct} = n [t_d + t_u(1-t_d) ] (1- c_h) - M(n)\), and thus depend on both tax rates. The result collapses to the foreign tax credit method used in the main text as the difference between the two tax rates increases. We use the foreign tax credit method for both cases, treaty or not, first for consistency and second because it is the regime most favorable to firms and thus makes it hardest for governments to agree. It should therefore give us a lower bound for the case where a tax treaty is favorable.

  17. 17.

    The relevance of the UN Model in treaties signed by developing countries is often more pertinent to some of its clauses than to its entirety. See Goede and Wijnen (2014) for a quantitative analysis and Pistone (2012) for a qualitative analysis.

  18. 18.

    These methods have been established by the OECD transfer pricing guidelines of 1979, last revised in 2010, the UN transfer pricing guidelines, established 2012, and many national guidelines.

  19. 19.

    In principle, countries can (and do) set transfer prices unilaterally. In this case, the firm’s global tax base may fall short or—more likely—exceed total profits. In order to avoid ulterior complications, we assume that countries adopt the same transfer price, as proposed by for instance the OECD (2010).

  20. 20.

    We are aware that cost plus, much like any transfer pricing regulation, is problematic. Cost plus has particularly gained notoriety as it typically assigns only small margins to the producer, and typically fails to include intellectual property in costs. Intellectual property has no particular role in our model, which is certainly more suited to finished or semi-finished products, where cost plus transfer pricing methods are widely used. The issue of small margins could be alleviated by leaving room for a negotiated adjustment mechanism. Here firms would negotiate with governments in a mutual agreement procedure (MAP) in advance over the margins applied. In case of disagreement, the OECD would act as an arbiter. In principle, the advanced pricing committee could be multilateral, also including the other government. As firms would have an interest to move most of their tax base to the low-tax developing countries, in bilateral negotiations they would act on behalf of the developing government’s interest.

  21. 21.

    This may obviously lead to the fact that a contracting state may refrain from signing a treaty ex ante.

  22. 22.

    Australian tax treaties with developing countries, in particular in cases where unilateral flows of information can arise, are generally accompanied by a memorandum of understanding (MOU) on extraordinary and ordinary costs to provide information. The relevant provision on costs is as follows: Pursuant to Article X of the Agreement it is mutually decided that costs that would be incurred in the ordinary course of administering the domestic tax laws of the requested party will be borne by the requested party when such costs are incurred for the purpose of responding to a request for information. Such ordinary costs will normally cover internal administration costs and any minor external costs.

    All other costs that are not ordinary costs are considered extraordinary costs and will be borne by the requesting party. Examples of extraordinary costs include, but are not limited to, the following:

    • reasonable fees charged by third parties for carrying out research;

    • reasonable fees charged by third parties for copying documents;

    • reasonable costs of engaging experts, interpreters, or translators;

    • reasonable costs of conveying documents to the requesting party;

    • reasonable litigation costs of the requested party in relation to a specific request for information; and

    • reasonable costs for obtaining depositions or testimony.

    All requests for payment must be supported by the relevant documentation, i.e. an invoice/receipt for payment.

    The above named parties will consult each other in any particular case where extraordinary costs are likely to exceed a certain threshold in order to determine whether the requesting party will continue to pursue the request and bear the cost.

  23. 23.

    We define ‘fair’ as the opposite of unfair. We consider it unfair if a country has to accept a tax treaty even if this deteriorates its situation. In that sense, a treaty is ‘fair’ if it improves the situation for at least one party without making others worse off.

  24. 24.

    We apply a conventional principal agent model to the case of tax treaties. For more information on these agency models, see e.g. Stiglitz (1987).

  25. 25.

    We will show below that this fee can be substituted with a higher mark-up \(\alpha\) of the transfer price. Alternatively, the fee could be paid directly in the form of a monetary transfer. Braun and Zagler (2014) recently demonstrated that the probability to sign a tax treaty increases with the amount of official development assistance.

  26. 26.

    We will determine the amount of the respective fees in the following by backwards induction.

  27. 27.

    In this state of the world just \(\eta\) firms make a low profit while the remaining \((n - \eta )\) make a high profit.

  28. 28.

    We believe that this condition is not met in the agreements that Switzerland has signed in 2011 with Germany and the United Kingdom on the single taxation of savings in the country of source. Such agreements, designed to preserve anonymity of investors, give the state of residence, which for the purpose of our article is in a similar situation to country \(D\), no possibility of cross-checking cases of misreporting or loose enforcement of taxes by Switzerland.

  29. 29.

    Since 2009, countries are willing to sign tax treaties with exchange of information provisions in order not to be listed in the groups of uncooperative tax jurisdictions and be internationally blamed for not effectively countering tax avoidance and evasion. For such reason, a developing country may be willing to sign a tax treaty with an exchange of information clause even when it knows that such clause will not yield any advantage for it with respect to tax revenue. However, we suggest that the developing country, even in such circumstances, will not effectively carry out tax audits unless it believes that it may gain from them.

  30. 30.

    Defined as the sum of tax revenues of the developing \(U\) and developed \(D\) country, \(T = T_u + T_d\).

  31. 31.

    Firms take into account only the part of the net relocation cost which is not tax deductible \(k = k^{gross} (1-t_d)\).

  32. 32.

    We do this in order to focus only on the effects of tax treaties on factor allocation decisions. Obviously, a country with a lower tax rate would always attract more investment given the same treaty status, and vice-versa. But this is beyond the scope of this paper. A more general, but also more complex, model would allow for different and possibly changing tax rates.

  33. 33.

    Considering that tax treaties generally apply the ordinary tax credit method, this is possible only to the extent that taxes, as is often the case, levied by the developing country (usually the country of source) are lower than those levied by the developed country.

  34. 34.

    This subsidy is a monetary transfer from government to firms independent of tax payments and conditional only upon remaining in the country. We can think of these subsidies either as a tax deduction offered to firms considering relocation, where the effective tax rate will be \(\tau _u=t_u-s/(\alpha \bar{c} - \bar{c})\), or a direct grant or transfer in kind (e.g. infrastructure), which would reduce production costs.

  35. 35.

    Many countries, and in particular developing countries that we have in mind here, however, pay substantial financial subsidies to firms. This kind of tax competition is widespread, e.g. in the ASEAN region, but could be potentially in conflict with the prohibition of subsidies under the WTO law. Furthermore, in some parts of the world monetary subsidies to firms remain a merely theoretical option, since some legal obstacles may prevent its implementation. This is the case in the European Union, where such incentives are in principle incompatible with the prohibition of state aid and need explicit ex-ante approval by the European Commission in order to lawfully apply.

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Acknowledgments

We would like to thank J. Braun, M. Dirkis, A. Gautier, C. Marchese and T. Pietra, the conference participants at IIPF, SIEP, SIDE-ISLE, at seminars at the Catholic University of Milan and at CRENoS-DEIR of the University of Sassari for helpful comments and suggestions. Paolini gratefully acknowledges financial support of MIUR-PRIN 2008 and from FNR (Measure AM2c), Luxembourg. Pistone and Zagler would like to acknowledge funding from the Austrian Science Fund (FWF) SFB international tax coordination. Zagler would like to acknowledge financial support from OeNB Jubiläumsfonds Projekt Nr. 16017 and thank CRENoS and DEIR (Università di Sassari) for their hospitality while working on this project.

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Correspondence to Dimitri Paolini.

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Paolini, D., Pistone, P., Pulina, G. et al. Tax treaties with developing countries and the allocation of taxing rights. Eur J Law Econ 42, 383–404 (2016). https://doi.org/10.1007/s10657-014-9465-9

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Keywords

  • Developing countries
  • Tax treaties
  • Exchange of information
  • Revenue sharing
  • Cost sharing
  • International tax justice

JEL Classification

  • F53
  • H25
  • H87
  • D82