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International business taxation and the business cash flow tax

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Abstract

Investments and business profits are internationally mobile. Countries respond by tackling international profit shifting. As a result, the international allocation of taxable profits becomes an increasingly complex and costly issue. Reform proposals either address the Organisation of Economic Co-operation and Development approach to international profit allocation or target tax bases that are less mobile than profits. This paper investigates cash flow as a tax base. A business cash flow tax abolishes current accrual accounting and has the potential to block international profit shifting. Financing vanishes to become a tax-planning tool because the investments’ market return is tax free under a cash flow tax. Profit shifting via intra-group transactions is eliminated if the business cash flow tax is based on the country of destination principle. However, a destination-based business cash flow tax might distort the investment decisions of international groups.

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Notes

  1. A tax on shareholder net cash flow, i.e., dividends and repayments of capital minus capital contributions, was already discussed in the seventies by The Institute for Fiscal Studies (1978).

  2. See Auerbach and Devereux (2010).

  3. See Bond and Devereux (2002).

  4. Many countries (including most continental European countries) exempt the profits of (legally not separated) foreign permanent establishments from domestic income taxation. Profits earned by (legally separated) foreign corporations are not included in the taxable income of the domestic shareholder, and domestic income taxes on distributed foreign profits can thus be deferred.

  5. Restrictions on internal debt financing are common (Jacobs 2011), and CFC rules recapture low-taxed interest income (Lang et al. 2004). Documentation requirements are increasingly demanding (Ernst and Young 2011), and compliance costs are substantial. The European Commission (2004) estimates the ratio of compliance costs to taxes paid in 2004 as 30.9 % for small- and medium-sized companies and 1.9 % for large-sized companies. Compliance costs increase with the number of foreign business locations.

  6. In addition to real cash flow (R cash flow), the tax base could include all payments related to debt (R + F cash flow), which necessitates the differentiation between equity and debt. This differentiation reintroduces financing issues to the tax base.

  7. See Bond and Devereux (2002), Auerbach and Devereux (2010).

  8. Within the European Union, the value added tax and the European Commission’s proposal of a common consolidated corporate tax base leave the tax rates to the discretion of the member states.

  9. Intra-group financing is neglected. Intra-group cash distributions and internal debt do not affect the tax base of the companies or the group’s total cash flow.

  10. From \( V = I_{S}^{*} \cdot (1 - \tau_{S} ) - O_{P} \cdot (1 - \tau_{P} ) \cdot q = 0, \) it follows that \( I_{S}^{*} = q \cdot O_{P} \cdot {{(1 - \tau_{P} )} \mathord{\left/ {\vphantom {{(1 - \tau_{P} )} {(1 - \tau_{S} )}}} \right. \kern-\nulldelimiterspace} {(1 - \tau_{S} )}} \) and that \( p^{*} = {{I_{S}^{*} } \mathord{\left/ {\vphantom {{I_{S}^{*} } {O_{P} }}} \right. \kern-\nulldelimiterspace} {O_{P} }} - 1. \)

  11. Adjustments of pre-tax cash flows reflecting the tax rate differential in both countries have the same effect. Either the received pre-tax cash flow of S Company must adjust to \( I_{S}^{ + } = I_{S} \cdot {{(1 - \tau_{P} )} \mathord{\left/ {\vphantom {{(1 - \tau_{P} )} {(1 - \tau_{S} )}}} \right. \kern-\nulldelimiterspace} {(1 - \tau_{S} )}} \) to achieve the group’s after-tax terminal value of \( V = I_{S} \cdot (1 - \tau_{P} ) - O_{P} \cdot (1 - \tau_{P} ) \cdot q, \) or the pre-tax cash disbursements of P Company must adjust to \( O_{P}^{ + } = O_{P} \cdot {{(1 - \tau_{S} )} \mathord{\left/ {\vphantom {{(1 - \tau_{S} )} {(1 - \tau_{P} )}}} \right. \kern-\nulldelimiterspace} {(1 - \tau_{P} )}} \) to achieve the group’s after-tax terminal value \( V = I_{S} \cdot \left( {1 - \tau_{S} } \right) - O_{P} \cdot \left( {1 - \tau_{S} } \right) \cdot q. \)

  12. Analogous results are obtained if S Company owns the group’s financial resources, E, invests only in country S (E = O S , O P  = 0), delivers the goods produced to P Company; P Company pays amount T for this intra-group transaction and sells the purchased goods exclusively to consumers in country P (I P  > 0, I S  = 0).

  13. The equivalence of an origin based BCFT and a destination based BCFT conforms to the well-known fact that a uniform indirect tax with flexible factor prices and exchange rates does not distort international trade patterns (irrespective of the application of the country of origin principle or the country of destination principle). For a comparable result, see Auerbach AJ and Devereux MP (2010) Consumption Taxes in an International Setting. Discussion Paper. Berkely, Oxford.

  14. See Ewert and Wagenhofer (2008, p. 576).

  15. Personal taxes are neglected in country P. Intra-group dividends distributed by S Company to P Company are tax free (affiliation privilege). In contrast, intra-group interest payments do influence the profit tax of P Company. Nevertheless, intra-group debt financing is again not considered to ensure that the uncoordinated and the coordinated taxation can be compared. In the model, intra-group debt financing and intra-group trading have the same tax effects.

  16. If the investment is located in country P, and if goods are sold in the same country, the group’s after-tax terminal value amounts to \( V = I_{P} - O_{P} \cdot q - \tau_{P} \cdot (I_{P} - O_{P} ) \). Because profits are taxed and personal taxes are neglected, \( p^{*} = {r \mathord{\left/ {\vphantom {r {(1 - \tau_{P} )}}} \right. \kern-\nulldelimiterspace} {(1 - \tau_{P} )}} \) results.

  17. The transfer payment of \( T = O_{P} \cdot [1 - ({{\tau_{S} } \mathord{\left/ {\vphantom {{\tau_{S} } {\tau_{P} }}} \right. \kern-\nulldelimiterspace} {\tau_{P} }}) \cdot q] \) ensures that \( p^{*} = r \). Depending on the tax rate differential, T can be negative.

  18. The same cost of capital is obtained if P Company’s pre-tax cash disbursement decreases to \( O_{P}^{ + } = O_{P} \cdot \left( {1 - \tau_{S} } \right) \). The group’s after-tax terminal value is then \( V = I_{S} \cdot (1 - \tau_{S} ) - O_{P} \cdot (1 - \tau_{S} ) \cdot q - \tau_{P} \cdot [T - O_{P} \cdot (1 - \tau_{S} )] \), and the cost of capital is derived by substituting O P with \( O_{P} \cdot (1 - \tau_{S} ) \) in Eq. (3).

  19. When the pre-tax cash flow is adjusted in country P, the tax-neutral transfer payment is \( T = O_{P} \cdot (1 - \tau_{S} ). \)

  20. The domestic investment’s cost of capital \( p^{*} = {r \mathord{\left/ {\vphantom {r {(1 - \tau_{P} )}}} \right. \kern-\nulldelimiterspace} {(1 - \tau_{P} )}} \) exceeds the cross-border investment’s cost of capital \( p^{*} = r \cdot (1 + \tau_{P} ). \)

  21. Intra-group dividends distributed by S Company to P Company are tax free (affiliation privilege).

  22. The same cost of capital is obtained if pre-tax cash receipts of P Company adjust to \( I_{P}^{ + } = I_{P} \cdot (1 - \tau_{S} ) \). The group’s after-tax terminal value is \( V = I_{P} \cdot (1 - \tau_{S} ) - O_{S} \cdot (1 - \tau_{S} ) \cdot q - \tau_{P} \cdot [I_{P} \cdot (1 - \tau_{S} ) - T] \), and the respective cost of capital is derived by substituting O S with \( O_{S} \cdot (1 - \tau_{S} ) \) in the brackets in Eq. (5).

  23. When the pre-tax cash flow is adjusted in country P, the tax-neutral intra-group transfer payment is \( T = O_{S} \cdot (1 - \tau_{S} ) \cdot q \).

  24. The US Congressional Budget Offices estimated that a switch from profit taxation to cash flow taxation reduced the compliance cost of companies from 40 bn to approximately 4–7 bn in 1988; see US Department of the Treasury (2007, p. 36).

  25. Under a cash flow tax with tax rate τ, the tax burden of company 1 that receives payment C1 is \( \tau \cdot C1 \). Company 2 that is supplied by company 1 and receives payment C2 pays a tax of \( \tau \cdot (C2 - C1) \). The total tax payment is \( \tau \cdot C2 - \tau \cdot C1 + \tau \cdot C1 = \tau \cdot C2. \) For diverging tax rates τ1 < τ2 = τ, the total tax burden decreases to \( \tau_{2} \cdot C2 - \tau_{2} \cdot C1 + \tau_{1} \cdot C1 < \tau \cdot C2 \). Because inputs are tax deductible, the cash flow tax is similar to the value added tax. However, the value added tax uses the input tax credit method and may operate with more than one tax rate (e.g., a zero tax rate and a reduced tax rate for certain types of consumptions) because taxes not collected early are collected later.

  26. The current criteria (Art. 5 OECD Model Treaty) do not capture cross-border trading; see Schön (2009, p. 100).

  27. See Crawford et al. (2010, p. 313), for comparable problems under the current value added tax.

  28. The President’s Advisory Panel on Federal Tax Reform (2005, p. 171), assumes the same position on the legal nature of a destination-based BCFT.

  29. See Grabitz et al. (2011, Art. 110, para. 15, Art. 111, para. 2).

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  1. Chair of Taxation, University of Mannheim, Schloss, 68131, Mannheim, Germany

    Ulrich Schreiber

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Schreiber, U. International business taxation and the business cash flow tax. Rev Manag Sci 7, 309–326 (2013). https://doi.org/10.1007/s11846-012-0089-6

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