Basic Choices in Considering Reform

In this chapter we explain the broad approach taken in the two detailed proposals set out in Chapters 6 and 7, namely the RPAI and DBCFT respectively. We discuss the extent to which international coordination would be required, or desired. We then consider the costs of transition to a new system. In broad terms, we can compare incremental reforms which are based on the existing structure, with more fundamental reforms that more radically change that fundamental structure. We also discuss what should be required in terms of revenue requirements, and the likely redistribution of revenues among countries. We then discuss two issues which are common to the two options: the scope of the tax and the concept and definition of destination.

Residual Profit Allocation by Income

This chapter sets out our first detailed reform proposal: the Residual Profit Allocation by Income (RPAI). This is one of a family of schemes based on separating multinational profit into ‘routine’ and ‘residual’ profit, a distinction that exists under the current system. The RPAI allocates the right to tax routine profit to the country where functions and activities take place. It allocates the right to tax residual profit to the market, or destination, country where sales are made to third parties. We evaluate the RPAI against our five criteria. We conclude that while it is far from perfect, it performs well against these criteria. Its superior performance stems primarily from allocating taxing rights for residual profit to the destination country, where there is a relatively immobile third party purchaser of goods and services sold by the company.

Key Issues in Taxing Profit

This chapter sets out the key conceptual issues that arise in designing a business-level tax on profit in an international setting. It is in four parts—each addressing a basic question. First, what is meant by a tax on profit? We identify different approaches to taxing profit and show that there are a number of equivalences between taxes. Second, what criteria should be used for evaluating a business-level tax on profit in an international setting? We set out five criteria in some detail: economic efficiency, fairness, robustness to avoidance, ease of administration, and incentive compatibility. Third, given these criteria, is a business-level tax on profit a useful addition to the set of taxes that can be employed by national governments? We consider different possible underlying rationales for taxing business profit, especially in an international context. Fourth, is taxation at both the business and the owner-level problematic? We consider whether there is need for relief from this form of double taxation.

The Current International Tax Regime

This chapter describes and evaluates the current regime for taxing the profit of companies in an international setting. It explains its basis in domestic law and international treaties and sets out three of its distinguishing features: the distinctions between residence and source, between active and passive income, and its basis of separate accounting. At the time of writing the existing regime is undergoing a sustained period of review and reform, although this has so far resulted mostly in the introduction of a number of new rules and a tightening of existing rules. We evaluate the current regime in the context of the five criteria set out in Chapter 2. We also briefly review further reform proposals that are currently being considered.

Destination-Based Cash Flow Taxation

This chapter sets out and evaluates our second main proposal: the Destination-based Cash Flow Tax (DBCFT). This has two basic components: (a) a ‘cash flow’ element, which gives immediate relief to all expenditure, and (b) a ‘destination-based’ element, which introduces border adjustments of the same form as under the value added tax (VAT): exports are untaxed, while imports are taxed. This is equivalent in its economic impact to introducing a broad-based, uniform rate VAT and making a corresponding reduction in taxes on wages and salaries. A central motivation for the DBCFT is to improve economic efficiency by taxing business income in a relatively immobile location; the DBCFT should not distort either the scale or the location of business investment. It also has the considerable advantage of being robust against avoidance through inter-company transactions.

Fundamental Reform Options

This chapter sets out and evaluates a number of possible reform options; we group options by four broad locations in which profit could be taxed. First, profit could in principle be taxed in the country of residence of the owners of the business. A second option is the country of residence of the parent company or business headquarters. A third option is the country where the business undertakes its functions and activities, or where its assets—defined broadly to include financial assets—are held. We refer to this location as ‘origin’. And finally, a business could be taxed in the location of its customers. We refer to this location as ‘destination’. Each of the activities taking place in these four locations might be thought to be necessary, but not sufficient, for the generation of profit, and therefore generate a nexus which would justify taxation. We evaluate specific options according to the five criteria set out in Chapter 2.

Introduction

The key problems confronting the international tax system are introduced in this chapter—including problems of tax avoidance through shifting profit to low tax countries, distortions to international investment and trade created by the existing system, and two different forms of competition between countries. The main ideas of the book are introduced, including the approach of the book which addresses the issue of designing an international tax system on business profit from first principles. It explains the key direction of reform—moving to allocating tax rights to the country in which businesses sell their goods and services.