Monday, October 05, 2015

The ludicrous farce of "arm's length" transfer pricing and "cost-sharing"

I'm currently teaching a class on U.S. international tax law, which has helped me to reconnect with nitty-gritty details of the existing rules that don't always feature in my (or other people's) analyses of broader conceptual issues in the field.  In a class that is coming up soon, we will be discussing the U.S. transfer pricing rules.

From a purely pedagogical perspective, when I read the recent case of Altera Corp. v. Commissioner, decided unanimously by 15 U.S. Tax Court judges on July 27 of this year, I felt like the recipient of a rare gift. Most of the transfer pricing cases are long, fact-specific, and based on past iterations of the transfer pricing regulations that the IRS and Treasury subsequently tried to fix. This tends to leave the cases' continuing precedential value and broader interest far too limited to justify spending a lot of the time on them in a 3-hours-per-week general survey course.

The frequency of changes to the relevant regulations reflects Rule 1 of U.S. transfer pricing litigation, which holds that the government always loses. (This is not quite literally true - but in the few transfer pricing cases that the government won there were generally egregious taxpayer blunders, unlikely to be repeated, such as failing to do anything to establish a proper fig leaf, and/or leaving memos in the files avowing an intention to use bogus transfer prices.)

By such standards, Altera is a dream case for three reasons. First, the regulations under which it was decided remain almost up-to-date. (They were issued in 2003, and subsequently revised in 2011, but not, it appears, relevantly to the main issue in the case.)  Second, Altera was decided on summary judgment, so its discussion and analysis almost exclusively pertain to broader legal issues, rather than to narrower factual ones. Third, there could be no better illustration than this case of the farcical nature of U.S. transfer pricing practice, and of the need for it to change.

I view Altera as a farce in three acts (more on this shortly), but this does not count the already farcical set-up. Section 482 of the U.S. Internal Revenue Code authorizes the Commissioner to restate the claimed terms of purported transactions between commonly-owned businesses if "he determines that ... [this] is necessary in order .. clearly to reflect ... income."  These words could hardly sound more deferential to the Commissioner's administrative discretion. But unfortunately, the regulations state that "the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer."

This is far more limiting that "clearly reflecting income," and can be read as suggesting a need to treat actual arm's length transactions between unrelated parties as relevant legal precedents for IRS transfer pricing determinations under section 482. Now, there is a huge literature about all this, which (in my reading, at least) has reached the predominant conclusion that an arm's length approach is completely useless, due to the both theoretical and practical problems that it faces. But for many in the field, adherence to arm's length appears to remain a matter of quasi-religious faith.

Altera itself concerned a regulatory election, under which U.S. taxpayers with foreign affiliates can opt to use an approach called "cost-sharing" for purposes of determining the applicable transfer prices within the group. In the typical case, a U.S. company with U.S. employees who live, say, in California or the Pacific Northwest is creating what it hopes will be valuable intellectual property (IP) that can be profitably exploited worldwide.  Cost-sharing is a device that they use to shunt as much of the overall profits as possible to tax haven subsidiaries in, say, the Cayman Islands.

Now, in the real world of transactions between unrelated parties there sometimes are actual "cost-sharing" agreements. For example, two companies with complementary skill sets might agree to collaborate on something that they hope will make them both a lot of money.  In such a case, they may agree that the ultimate profit split will be affected by how much $$ each of them has expended in the development process.

Then there is fake cost-sharing between affiliates, the topic of interest here. Back to our U.S. company. It has all the employees and all of the relevant skills for developing particular IP. But it creates a Caymans affiliate that, in substance, contributes nothing to the process. But the Caymans affiliate does indeed observably purport to contribute cash to help pay for developing the IP. Where did it get the cash?  Easy, the U.S. parent will typically have given it the cash, in exchange for all of its equity, so that the affiliate could hand the cash right back to the U.S. parent via the pretense of paying for a portion of the development costs. The Caymans affiliate may then get, say, 100% of the upside with regard to profits from selling the IP in all countries outside the U.S.

In short, the typical deal is like (one suspects) almost no actual cost-sharing arrangement in the history of arm's length transactions.  One party (the U.S. parent) contributes everything, while the second party (the Caymans sub) contributes nothing, except for giving back cash that the first party had placed in its bank account 5 minutes earlier.

It is already giving these transactions too much credit to say that the Caymans affiliate has effectively gotten the entire foreign "upside" in exchange for nothing. Its getting this upside (and thereby "bearing risk" regarding how great this will actually be) is completely meaningless, given common ownership. But in fact no party to a true arm's length cost-sharing arrangement would get the opportunity to make this sort of a deal. You don't get a piece of the upside without bringing something real to the table. So it's fundamentally ludicrous to look at actual arm's length cost-sharing deals for evidence of how a particular item within the broader deal ought to be treated in related-party arrangements.

Giving away all the foreign upside in exchange for nothing is already a nice feature of supposed cost-sharing arrangements between commonly owned affiliates. But it's better still if, contrary to the supposed logic of section 482 cost-sharing, you can also give disproportionate deductions to the U.S. affiliate. This further increases the proportion of taxable income that can be treated as arising in a tax haven, rather than in the U.S.

Taxpayers have assiduously pursued these opportunities. Earlier versions of the cost-sharing regulations had proven ripely exploitable, forcing the IRS to revise them, but it had also taken two beatings in prior litigation concerning the earlier regulations.

So the farce really started long before Altera. In Altera itself the legal issue was relatively narrow, although (as we will see) its implications are considerably broader. Taxpayers evidently saw how they could take advantage of the fact that common practice in the IP industry involves giving the "talent" incentive compensation. Stock options, for example - so that, if the engineering team contributes to hitting a home run, such that the value of the company's stock skyrockets, the members of the team will see the value of their compensation go up accordingly.

So the trick that taxpayers came up with was to argue that, under the cost-sharing regulations, this incentive compensation - often a huge piece of the overall development costs - should be excluded from those that the Caymans affiliate needs to "share."  This wouldn't matter economically, but it would permit the U.S. parent's taxable income to be lower, and the foreign affiliates' share to be higher, than if such costs were included in the cost-sharing formula.

Even before the final version of the 2003 cost-sharing regulations came out, it was clear that they would require including incentive compensation in the costs to be "shared." So the regulations would have to be invalidated in this regard, if the above plan was to work. Taxpayers therefore set up a farce that played out in the following 3 stages:

(1) The industry and its friends flooded the notice-and-comment process that gave rise to the 2003 regulations with extensive information documenting that true arm's length cost-sharing deals NEVER require the parties to share the cost of each other's incentive compensation.  They also explained why this was so. For example, it would give unrelated parties odd incentives, e.g., to try to drive down each other's stock price so that the costs one had to share would be lower.  Needless to say, these considerations don't actually apply to related party deals, where there is only one affiliated group, playing on both sides.

Also, the taxpayers of course made no effort to show (as would have been impossible) that arm's length parties would ever make a deal in which one side provides all the true assets, and the other gets a huge piece of the upside. For good measure, the taxpayers proffered remarkable statements by reputable leading experts, such as to the effect that there is no economic cost to a corporation or its shareholders of providing stock-based compensation. If this is true, I would like to offer $5 per firm for options just like those that high-end IP firms grant to their star employees.

(2) As no doubt was expected, the Treasury stuck to its guns in the final regulations. It kept the requirement that incentive compensation be included in cost-sharing.  In two important respects - each no doubt anticipated by the strategists on the other side - the way in which this was done placed the regulations in legal peril. First, the transfer pricing regulations as a whole continued to say that the standard in all cases is that of arm's length transactions between unrelated parties. There was no separate reliance on clear reflection of income. Second, the preamble to the regulations offered conclusory statements to the effect that the Treasury was simply unpersuaded by the evidence that taxpayers had offered in step (1) of the farce. The preamble did not carefully explain, for example, why the facts evinced concerning true arm's length deals had little bearing here, given other differences between the two settings. What made this unsurprising was common practice by the Treasury. Preambles generally are not written as litigation documents - although, after Altera, they probably will be - because the Treasury evidently believes (or has believed) that its seemingly broad administrative discretion makes this unnecessary.

(3) The final stage of the farce took place before the Tax Court in Altera. The taxpayer's litigators successfully peddled a dramatic story of stubborn regulatory high-handedness. In fact, what the Treasury had been guilty of was indifference to evidence that was logically irrelevant. But 15 Tax Court judges bought the story sufficiently to be unmoved even by the IRS argument that cost-sharing's elective character as a taxpayer method should make full adherence to "arm's length" unnecessary here, even if it is required elsewhere under the transfer pricing regulations.

Altera likely has broader implications for the tax regulatory process. Taxpayers will regularly flood the notice-and-comment process with evidence and arguments that the Treasury has now learned it will need to rebut expressly and extensively, such as in preambles to final regulations.  The point need not be to persuade the Treasury - just to delay it and raise the legal risks it faces. The preambles, or other published support for final regulatory pronouncements, will need to be written as litigating documents, in cases where a serious and well-funded legal challenge can be anticipated.

In addition, the transfer pricing regulations generally (i.e., not just in cost-sharing) are likely to be subject to multiple challenges.  These regs have developed over the years to have an ever more "formulary" character.  They set forth multiple approaches that look, say, at the profit split or rates of return being claimed by the different members of a commonly owned group. In many of these cases, taxpayers may be able to adduce evidence that, in arm's length deals of a seemingly (but not actually) similar character, particular aspects of a given formula are not in fact taken into account.  So the farce of existing transfer pricing practice has a good chance of getting a lot worse.

How the Treasury should respond to this is not entirely clear. But one thing they certainly should do is delete, as soon as possible, the statement in the regulations that arm's length, rather than clear reflection of income, applies "in every case."

There are also arguably broader implications for the ongoing BEPS process. Obviously, Altera is not a relevant precedent outside the United States. But it shows what can happen if one doggedly tries to apply arm's length "evidence" and reasoning outside their actual realm of economic meaningfulness and relevance.

Friday, October 02, 2015

Bankman-Shaviro article on Piketty's Capital in the 21st Century

These days virtual publication matters more than actual, so far as readership is concerned. But I'll nonetheless note that the article I co-authored last year with Joe Bankman, "Piketty in America: A Tale of Two Literatures," has now officially come out.  It's at 68 Tax Law Review 453-516 (2015).

The online version, differing little from the final one, is available here.

The Tax Law Review issue (vol. 68, #3) in which it appears contains all five of the papers from the symposium on Piketty's book, Capital in the Twenty-First Century, which took place here at NYU just over a year ago. The others are by Gregory Clark (with Neil Cummins), Wojciech Kopczuk, Suzanne Mettler, and Liam Murphy. There's also a response by Piketty that mainly covers some aspects of what he had in mind with the book.  He appears to have no quarrel with our commentary.

Thursday, October 01, 2015

Chirelstein memorial session

The Chirelstein memorial session at Columbia was quite nice. Lots of people have great memories of him, with complementary stories, and a very clear picture emerges of a unique and delightful man.

One thing we heard a lot about, at the session, was how much Chirelstein ostensibly liked students. He definitely liked teaching and performing. But one thing my group at Yale Law School - an extremely skeptical and hard-bitten group regarding most of our professors, but unabashed Chirelstein fanboys - most liked about him was that he wasn't cuddly or ingratiating or seeking our approval or friendship.  He seemed above all that - albeit wholly lacking (thank goodness) in Kingsfieldian pretense and pomposity.

Oddly, of the 8 speakers, only one of them (Stephen Cohen) was part of the tax world. We heard lots and lots about Chirelstein's engagement with colleagues concerning contracts (and also about his path-breaking corporate finance work), but very little about tax.

I'm not sure why there weren't more tax speakers - for example, his Columbia tax colleagues Graetz and Raskolnikov were there, not to mention his one-time Columbia tax colleague (and co-author) Zelenak. I also would have had plenty to say about Chirelstein, if I had been asked. But admittedly I was by no means an intimate of Marvin's, nor I suspect, were these other individuals.  The answer may be that Chirelstein preferred the contracts world and contracts people to those in tax, leading to closer personal connections there, by his choice.

Wednesday, September 30, 2015

Donald Trump tax plan: Is the glass 60% full or 40% empty?

From having seen preliminary revenue estimates of the Donald Trump tax plan, a rough back-of-the-envelope summary might conclude that it would reduce federal individual plus corporate income tax revenues, over a 10-year period, by about 40 percent.

A hater or "loser," I suppose, would say that Trump is proposing to go 40% of the way towards zeroing out the main source of federal government revenue, while also apparently planning to spend a lot of money on various things.

Or I suppose one could instead say: He's 60 percent NOT wiping out these revenues. After all, to drain 40% out of the glass is to leave 60% of it still there.

Perhaps a few tall shots of bourbon, from a 100% full glass, would be all that one needed to reach the conclusions that (a) these two alternative perspectives are equally valid, and (b) the second one is more uplifting and positive and nice. Why not be a yea-sayer, rather than a nay-sayer, when it's just two ways of saying the same thing?

All kidding aside, I am actually disappointed by the Trump tax plan. I had been wondering if he might actually live up to the hints he had been dropping that he didn't accept the Republican tax orthodoxy about adopting massive unfinanced and regressive tax cuts. But instead he just amped it up a few magnitudes. It's the already feckless Jeb Bush tax plan, converted into performance art.

What makes this all the more disappointing relates to the sense I had been getting that Republican voters, unlike Republican donors and elites, actually don't uniformly thrill to endless replays of George W. Bush 2001. And this may indeed still be true. But the Trump tax plan appears to rebut the premise that his being self-financing might lead to his exploiting the gap between the conservative elites and the Republican base on these issues. This is a shame because, in the long run, he might have helped to push the Republicans back towards the sort of empirically-based policy-making that they were engaged in as recently as the George H.W. Bush Administration (which, come to think of it, does not, these days, exactly stand as "recent" any more).

Letter to Congress on international tax policy

I've joined 23 other law professors, economists, and practitioners in signing this letter to Congress concerning international tax policy.  It argues against adopting a territorial tax system - especially if it's what I would call crude "cartoon territoriality," rather than a system that, whatever its name, seriously addresses profit-shifting and the use of tax havens to undermine U.S. tax revenues. It also calls for anti-inversion legislation, and criticizes both repatriation tax holidays (or deemed repatriations at too low a rate) and the proposed creation of a U.S. "patent box" regime.

Inevitably for a document with so many signatories, it doesn't convey the precise message and nuance that I might have chosen in a sole-authored letter. For example, while I'd like to repeal deferral and make U.S. companies' foreign source income currently includable, I would want the U.S. tax rate for such income to be significantly lower than that for U.S. source income, and I also don't believe in full foreign tax creditability. (See, for example, the brief discussion that I recently posted here.)

But one would never get 24 signatories, from the sorts of people (myself included) who signed this letter, without keeping it at a more general level that we all can accept, in the hope of maximizing the positive public impact. Insert here the standard reference to herding cats.

Memorial service for Marvin Chirelstein

This evening, at 6 pm, I will be paying my respects to the great Marvin Chirelstein by attending a memorial service in his honor that will be held at Columbia Law School. Details are available here.

Last February, I included some Chirelstein reminiscences here.  The comments on this post that several friends left are also worth checking - they contain more stories about him.

More Chirelstein stories are available at the Columbia website here.  Here are just a few of the most amusing bits:

One former Chirelstein student writes: I loved Chirelstein’s war stories, and his dry, oddball, self-effacing humor so much, I started jotting down his quotable quotes. Here are a few that folks may appreciate. On the first day of class: “Lectures stink, if you ask me. On the other hand, answering student questions takes a lot of work. It is far easier to fill an hour with babble, than answering your questions – which will be ill expressed.” On an opinion by Justice Stone: “Did Justice Stone write this opinion – he’s one of our boys, isn’t he? And we’re proud of him. Are we? I am. Whoever he was. Oh, there are portraits of him in the law school. Let’s adjourn and go look at his portraits. Handsome man that he was.” On an opinion by Justice Cardozo: “Cardozo’s language always makes me think of an overstuffed sofa. . . Unfortunately, Justice Cardozo's opinion contains so much soggy philosophy that its main thesis is difficult to locate. On his lecture: “Can you follow this lecture? I don't know how.” Reciting a problem in the casebook: “I can’t bring myself to recite it - it is so boring.” On the assignment: “Read these opinions with your eyes half-closed.” In response to a student question: “That’s the answer to your question. Don't ask anything further. Stifle your curiosity.” “This is what you have to know if you want to be a partner in the tax and estates department [chuckles] Pretty exciting life.” “You know what your trouble is? You don't smoke.” On a chart illustrating the operation of tax law: “My grandchild made this chart, which proves that Quintilian was right that a full deduction is the same as no tax on gain.” “As Leonidas said at the Battle of Marathon - the tax benefits are deferrable”

Another writes: You had the feeling he had just come from a smoke-filled boardroom where he was smoking a cigar and advising world leaders. It always seemed he was only sharing half of his wisecracks and secretly chuckling to himself at the rest while he weighed how much of his wit to share with the world. If I may add some quotes, which I still remember after 17 years... On the first day of class in 1997, "Welcome to law school. You are now middle-aged." On a complicated contract dispute between 2 parties: "Aren't you kind of starting to hate them both, Mr. Adams...?" On a contract case: "They had more printing machines than you could count in a week." On a litigant who had secretly obtained legal counsel, "Now this guy's been talking to a lawyer...can't you smell it?"

A third, who also had him for contracts, quotes him as saying: "Haven't you noticed that all these cases -- the pregnant cow, the tack in the blueberry pie -- all these cases have this dreamlike quality to them? It's like you're walking down the street and all the buildings are upside down but somehow that doesn't seem strange. Or you're underwater and yet you're breathing just as though it was the most natural thing in the world. In each of these cases there is something that is out of order and yet, you don't notice it. That's really all this course is about. There's not much to it really."

(What a contrast between this last one and the pomposity of, say, Professor Kingsfield in The Paper Chase - also a contracts teacher, but rather a more presumptuous one, not to mention lucky (if we ignore that he is a fictional character) to have predated the law and economics / law and other X, Y, or Z revolution that swept away the Kingsfieldian world, and yet that Chirelstein precociously understood and anticipated.)

Tuesday, September 29, 2015

A well-deserved honor / literary recommendation

A writer named Julie Schumacher has just won the 2015 Thurber Prize for American Humor by reason of her recent novel, Dear Committee Members. Among the better-known past winners are David Sedaris, Jon Stewart, the writers at the Onion, and Christopher Buckley.

I mention this because I've read Dear Committee Members and found it hilariously funny (the cliche "laugh-out-loud funny" was literally true).

The basic premise sounds like a stunt. It's not just an epistolary novel, but one consisting solely of letters of recommendation (for jobs, academic promotion, grants, etc.) penned by a creative writing professor who is cracking up. Try writing something like that, if you want a technical challenge. Yet Schumacher (apparently effortlessly) pulls it off, keeping the plot moving forward and drawing you in - aided, of course, by the fact that the lead character invariably writes wildly inappropriate letters that are quite unlikely to accomplish their apparent objectives.

Per the description at Schumacher's website:

Jason Fitger is a beleaguered professor of creative writing and literature at Payne University, a small and not very distinguished liberal arts college in the midwest. His department is facing draconian cuts and squalid quarters, while one floor above them the Economics Department is getting lavishly remodeled offices. His once-promising writing career is in the doldrums, as is his romantic life, in part as the result of his unwise use of his private affairs for his novels. His star (he thinks) student can’t catch a break with his brilliant (he thinks) work Accountant in a Bordello, based on Melville’s Bartleby. In short, his life is a tale of woe, and the vehicle this droll and inventive novel uses to tell that tale is a series of hilarious letters of recommendation that Fitger is endlessly called upon by his students and colleagues to produce, each one of which is a small masterpiece of high dudgeon, low spirits, and passive-aggressive strategies.

This is certainly accurate, but scarcely does justice to how delightful it is.  As someone else once said about a novel, it was "funny and fast-paced, a great summer quick read. I devoured it on a plane to [in my case, Santa Fe]."

Wednesday, September 23, 2015

Yogi Berra, public utility

Sad to hear of Yogi Berra's death, although I admit that I have never gone to the Yogi Berra Museum, despite its being just 12 miles past the Lincoln Tunnel.

The great quotes, many of which I gather he actually did say, are truly a cultural resource. Despite their over-familiarity, I couldn't resist opening my international tax book with one of them ("When you come to a fork in the road, take it"), and closing it with another ("It's hard to make predictions, especially about the future").  But my favorite is probably the justly famous restaurant quote ("Nobody goes there any more; it's too crowded"),

I'm old enough to remember Berra's baseball days, albeit just as a manager, not a player. I faintly remember the infamous Phil Linz harmonica incident while he was managing the 1964 Yankees, but he also was on hand for the Mets' dizzying charge to the 1973 World Series.  (Ed Kranepool once said, at a Mets fan club gathering I attended, that the Mets would have held on to defeat the Athletics had Yogi stuck with his initial plan to pitch George Stone in Game 6, and give the tired Tom Seaver an extra day of rest for Game 7 if needed, but who knows.)  I suppose his Mets connection made it easier for me to regard him as an actually benign part of what I otherwise (fairly or not) deem the toxic waste dump of Yankees history.

Thirty-five Yogi quotes are available here, and there are plenty more here.

Short international tax paper posted on SSRN

I have just posted on SSRN a short paper (less than 3,000 words) entitled "The Two Faces of the Single Tax Principle." It's available for download here.

I prepared it for a symposium, entitled "Reconsidering the Tax Treaty," that will be held at Brooklyn Law School on October 23, 2015. Registration info for this symposium is available here.

The abstract for the paper goes something like this:

This short paper ... examines the “single tax principle,” arguably underlying bilateral tax treaties, in connection with evaluating the treaties’ future role in the development of international tax law and policy. It distinguishes between “upside” departures from the single tax principle, which occur when the same dollar of income is taxed more than once, and “downside” departures, which occur when it is not taxed at all.

The paper argues that a focus on barring upside departures from the single tax principle can be quite misguided. While over-taxing cross-border activity, relative to that occurring in one country, may be undesirable, this should not stand in the way of letting residence countries tax foreign source income at a reduced rate, in lieu of wholly offsetting source country taxes via foreign tax credits. As for barring downside departures from the single tax principle, such as by addressing stateless income, while this often is desirable from a given country’s unilateral national welfare standpoint (and is even more clearly worth pursuing multilaterally), the issues raised are more complicated than adherence to the single tax principle might appear to suggest.

Tuesday, September 22, 2015

U.S. international taxation: source rules, the origin basis, and the destination basis

My last post offered a rumination prompted by my teaching a class in Corporate and International Tax Policy. This time around, the sand in the oyster (as I’d like to think) comes from teaching Survey of U.S. International Taxation.

Yesterday in this class, I was slogging through the main source rules in U.S. international tax law. These are the rules that determine, for U.S. income tax purposes, whether a given taxpayer has U.S. source income or foreign source income (FSI).

Foreign taxpayers are potentially taxable in the U.S. only on what we classify as U.S. source income. As for U.S. taxpayers, be they individuals or resident corporations, source matters because they need sufficient FSI to claim all otherwise available foreign tax credit. So U.S. taxpayers may actually not care about source determinations, if they do not have to worry about running into the foreign tax credit limitation. (In some settings, however, the factors that underlie source determinations overlap with something that typically matters a lot more – whether a given increment of income is going to be treated as U.S. source income of a U.S. entity, or FSI of an affiliated foreign entity.)

Anyway, teaching the source rules can be deadly for all concerned because the rules are so tedious and empty. They follow the usual “cubbyhole” approach of tax law – you have a bunch of categories, so for each item on your tax return you decide where to shove it, and that determines how the source question will be handled.

For example, the source of dividend and interest income depends (in the general case) on the residence of the payor. Dividends and interest paid by, say, Apple or GE yield U.S. source income, whereas those paid by, say, Tim Hortons or Siemens yield FSI.

For personal services, source depends on where you render the services. But for rents and royalties, it depends on where the use occurs. For sales of personal property (other than business inventory), it generally depends on the residence of the seller. For example, if I sell a painting the gain is U.S. source, but, if Pablo Picasso sells it, it’s FSI.

Ho-hum. A natural question to ask about these rules is why they come out as they do, and what they are trying to implement or accomplish. No short answer, of course, and even the long answers aren’t very satisfying. One of their annoying features in practice is that, in many cases, the same thing economically can be structured to fit into one cubbyhole or another.

A classic example that we discussed in yesterday’s class was the Wodehouse case. Yes, that Wodehouse – Pelham Grenville, aka P.G., aka Plum. While Wodehouse was living in the French Riviera (and/or in German prison camp after France fell in 1940), he wrote Uncle Fred in the Springtime – one of my absolute favorites, a hilarious masterpiece – and also Money in the Bank, which is great fun although not quite as top-drawer for him – and sold their North American (i.e., mainly U.S.) rights for $40,000 each. So what was the source of his income?

Economically, this really was income received for personal services. He sat there in his little French cottage (or the less commodious German arrangements that followed for him until 1945) and beavered away, so to speak, ultimately to the great joy of his many readers. This would mean that he had FSI, not taxable by the U.S. But as a matter of legal form this characterization had no chance.

A second view held that he was getting royalties for the U.S. use of the intellectual property that he had created through his labors.  This was also true, unless we adopt View #3 below, and it would mean that he had U.S. source income.

A third view held that he had sold personal property, i.e., his U.S. rights. At the time, this would mean he’d have FSI, as a foreign national selling such property. (The law has no changed since then, so that he would lose under this view because he was selling a piece of the copyright, rather than other personal property.)  But under tax law at the time, he would win if one regarded all of the North American rights, but no other rights, as sufficiently an item of separate “property” to avoid its being treated as a mere advance sale of royalties. Obviously, whenever one sells property that will yield expected rents or royalties, one is in effect selling them in one lump, and yet in some cases this works as a matter of tax characterization – e.g., to create capital gains rather than ordinary income, where that is the issue presented. (The inevitably unsatisfying line-drawing cases here assess when capital gains "carve-outs" will work for tax purposes versus not working.)

What are all these source rules even about? The framework I came up with, for purposes of trying to make it more than just a list, involved the distinction between origin-based and destination-based rules for carving up the tax base when there are multi-jurisdictional transactions.

Suppose initially that you have just one jurisdiction and no cross-border trade. So everything produced there is also consumed there. Each item’s point of origin – where it was produced – is the same as its point of destination – where it was consumed. Leaving aside the intertemporal issues raised by the choice between income taxation and consumption taxation, it makes no difference whether one taxes everything on the origin basis or the destination basis. The source of each item is the same either way.

Now suppose we allow for cross-border trade. Individuals who live in the jurisdiction now can swap some of their production for others’ production. Given trade’s reciprocity, the value of what they produce still equals (in market terms) the value of what they get to consume.  But tax bases defined, in source terms, using the origin basis and the destination basis tax bases no longer include exactly the same items. Exports but not imports are treated as domestic source via the origin basis, while imports not exports are treated as domestic source via the destination basis.

The equivalence underlies standard thinking about international trade. For example, export subsidies are pretty much the same as import tariffs. And this often has tax policy implications. For example, a destination-basis VAT is not distorting trade by reason of its exempting exports and taxing imports. By contrast, an origin-basis income tax that departs from its standard approach by including targeted export subsidies is getting just what it deserves when the World Trade Organization strikes down the subsidies.

How do the source rules relate to this? To some extent, they can be divided into those that are (at least kind of) origin basis, and those that are destination basis.

The rule that the source of dividend and interest income depends on the residence of the issuer makes these what I would call fake origin-basis rules. They’re origin basis in the sense that where the money came from – the residence of the counterparty that paid it to you, i.e., where it “originated” or the use of the underlying funds occurred – determines the source. What makes these rules only fake origin-basis is that there are need not actually be any significant connection connection between the payor’s formal residence (e.g., as a legal entity) and any actual set of facts about where the associated use of the underlying funds occurred.

The rule for personal services is clearly an origin-based rule. Wodehouse wrote his comic masterpieces in England and then France (before moving ultimately to Long Island), so that’s where the production occurred, and then his work was exported to the U.S. among other markets.

The rule for rent and royalties is, by contrast, a destination-based rule. Revenues from consumer use under the U.S. copyright to Uncle Fred in the Springtime would face a well-designed destination-basis U.S. VAT, but would not face income taxation here if we relied on where the production activity occurred.

Finally, the rule for sales of personal property is probably best-viewed as origin-based, insofar as it’s actually one or the other. It looks at the person who sold the property, and who thus perhaps “produced” the gain from sale (even if only in the sense of picking something that would appreciate in value). In a Wodehouse-type case, of course, this is especially clear, as he actually created the property that he is selling through his personal efforts.

It’s a truism that, for reasons I’ve discussed elsewhere, an income tax pretty much has to use the origin basis as its main method, whereas a consumption tax can use either the origin-basis or the destination-basis.  But nonetheless real world income taxes often use destination-basis rules, such as when determining the source of income from cross-border transactions. A good example, apart from certain of the source rules that I’ve discussed above, is the use of sales factors in formulary apportionment. These cause a business that is active in multiple jurisdictions to be taxed, in a given jurisdiction, based at least partly on its sales to consumers and others in that jurisdiction.

Why does the U.S., along with other countries in their source rules, build as much destination basis as it does into its source rules? Well, suppose initially we were thinking of this in a standard international trade context. Here it’s a bit like having an import tariff, on top of taxing domestic production even when exported. Import tariffs can be domestically popular, as a political matter, even when they’re good policy. But they can actually be good policy, from the standpoint of residents’ economic welfare, where the jurisdiction has market power, e.g., because importers would be enjoying rents (in the economic sense, as distinct from that of “rents and royalties” under the source rules). So one isn’t surprised to see, say, the U.S. adopting rules that might permit it to tax P.G. Wodehouse on his work in that French Riviera cottage, given that it led to the situation where U.S. consumers would pay for the reader’s privilege (at zero extra marginal production cost to him).

Does our mix between origin-basis and destination-basis source rules mean that we are effectively imposing tariffs on certain imports? Perhaps in some cases, but my sense of the rules’ overall tenor is somewhat different, for three main reasons.

First, destination-basis rules tend to apply to outbound as well as inbound transactions. Computer engineers in California who design IP to generate rents and royalties abroad would therefore be generating FSI even without access to the full panoply of tax planning tricks that have flourished in the last couple of decades.

Second, to the extent that different countries measure source consistently, the importer’s domestic source income under a destination-basis rule will be FSI in the exporting country. In such a case, the latter country may offer exemption or foreign tax credits that eliminates “double taxation” (or, more meaningfully, combined relative over-taxation).

Third, by structuring carefully, taxpayers have considerable ability to decide which rule will apply to their business income. Add in all the other tax planning opportunities that they have, and “stateless income” may loom considerably larger as an issue than tariffs. Indeed, even just the ability to choose between origin-based and destination-based rules may significantly move the effective overall regime in that direction.

Debt versus equity ruminations

One of the two classes that I’m teaching this semester, Corporate and International Tax Policy (the other is Survey of U.S. International Taxation) occasionally prompts me to think in general terms about familiar topics. Last week the topic was debt versus equity in the corporate tax setting.  Preparing for the class led me to think about the following:

It’s either a sign of mental health or schizophrenia – I’m not sure which – if you can believe two inconsistent things at the same time. This is very true of the tax policy issues raised by debt and equity, or more generally by the variegated taxation of financial instruments. Each of the two competing lead stories has some truth. Yet they can’t simultaneously be true (except each and inconsistently in part). And the truer one story is, the less true the other one is.

Idea 1 holds that the tax bias between debt and equity – usually, though not always, involving a relative tax preference for debt – creates damaging economic problems when people pick the wrong instrument (as judged on a pre-tax basis) for tax reasons. For example, excessive use of debt might create undue systemic default risk.

Idea 2 says instead: C’mon, people can make whatever economic arrangements they like, and label them “debt” or “equity” as they like.  It just takes a bunch of lawyers writing 12-factor memos and concluding that, more likely than not, the taxpayer’s preferred characterization of a given arrangement would stand up if closely examined by the IRS.  So the real problem isn’t economic distortion, given the fact that people can dress up their arrangements with whatever they like – it’s electivity of tax treatment.  For example, tax-exempts use “debt,” thereby zeroing out the entity-level tax on their share of the business income. Meanwhile, taxables, if their marginal rate exceeds that at the entity level (which lowering the corporate rate would make far more common) use “equity” and avoid owner-level realization, thus electing into a lower tax rate environment.

Obviously, these two stories can’t both be entirely true at the same time – they contradict each other.

Relatedly, here are two different ways of viewing the universe of financial instruments:

Idea 1 holds that 2 fixed points, classic fixed return debt and classic common-shares equity, retain enormous importance in financial markets, thus creating the above-referenced Idea 1 distortions.

Idea 2 holds that financial instrument choice is an undifferentiated, multidimensional continuum.  For example, how fixed versus variable, on the upside and the downside, is the expected return? Options, default risk, payment variables, etcetera, can all result in slicing and dicing this pretty fine.  Likewise, classic differences between “debt” and “equity” such as enforceability for the former and voting power for the latter can perhaps be made to vary continuously in their actual economic significance.  With a multidimensional continuum in which investors can point whatever point they like, a one-dimensional “debt versus equity” continuum may be unlikely to affect them very much, other than in requiring that they pay lawyers (along with accountants and others) to fine-tune things, and accept perhaps a very slight risk of serious IRS challenge.

The two Idea 1’s reinforce each other, as do the two Idea 2’s. The analytical problem is that, while both sets of ideas appear to have some truth, each undermines the other. So even if we agree (as I do) that we have a debt-equity problem, it’s not entirely certain just how (as a matter of relative weighting for the two sets of competing concerns) we should think about the problem.