Essays in Honor of Roy Bahl
Edited by Richard M. Bird and Jorge Martinez-Vazquez
Chapter 5: Territorial versus worldwide corporate taxation: Implications for developing countries
Global investment and cross-border enterprise in low-income countries (LICs) mean that effective taxation of foreign investors is of increasing importance to their economies. This is particularly true in light of the fact that corporate income tax from all sources constitutes on average a more significant part of domestic revenue in low-income countries than in advanced economies – even after the widespread introduction of the VAT across most low-income countries. It is thus of considerable concern that the historical framework for cross-border income tax arrangements, which began to evolve in the early 20th century to handle income flows between advanced economies, appears increasingly poorly suited to allow low-income countries effectively to generate tax revenues from profits on foreign direct investment. Several factors contribute to this: (1) bilateral double taxation treaties can be used to strip taxable income from source (host) countries and move it to low tax jurisdictions; (2) the existing transfer pricing methodology is difficult for low-capacity countries to implement effectively – leading to calls by some academics and CSOs for the abandonment of the “arm’s length” method of splitting profits in favor of “formulary apportionment” (or “unitary taxation”); (3) taxation of indirect gains related to assets located in a source country are typically not captured domestically, when the direct transfer occurs elsewhere; and (4) – the subject of this chapter, with less clear implications for low-income source countries – the trend to shift from “worldwide” taxation to “territorial” taxation – the latter being a framework in which only the source country has jurisdiction to tax profits deemed to arise there.
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