Valparaiso University Law Review

Volume 47
Number 1 pp.313-355
Fall 2012
Closing International Loopholes: Changing the
Corporate Tax Base to Effectively Combat Tax
Avoidance
John T. VanDenburgh
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Recommended Citation
John T. VanDenburgh, Closing International Loopholes: Changing the Corporate Tax Base to Effectively Combat Tax Avoidance, 47 Val. U.
L. Rev. 313 (2012).
Available at: http://scholar.valpo.edu/vulr/vol47/iss1/8
313
CLOSING INTERNATIONAL LOOPHOLES:
CHANGING THE CORPORATE TAX BASE TO
EFFECTIVELY COMBAT TAX AVOIDANCE
I. INTRODUCTION
NoTax is a publicly traded technology corporation that deals
primarily with internet-based services and products. NoTax is
headquartered in California, incorporated in Delaware, and does the
majority of its business within the United States. In 2010, NoTax
reported three hundred and fifty million dollars in worldwide revenue
to its shareholders and reported a net income of one hundred million
dollars to the IRS. NoTax paid the standard 35% federal tax rate, or
thirty-five million dollars, to the IRS. Subsequently, NoTax’s president
and board of directors decided to hire a group of tax consultants and
attorneys to see if there was a way to reduce their corporate tax. In 2011,
NoTax reported approximately the same level of revenue and business
to its shareholders but reported a much lower net income and only paid
around two million dollars to the IRS. NoTax did not physically move
its headquarters, change its products, or cut any employees. How was it
able to cut its corporate taxes by nearly thirty-three million dollars?
NoTax employed a complex scheme of tax planning strategies to
manipulate its financial records, take advantage of international tax
loopholes, and avoid paying U.S. taxes. Even more remarkable, NoTax
was able to do this primarily with paper transactions that are completely
legal.1
Many U.S. corporations have started using similar tax avoidance
strategies to reduce their corporate tax.2 These strategies have become a
problem in the last few decades because of the globalization of the world
economy, improvements in technology, and increased tax competition.3
1 NoTax is a fictional company. The author of this Note created this hypothetical to
explain the concept of international tax avoidance.
2 “Tax avoidance” refers to the legal strategies corporations employ to get around
paying taxes, as opposed to “tax evasion,” which refers to the avoidance of tax obligations
through illegal means. See JANE G. GRAVELLE, MAJOR TAX ISSUES IN THE 111TH CONGRESS,
CONG. RESEARCH SERV. 13 (May 6, 2009), http://royce.house.gov/uploadedfiles/
major_tax_issues_in_the_111th_congress.pdf (explaining the major differences between tax
evasion and tax avoidance techniques); see also Michelle Hirsch, Tax Havens: Offshore
Operations Cost U.S. Billions, FISCAL TIMES, Sept. 7, 2010, http://hsgac.senate.gov/public/_
files/071708PSIReport.pd (noting that eighty-three out of the largest one hundred publicly
traded U.S. companies have subsidiaries in countries with lower corporate tax rates than
the United States).
3 See Reuven S. Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the
Welfare State, 113 HARV. L. REV. 1573, 1575–76 (2000) (discussing the increased mobility of
capital from technology advances, which has led to international tax competition because
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314 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
Most of these methods involve setting up a shell corporation—a
corporation with no operations or assets—as a subsidiary in a lower tax
jurisdiction and then manipulating the parent corporation’s financial
records to show that the income was earned by the shell subsidiary
outside of the United States.4 What these corporations are doing is
technically legal, but only because of the difficulty of applying U.S. tax
law to other sovereign countries.5 There have been many attempts to try
to fix this current tax avoidance problem while keeping the same tax
base, but these have all proved to be ineffective, which is evident from
the alarming number of corporations that are employing tax avoidance
schemes.6 Tax avoidance strategies are causing the United States to lose
companies can easily shift capital to low-tax jurisdictions). Tax competition in this context
refers to countries lowering their tax rates to make it more desirable for corporations to do
business in their country. Id. See also Jason Bordoff & Jason Furman, General Essay,
Progressive Tax Reform in the Era of Globalization: Building Consensus for More Broadly Shared
Prosperity, 2 HARV. L. & POL’Y REV. 327, 328 (2008) (explaining that tax reform might be
necessary with recent changes in the economy); Timothy V. Addison, Shooting Blanks: The
War on Tax Havens, 16 IND. J. GLOBAL LEGAL STUD. 703, 711 (2009) (discussing several
reasons for why tax havens exist); Diane Ring, Who is Making International Tax Policy?:
International Organizations as Power Players in a High Stakes World, 33 FORDHAM INT’L L.J.
649, 702 (2010) (explaining why some countries lower their tax rates).
4 See Press Release, The White House, Executive Office of the President, Leveling the
Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs
Overseas, May 4, 2009, available at http://www.whitehouse.gov/the_press_office/
LEVELING-THE-PLAYING-FIELD-CURBING-TAX-HAVENS-AND-REMOVING-TAXINCENTIVES-
FOR-SHIFTING-JOBS-OVERSEAS/ [hereinafter Press Release] (providing
examples of several problems that exist under current U.S. law and describing proposals to
fix each problem).
5 See Ilan Benshalom, The Quest to Tax Financial Income in a Global Economy: Emerging to
an Allocation Phase, 28 VA. TAX REV. 165, 166 (2008) (noting how the corporate structure has
changed because of changes in the global economy); Diane M. Ring, What’s at Stake in the
Sovereignty Debate?: International Tax and the Nation-State, 49 VA. J. INT’L L. 155, 156–57
(2008) (explaining the link between sovereignty and international tax laws). Countries are
not able to enforce their tax laws in other sovereign states because those sovereign states
represent the supreme source of the law on internal matters, such as corporate taxation. Id.
at 160. See also David R. Tillinghast, Issues of International Tax Enforcement, in THE CRISIS IN
TAX ADMINISTRATION 38, 38–42 (Henry J. Aaron & Joel Slemrod eds., 2004) (discussing a
number of challenges facing the IRS in enforcing U.S. tax laws in foreign jurisdictions, as
well as the complexity of the Tax Code and the difficulty in obtaining financial
information). See generally Nancy Birdsall, Asymmetric Globalization: Global Markets Require
Good Global Politics, (Ctr. for Global Dev., Working Paper No. 12, 2002), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1106282 (explaining how the global
economy has made it more difficult to enforce tax laws).
6 See Ilan Benshalom, Sourcing the “Unsourceable”: The Cost Sharing Regulations and the
Sourcing of Affiliated Intangible-Related Transactions, 26 VA. TAX REV. 631, 642–44 (2007)
(explaining the Arm’s Length Standard as one attempt to prevent corporate tax avoidance
through the use of subsidiaries); see also Tracy A. Kaye, The Regulation of Corporate Tax
Shelters in the United States, 58 AM. J. COMP. L. 585, 588–92 (2010) (describing the judiciary’s
development of different common law doctrines to combat tax avoidance, such as
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billions of annual tax dollars that could be used to pay off the current
budget deficit.7 Allowing corporations to escape paying U.S. taxes when
they actively derive benefits from the U.S. market is unacceptable.8 The
attempts and proposals to fix this problem through legislation have
focused on creating laws to force corporations to stop manipulating their
net income; however, the more effective method to combat this issue
might be changing the tax base altogether.9 This Note proposes that the
United States needs to change the current tax base so that corporations
no longer have the incentive to manipulate their financial information.10
First, Part II of this Note briefly provides a historical context of the
U.S. corporate tax, presenting relevant background information, theories
for and against taxation, and popular techniques used by corporations to
avoid tax.11 Next, Part III offers an analysis of the current tax base and
“substance over form,” “step-transaction,” “business purpose,” and “economic
substance”); Abrahm W. Smith, Tax Dodgers Beware: New Foreign Account Tax Compliance
Legislation, 84 FLA. B.J., July–Aug. 2010, at 52–53 (explaining legislative attempts by the
Obama Administration to correct the tax avoidance problem); Anthony D. Todero, Note,
The Stop Haven Abuse Act: A Unilateral Solution to a Multilateral Problem, 19 MINN. J. INTL. L.
241, 258–60 (2010) (examining the Stop Tax Haven Abuse Act (STHAA), which was another
attempt to prevent corporations from establishing tax havens).
7 See Frederick J. Tansill, Asset Protection Trusts (APTS): Non-Tax Issues, ST012 A.L.I.-
A.B.A., in INT’L TRUST & EST. PLAN. 293, 309 (2011) (noting how President Obama’s
administration had clear plans to crack down on tax avoidance to pay for the U.S. deficit);
see also Lilian V. Faulhaber, Sovereignty, Integration and Tax Avoidance in the European Union:
Striking the Proper Balance, 48 COLUM. J. TRANSNAT’L L. 177, 179 (2010) (explaining that tax
avoidance is a problem, not only in the United States, but also in the European Union);
Hirsch, supra note 2 (explaining that U.S. multinational corporations are collectively
avoiding anywhere between $10 billion and $60 billion a year in taxes by shifting their
earnings on paper to overseas subsidiaries); Anup Shah, Tax Havens; Undermining
Democracy, GLOBAL ISSUES, http://www.globalissues.org/article/54/tax-havensundermining-
democracy (last updated July 12, 2009) (explaining some effects that tax
havens are having on the U.S. economy).
8 See infra Part II (discussing the benefits theory of taxation). The U.S. companies that
are using these tax avoidance strategies are taking advantage of the benefits that the U.S.
market provides. Id. See also Jennifer Barton, Comment, Running from the United States
Treasury: The Need to Reform the Taxation of Multinational Corporations, 43 J. MARSHALL L.
REV. 1041, 1051 (2010) (noting the need for reform in the corporate tax structure because of
tax avoidance issues).
9 See I.R.C. § 11 (2006) (containing the current tax base for corporations—net income);
Rachelle Y. Holmes, Deconstructing the Rules of Corporate Tax, 25 AKRON TAX J. 1, 2 (2010)
(noting that most proposed solutions to the tax problem are structural, including statutory
changes to stop companies from using loopholes); see also infra Part IV (proposing a change
in the tax base, thus altering the way that companies are taxed altogether, rather than
adding new laws to the already complicated Tax Code).
10 See infra Part IV (explaining how changing the tax base to corporate revenue will
decrease the incentive to shift income abroad and avoid paying U.S. taxes).
11 See infra Part II (providing relevant background information on U.S. corporate
taxation, as well as describing popular tax avoidance methods and previous legislation).
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its weaknesses.12 Further, Part III illustrates the potential effects of
failing to change the tax base in the near future.13 Finally, Part IV
proposes a change of the tax base that will take away corporations’
incentives to manipulate their financial records and that will fairly tax
corporations based on the benefits they derive from the U.S. market,
which will lead to a much more efficient and profitable U.S. economy.14
II. BACKGROUND
Despite recent legislative changes aimed at stopping U.S. corporate
tax avoidance and President Obama’s full commitment to reforming the
corporate tax system, many corporations continue to use aggressive tax
planning to circumvent much of their corporate tax obligations.15 There
is difficulty in making effective legislative changes, because there are
many problems with the U.S. corporate tax base—or general pool of
wealth to which tax liability is imposed.16 Currently, the U.S. corporate
tax base consists of net income, which is calculated by taking revenues
and adjusting for (subtracting) expenses, interest, depreciation, taxes,
and amortization. Corporations are presently able to manipulate their
12 See infra Part III (analyzing why the current tax base has led to corporate tax
avoidance).
13 See infra Part III (presenting the possible effects on the U.S. economy of continuing to
allow corporations to legally avoid paying taxes).
14 See infra Part IV (proposing a change to the current tax base that will eliminate the
corporate incentive to transfer income abroad in order to avoid paying U.S. taxes); see also
The World’s Largest Economies, ECONOMYWATCH.COM (June 30, 2010),
http://www.economywatch.com/economies-in-top/ (noting the profitability of top
economies in the world).
15 See Holmes, supra note 9, at 2 n.3 (explaining some recent prevalent recommendations
for changing the U.S. tax system); Kaye, supra note 6, at 594 (explaining the emergence of
the American Jobs Creation Act of 2004, which enacted new penalties, strengthened
disclosure requirements, and changed substantive law against tax shelters); David J. Lynch,
Does Tax Code Send U.S. Jobs Offshore?, USA TODAY, Mar. 21, 2008,
http://www.usatoday.com/money/perfi/taxes/2008-03-20-corporate-taxoffshoring_
N.htm (“‘Big businesses will always look for ways to skirt the tax code. An
Obama administration will close loopholes and will tighten (IRS) enforcement so
companies cannot go around tax regulations,’ says Bill Burton, a spokesman for the Obama
campaign.”).
16 See BLACK’S LAW DICTIONARY 1599 (9th ed. 2009) (defining the tax base as the “total
property, income, or wealth subject to taxation in a given jurisdiction; the aggregate value
of the property being taxed by a particular tax”); Melissa J. Morrow, Comment, Twenty-Five
Years of Debate: Is Acquisition-Value Property Taxation Constitutional? Is It Fair? Is It Good
Policy?, 53 EMORY L.J. 587, 591 (2004) (“The tax base is the ‘assessed value’ of the taxable
property.”).
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net income, because it is separately reported to the IRS, and there is no
incentive for them to keep this figure high.17
Before analyzing the benefits associated with changing the corporate
tax base, Part II.A of this Note provides the key history of the corporate
tax, highlighting the major theories supporting why corporations should
be taxed.18 Next, Part II.B lays out the basic framework of how
corporations are taxed in the United States.19 Part II.C then examines the
major tax avoidance techniques that corporations use, providing a more
in-depth context of these techniques by looking at what Google does to
reduce its taxes.20 Then, Part II.D briefly mentions four of the most
popular proposals to fix tax avoidance in the United States.21
A. The History of the Corporate Tax
The corporate tax was first enacted in 1909 on corporate income to
provide support for a general individual income tax on citizens.22 The
goals of this tax were: (1) to provide the government with knowledge
about profits in order to prevent the abuse of power; (2) to raise
additional revenue; (3) to supervise corporations; and (4) to discourage
excessive borrowing.23 Many corporations challenged the tax in court,
17 See infra Part III (analyzing the problems with the current tax base); see also MICHAEL
MAZEROV, STATE CORPORATE TAX SHELTERS AND THE NEED FOR “COMBINED REPORTING” 1
(CTR. ON BUDGET & POL’Y PRIORITIES 2007), available at http://www.cbpp.org/files/10-26-
07sfp.pdf (advocating for combined reporting); Michael J. McIntyre, Paull Mines & Richard
D. Pomp, Designing a Combined Reporting Regime for a State Corporate Income Tax: A Case
Study of Louisiana, 61 LA. L. REV. 699, 702–05 (2001) (examining the benefits of a combined
reporting regime for corporations at the state level).
18 See infra Part II.A (providing the key history of the corporate tax and highlighting the
major theories supporting why corporations should be taxed).
19 See infra Part II.B (laying out the basic framework of how corporations are taxed in the
United States).
20 See infra Part II.C (providing a more in-depth context of the major tax avoidance
techniques by specifically looking at what Google does to reduce its taxes).
21 See infra Part II.D (defining four of the most popular proposals to fix the U.S. tax
avoidance problem).
22 See Corporate Tax Act of 1909, Pub. L. No. 61-4, § 38, 36 Stat. 11, 112 (establishing the
corporate tax by creating an excise tax for corporations measured by corporate income); see
also Steven A. Bank, Entity Theory as Myth in the Origins of the Corporate Income Tax, 43 WM.
& MARY L. REV. 447, 464 (2001) (noting that there were several motivations for the first
corporate income tax); Jane G. Gravelle, The Corporate Income Tax: A Persistent Policy
Challenge, 11 FLA. TAX REV. 75, 78 (2011) (explaining that there was support for the income
tax because it taxed the wealthy, reduced the concentration of power, and provided for a
flexible revenue source).
23 See W. ELLIOT BROWNLEE, FEDERAL TAXATION IN AMERICA: A SHORT HISTORY 50–52
(1996) (highlighting how corporations originally fit into the U.S. tax policy); SIDNEY
RATNER, TAXATION AND DEMOCRACY IN AMERICA 280–83 (1980) (providing a detailed
account of the congressional deliberations that lead up to the Corporate Tax Act of 1909).
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because they thought the government was overstepping its boundaries,
discouraging the corporate form, and killing the profit motive.24 The
Supreme Court upheld the tax, reasoning that it was an appropriate tax
on the privilege of doing business in the corporate capacity.25
Then, in 1918, the taxation of international income began with the
Revenue Act of 1918, which allowed a credit against U.S. income for
taxes paid by a U.S. corporation to any foreign government on income
earned outside the United States.26 In 1928, the League of Nations
created the first model bilateral treaty agreement, giving a corporation
relief from being taxed twice on income earned abroad.27 Subsequently,
in 1934, the Supreme Court decided, in Helvering v. Gregory, that a
corporation could not simply “reorganize” for tax purposes and that
24 See Gravelle, supra note 22, at 78–79 (noting some general reasons why many people
opposed the 1909 corporate income tax); Marjorie E. Kornhauser, Corporate Regulation and
the Origins of the Corporate Income Tax, 66 IND. L.J. 53, 125 (1990) (illustrating some of the
objections to the corporate income tax in 1909).
25 See Flint v. Stone Tracy Co., 220 U.S. 107, 176 (1911) (upholding the corporate excise
tax in its entirety); see also Kornhauser, supra note 24, at 118 (explaining that the Corporate
Tax Act of 1909 was challenged immediately after it was enacted, but a decision by the
Supreme Court was not rendered until 1911).
26 See Revenue Act of 1918, ch. 18 §§ 222(a)(1), 238(a), 240(c), 40 Stat. 1057, 1073, 1080–82
(1919) (providing a foreign tax credit for individuals and a similar credit for domestic
corporations and describing creditable taxes). The Revenue Act of 1921 limited this foreign
tax credit so that it could not exceed the amount of the U.S. tax liability on the taxpayer’s
foreign source income. Revenue Act of 1921, ch. 136 §§ 222(a)(5), 238(a), 42 Stat. 227, 249,
258 (1923). This limitation was intended to ensure that U.S. companies and individuals
could not use foreign taxes to reduce or eliminate U.S. taxes on U.S. source income. Id.
27 See Michael J. Graetz & Michael M. O’Hear, The “Original Intent” of U.S. International
Taxation, 46 DUKE L.J. 1021, 1023 (1997) (explaining the importance of the League of
Nations’ 1928 model bilateral income tax treaties); C. John Taylor, Twilight of the
Neanderthals, or Are Bilateral Double Taxation Treaty Networks Sustainable?, 34 MELB. U. L.
REV. 268, 270–71 (2010) (providing a brief history of bilateral tax treaties as a model to
relieve corporations from double taxation). Double taxation refers to instances where
income is taxed by one jurisdiction and then taxed again by another jurisdiction. Id. For
example, if country A taxes a corporation at a rate of 35% on income because the income
was earned in its county, and then country B taxes the same income by that corporation at a
rate of 30% because that corporation is a resident of country B, then the corporation is
forced to pay an astronomically high total effective tax rate of 65% on that net income. See
infra part II.B (explaining in more depth source income and residence income). One way
that countries eliminate double taxation is by cooperating with each other through bilateral
tax treaties. See also Sunita Jogarajan, Prelude to the International Tax Treaty Network:
1815–1914 Early Tax Treaties and the Conditions for Action, 31 OXFORD J. LEGAL STUD. 679, 680
(2011) (noting that there are over three thousand bilateral tax treaties in the world
currently). The common bilateral tax treaties account for double taxation by making it so
that one country agrees unilaterally not to impose tax on income earned in another
country, reducing the amount of tax payable in their country for any tax paid in another
country on the same income, or by allocating taxation rights from different types of
incomes between the different countries. Id. at 683.
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there must be a business purpose for the corporate reorganization
outside of saving on corporate taxes.28 This decision was particularly
important because it was the first decision addressing corporate
techniques to avoid paying taxes.29 The international income tax regime
has remained reasonably intact, despite the growth of the economy,
increases in technology, and the globalization of business.30
Throughout history, the U.S corporate income tax has been based on
the benefit theory of taxation, which indicates that corporations should
be taxed because they take advantage of the benefits that the state
provides.31 The United States taxes corporations under this theory in
28 Gregory v. Helvering, 293 U.S. 465, 469 (1935) (holding that the transfer of the original
corporation’s assets to the shareholder did not qualify as reorganization because it was a
“mere device which put on the form of a corporate reorganization as a disguise for
concealing its real character”). The Court further held that there had to be a business
purpose for the reorganization and not just the benefit of saving on taxes. Id.
29 Id. Though it was not a decision regarding corporations using international law to
avoid taxes, the decision represented the Court’s stance that business decisions should not
be made for the sole reason of avoiding taxes. Id. These types of decisions affect the
business market and make it less efficient. See Donald C. Lubick, Remarks to the Tax
Executives Institute, reprinted in FOUNDATIONS OF INTERNATIONAL INCOME TAXATION 19–21
(Michael J. Graetz ed., 2003) (explaining different policy goals in the area of international
taxation). The goals of having an efficient market, market neutrality, and a competitive
market sometimes conflict, and the goal is to find to what extent taxation can be reduced to
stay competitive internationally while not distorting business decisions based on this
reduced taxation. Id. The author then explains the two major types of efficiency norms
that exist in the market: (1) capital import neutrality (CIN) and (2) capital export neutrality
(CEN). Id. at 21. See also William B. Barker, International Tax Reform Should Begin at Home:
Replace the Corporate Income Tax with a Territorial Expenditure Tax, 30 NW. J. INT’L L. & BUS.
647, 654 (2010) (explaining that an efficient tax is a neutral tax, which does not change the
relative price of goods or services).
30 See Avi-Yonah, supra note 3, at 1575–76 (explaining how technological advances have
led to a much more global economy); see also MICHAEL J. GRAETZ, FOUNDATIONS OF
INTERNATIONAL INCOME TAXATION 4 (2003) (noting that the basic framework of the
international structure remains the same as it did in the early 1920s). The author explains
that the basic international tax structure has not changed, because it has never proved to be
a barrier to the international flow of goods, services, or capital. Id. See generally Holmes,
supra note 9, at 3 (noting that the only two major changes in international tax law came in
the form of the Revenue Act of 1962 and the Tax Reform Act of 1986).
31 See Reuven S. Avi-Yonah, International Taxation of Electronic Commerce, 52. TAX L. REV.
507, 521 (1997) (explaining the Benefits Principle, which gives the right to tax active
business income primarily to the source jurisdiction, while the right to tax passive
investment income is assigned primarily to the residence jurisdiction); Jeffrey M. Colón,
Changing U.S. Tax Jurisdiction: Expatriates, Immigrants, and the Need for a Coherent Tax Policy,
34 SAN DIEGO L. REV. 1, 11 (1997) (“The theoretical basis for source and trade or business
taxation is that the United States has provided the benefits that generated the income.”);
Steven A. Dean, More Cooperation, Less Uniformity: Tax Deharmonization and the Future of the
International Tax Regime, 84 TUL. L. REV. 125, 144 n.79 (2009) (explaining that source income,
or income earned in one country, is based on the notion that the government has the right
to collect tax revenues by providing the services that make the creation of that underlying
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two different ways: (1) on the benefits resulting from being incorporated
in the United States, or residence based tax; and (2) on the benefits that
corporations receive from using the U.S. market to derive their income,
or source based tax.32 Examples of some of the benefits that U.S.
corporations receive include the: transportation facilities, infrastructure,
education system, labor force, financial institutions, customer base, and
stock markets.33 The basic framework of the U.S. tax system follows this
theory and taxes corporations based on their residence and whether their
income is derived within the United States.34
income possible); Edward A. Zelinsky, Citizenship and Worldwide Taxation: Citizenship as an
Administrable Proxy for Domicile, 96 IOWA L. REV. 1289, 1293–94 (2011) (maintaining that
source based taxation reflects the notion that a certain tax jurisdiction provides benefits that
protect income and assets maintained in that jurisdiction); see also Peggy B. Musgrave,
Interjurisdictional Equity in Company Taxation: Principles and Applications to the European
Union (2000), reprinted in FOUNDATIONS OF INTERNATIONAL INCOME TAXATION 6 (Michael J.
Graetz ed., 2003) (explaining that a jurisdiction should be able to charge a tax to pay for the
services that it renders).
32 See Deborah A. Geier, Letter to the Editor, Time to Bring Back the “Benefit” Norm?, 102
TAX NOTES 1155, 1157 (2004) (advocating the benefits theory of taxation because of the
exploitation of the U.S. economic system); Majorie E. Kornhauser, Choosing a Tax Rate
Structure in the Face of Disagreement, 52 UCLA L. REV. 1697, 1708 (2005) (“[B]enefit taxation
underlies international tax principles that allow both the country of residence and the
source country to tax income.”); Herwig J. Schlunk, Double Taxation: The Unappreciated
Ideal, 102 TAX NOTES 893, 895 (2004) (explaining the two types of taxation and analyzing
them under the benefits theory); see also infra Part II.B (explaining the framework of U.S. tax
policy, specifically residence and source based taxation).
33 See Ruth Mason, Tax Expenditures and Global Labor Mobility, 84 N.Y.U. L. REV. 1540,
1553–54 (2009) (explaining some of the benefits conferred on corporations associated with
source based taxation, including human resources, natural resources, infrastructure, and
markets); see also Musgrave, supra note 31, at 6 (explaining the more complicated benefits
that come from source and residence based income). A company may also benefit by
having a lower intermediate goods cost, which in turn lowers the total cost of production.
Id. Benefits also arise when the government contributes capital to the capital of the
corporation in order to generate a profit. Id. But see Nancy H. Kaufman, Fairness and the
Taxation of International Income, 29 LAW & POL’Y INT’L BUS. 145, 184–85 (1998) (comparing
principles of source based taxation to those of benefit theory taxation).
34 See GRAETZ, supra note 30, at 5 (2003) (distinguishing between residence and source
taxation). There is much difficulty in defining residence and source, which creates
problems in international taxation. Id. See also Stephen E. Shay, J. Clifton Fleming, Jr. &
Robert J. Peroni, “What’s Source Got to do With It?” Source Rules and U.S. International
Taxation, 56 TAX L. REV. 81, 90–92 (2002) (explaining that source based taxation represents
the price paid for access to state markets, while residence based taxation represents the
benefits associated with being a citizen of that state).
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B. Basic Corporate Taxation Framework
There are two major types of taxation systems for international
corporations: (1) the territorial system and (2) the worldwide system.35
The territorial system, also known as the source system, taxes income
that is derived within a particular country.36 This means that a
corporation is taxed by a country if the corporation earns its income
within the country’s borders,