Why Corporate Tax Residence Is a Myth

Corporate inversions have captured the imagination of the public and the popular press as well as that of the academic community. The idea is that a little paperwork can convert a U.S. corporation (which pays tax on its worldwide income) into a foreign corporation (which pays tax only on its U.S. source income), and the consensus is that the exploitation of this loophole by multinational corporations is abusive and unfair. Responding to these concerns, Congress and the Treasury Department have attempted to make it more difficult for U.S. multinationals to obtain tax advantages by inverting.

Numerous commentators have argued that the problem behind the inversion phenomenon and other maladies of the current international corporate tax regime is a flawed definition of corporate residence. Consequently, they have proposed alternative tests that look to factors other than place-of-incorporation, such as management and control or the location of the corporation’s home office. However, the literature has hitherto failed to address what I believe to be the fundamental questions that must underlie any discussion of corporate tax residence. First, why is residence a relevant attribute when determining tax liability? Second, is the concept of tax residence applicable to the corporate entity? Instead, the tacit assumption underlying the discourse is that the concept of residence is in principle applicable to corporations and that it is the task of commentators and policy makers to formulate an appropriate test by which to determine the residence of corporations.

My argument is that such an assumption is unwarranted and that tax residence is an attribute of individuals only, inapplicable to the corporate entity. Note that the argument is not semantic. I am not arguing that as nonphysical beings corporations cannot “reside” in a place in the same sense that natural persons can. Rather I argue that the distinction between residents and nonresidents derives from the need to delineate the universe within which certain norms of distributive justice operate and that, as the nature of the corporate entity precludes its membership in any scheme of distributive justice, the categories of “resident” and “nonresident” are inapplicable to it.

The preliminary question is why residence is a relevant attribute in determining the tax liability of individuals. The role played by residence in international taxation is a function of the normative underpinnings of home-country taxation. Contemporary literature justifies the income tax by reference to the principle of ability-to-pay, the idea that those who are better off should contribute more to the provision of services for the general welfare than do those who are less well-off. Why they should do so is a question to which supporters of ability-to-pay taxation offer various answers. Some rely on utilitarianism and the decreasing marginal utility of money; some refer to the fairness principles of philosopher John Rawls; others mention sacrifice theory, and still others invoke intuitionism, which holds that fundamental principles are known directly by intuition. However, whatever its philosophical justification, ability-to-pay taxation concerns the welfare of the various members of the collective, the conflicting claims to material resources held by various members of the collective, and the rights and obligations of those who are better off vis-à-vis those who are not as well off.

The fact that income tax derives from the concept of ability-to-pay has an important ramification in the international arena. If the appropriate measure of ability-to-pay is accession to wealth, then tax liability must be a function of worldwide income, and not merely of domestic-source income. In contrast, benefit theory has a difficult time justifying the imposition of tax on foreign-source income.

The concept of ability-to-pay is meaningless without delineating the parameters of the collective: whose welfare, whose needs, whose claims, and whose resources are relevant? Although the contour of the relevant collective is a contentious issue in social philosophy, national legislatures adopt the approach that the norms of distributive justice apply to the members of the society and not to outsiders. Consequently, domestic law distinguishes between members (usually referred to as residents) and outsiders (usually referred to as nonresidents). While there is no universally accepted criterion by which countries make this distinction, the common denominator of all such criteria is that they reflect a personal attachment to the society in question: habitual abode, personal and social attachments, and domicile.

The goal of the tax system and of the services that it funds is to promote the welfare of residents. The welfare of nonresidents is not an essential element in the matrix. When a nation imposes tax on or provides services to nonresidents, the purpose is not to include them within the ambit of its distributive justice scheme. It taxes nonresidents because it can thereby relieve its own residents of some of their tax liability. It provides nonresidents with services to encourage investment from which it hopes its residents will benefit. The taxation of nonresidents derives from the principles not of distributive but rather of commutative justice.

Thus, for individuals, residence means a personal connection significant enough that one’s welfare is properly taken into account as part of the matrix of distributive justice and that one is therefore properly subject to taxation in accordance with the principles of ability-to-pay. The question we now need to examine is whether the concept of residence is applicable to corporations.

Residence is a matter of whose welfare is important. Therefore, when we ask which corporations are residents and which are not, we are effectively asking which corporations’ welfare should constitute part of the matrix by which we determine economic and social policy. Phrasing the question in this manner underscores the absurdity therein. A corporation is not a sentient being. Well-being, in the sense that is relevant to distributive justice, is not an attribute of juristic entities.

Furthermore, the principle of ability-to-pay applies to those with substantial personal connections to the country concerned. Purely economic connections, however extensive, are in themselves insufficient to invoke the rights and obligations of distributive justice. Of course, the fact that economic connections cannot serve as the basis for individual residence does not mean that economic connections cannot serve as the basis for the imposition of tax. A country has the right under international law to charge nonresidents for access to its territory and its markets. In the field of income taxation, this means that countries have the right to impose tax on nonresidents for income derived from domestic sources. They do not have the right to impose tax on the foreign-source income of nonresidents.

Corporations have no personal connections. Due to its nature as a juristic person, the only type of connection that a corporation can have with a country is economic. The country with which it has such a connection may impose tax on the income that the corporation derives from its economic involvement with the country. However, because an economic connection by itself is insufficient to establish a right to impose tax on foreign-source income, there can be no justification for imposing tax on a corporation’s foreign-source income. An individual’s business life – the location of her investments and her business interests, where she works, and so forth – determines where she is subject to territorial taxation. An individual’s business interests, however extensive, are by themselves insufficient to trigger residence and to subject the individual to tax on foreign-source income. In contrast, corporations have no personal lives; they have only business lives. Therefore, a proper analogy would lead to the conclusion that corporations should be subject to territorial taxation wherever they have economic interests and should nowhere be subject to worldwide taxation. In other words, the ontological nature of a corporation precludes it from being a resident of any country.

On a deeper philosophical level, taxation in accordance with ability-to-pay, much more so than competing theories, reflects Immanuel Kant’s imperative to treat rational beings not merely as means but always also as ends. However, corporations are not rational beings in the Kantian sense of the term. They do not exist as ends in themselves, but are rather means for the furthering of human welfare. The Kantian moral duty to respect the humanity in every person – the basis of his categorical imperative – does not impose the moral duty to respect the humanity of a corporate entity.

The academic, political, and popular discourse regarding corporate residence in general and corporation expatriation in particular rests upon a faulty premise. Because the concept of residence is inapplicable to corporations, the distinction between domestic corporations and foreign corporations is incongruous for tax purposes. However, it is crucial in this context to distinguish between corporations and their shareholders. In contrast to the corporation in which they own shares, individual shareholders can be residents of a country. As such, and in accordance with the principle of ability-to-pay, resident shareholders would need to account for their accession to wealth derived from shareholding. The question is how best to do so.

In the domestic arena, the corporate income tax effectively operates as an indirect tax on shareholders. In the international arena, imposing tax on the corporate entity as a proxy for taxing individual shareholders is not a feasible solution. A country would need to tax the worldwide income of every corporation on the planet or at least of every corporation that has at least one domestic shareholder. Even if it were within the power of a country to impose and enforce a worldwide corporate income tax, such a tax would constitute unjustifiable overreaching.

Current law distinguishes between domestic corporations and foreign corporations and imposes tax on the worldwide income of the former and on the domestic income of the latter. The problem with this approach is that residents who own shares in a “foreign corporation” (however defined) effectively escape tax on their accession to wealth attributable to the corporation’s foreign earnings, and nonresidents who own shares in a “domestic corporations” (however defined) are effectively subject to U.S. tax on income that is not earned in the U.S.

The corporate tax regime confronts an irresolvable predicament in the international arena. Residence is a fundamental concept in the field of international taxation, but the idea of residence is inapplicable to corporations. It is no wonder that the current international corporate tax regime has proven unworkable and the reform proposals – which continue to rely upon the concept of corporate residence – fair little better. Consequently, there is no feasible alternative other than to abandon the current international corporate regime and replace it with one that focuses on individual shareholders – to whom the concept of residence is applicable – rather than on corporations. A detailed proposal for such a regime is far beyond the scope of this post. What I can do here is describe in broad outline the most fundamental issues that such a regime would face and suggest how it might go about dealing with those issues.

The first issue that a shareholder-focused international corporate tax regime would need to confront is how to determine the income of resident shareholders. Publicly traded shares present the fewest problems in this regard, as shareholders’ accession to wealth can be calculated mark-to-market. Residents who own shares in a closely-held corporation could provisionally be taxed on their proportionate share of the corporation’s earnings with a final reckoning when the shares are eventually sold. If a closely-held corporation does not prepare financial statements, does not calculate its income in accordance with U.S. tax principles or does not permit U.S. tax authorities to audit its books, there may be no option other than to defer the determination of the shareholders’ accession to wealth and the payment of tax until the shares are sold. However, in such a case, the shareholder should be subject to an interest charge to compensate the government for the deferral.

The second issue that the proposed international corporate tax regime would need to confront is the treatment of nonresident shareholders. Enforcing a direct tax on nonresident shareholders for their accession to wealth attributable to the corporation’s domestic income is likely to prove impractical. Consequently, taxing nonresidents on their domestic income probably requires the imposition of a territorial tax on the corporate level. As the sole intended targets of the corporate-level tax would be nonresident shareholders, the corporate tax rate would equal the rate applicable to nonresident individuals who derive U.S.-earned income. Furthermore, a corporation all of whose shareholders were U.S. residents would be exempt from the tax, as would a corporation all of whose nonresident shareholders agreed to file U.S. tax returns and to pay U.S. tax on their share of the corporation’s U.S.-earned income.

The third issue would be avoiding double taxation when U.S. residents own shares in a corporation that is itself subject to income tax. This would best be accomplished by granting resident shareholders a credit equal to their proportionate share of the tax paid by the corporation.

In summary, corporate personhood is a legal fiction, useful in some contexts, less so in others. Corporate residence is not a legal fiction. It is an oxymoron, an attempt to assign to corporations an attribute that contradicts their fundamental nature. Residence delineates the boundaries of taxation in accordance with ability-to-pay, and ability-to-pay is a concept that is inapplicable to the corporate entity.

Because residence is such a fundamental concept in international taxation, the incongruity of corporate residence undermines the current international corporate tax regime. There is no realistic alternative other than imposing tax directly on resident shareholders, while retaining a territorial corporate income tax as a means of taxing foreign individuals who indirectly derive income from domestic sources.

The current international corporate tax regime has proven unworkable in practice. To a great extent, the seemingly insurmountable challenges encountered by the current regime – such as expatriation and the exploitation of foreign subsidiaries – are simply practical manifestations of a flaw in the underlying theoretical framework. Abandoning the concept of corporate residence is the most thematic and most effective way to reform the international corporate tax regime.

This post comes to us from David Elkins, a professor at Netanya School of Law in Israel and a visiting professor at Tulane University Law School. It is based on his recent article, “The Myth of Corporate Tax Residence,” available here.