University of London THE DILEMMA OF INTERNATIONAL TAX ARBITRAGE: A COMPARATIVE ANALYSIS USING THE CASES OF HYBRID FINANCIAL INSTRUMENTS AND CROSS-BORDER LEASING SHAY NISAN MENUCHIN A THESIS SUBMITTED TO THE DEPARTMENT OF LAW OF THE LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE FOR THE DEGREE OF DOCTOR OF PHILOSOPHY LONDON, UK. 2005 UMI Number: U615868 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI U615868 Published by ProQuest LLC 2014. Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code. ProQuest LLC 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 % \jtyraty •0 Abstract My thesis addresses the question of International Tax Arbitrage (“ITA”). The discussion is comparative in nature, covering the United States and the United Kingdom. The study builds a foundation to discuss cross-border transactions where the laws of more than one jurisdiction apply to the transaction in question. Weighing the intervention of national revenue authorities in these transactions requires us to look also at the different background and policy objectives of each country, including the varying tax incentives that exist in each jurisdiction and the attitude of each country towards cross-border transactions. ITA is a situation whereby a given taxpayer structures her affairs in a way that allows her to follow and comply with the tax laws of two or more jurisdictions while receiving a tax advantage without any net investment as a result of inherent inconsistencies between the tax laws of the different jurisdictions, thus reducing her overall world tax rate. I focus on the question whether taxpayers should be allowed to exploit inherent differences between the tax rules of different jurisdictions. I discuss this question both at the practical level and at the policy level. To properly answer this important question, we need first to determine what are the relevant policy considerations that should be taken into account. In this analysis, attention has to be given also to considerations that are not always included in the analysis, like foreign policy and political considerations, including in the UK, the impact of EC law on tax policy. Once the considerations have been identified, it is necessary to apply them to the situation at hand. In the thesis, I explore the different considerations both independently and in relation to specific case studies and develop an approach to analyze the appropriateness of ITA in given situations. 2 Acknowledgements..........................................................................................................4 Chapter 1 - The Dilemma in its Legal Context...........................................................7 The Hypothesis..............................................................................................................7 Working assumptions...................................................................................................8 The Case studies............................................................................................................8 The Analysis..................................................................................................................9 Appropriateness and the coherence of the system....................................................12 International Law.........................................................................................................16 Chapter 2 - The Traditional Arguments...................................................................23 The Efficiency Debate................................................................................................23 The Equity Debate......................................................................................................31 Graetz’s Critique and the International v. National Level Discussion...................38 Competitiveness..........................................................................................................43 Summary......................................................................................................................52 Chapter 3 - Additional Policy Considerations.........................................................54 Competitiveness, harmful tax competition & cooperation......................................54 Revenue Loss........................................................................... 59 Unintended Result.......................................................................................................63 Chapter 4 - Practical Considerations.........................................................................65 Foreign Policy..............................................................................................................65 Political Considerations..............................................................................................67 Implementation............................................................................................................71 Chapter 5 - Background to the Case Studies............................................................73 United Kingdom................................................................ 73 United States................................................................................................................96 Chapter 6 - Hybrid Financial Instruments.............................................................114 The Traditional Distinction Between Taxation of Debt and Equity & Its Rationale 116 Hybrid Financial Instruments...................................................................................122 United Kingdom........................................................................................................127 United States..............................................................................................................146 Summary.....................................................................................................................164 Chapter 7 - Cross-border leasing..............................................................................168 Background................................................................................................................168 Reasons for entering into a leasing transactions.....................................................170 The Double-dip.......................................................................................... 176 UK - Characterization and capital allowances.........................................................181 US - Characterization and depreciation deductions................................................188 UK - Cross-Border Leasing - Specific Measures...................................................197 US - Cross-border Leasing - Specific Measures.....................................................204 Summary....................................................................................................................208 Chapter 8 - Discussion................................................................................................210 Applying to the case studies.....................................................................................221 EC law and the UK...................................................................................................242 Conclusions...................................................................................................................246 BIBLIOGRAPHY........................................................................................................249 TABLE OF CASES....................................................................................................257 3 Acknowledgements A few years ago, while I was working at Ernst & Young I realized that I wanted to write a dissertation. Some time later, I came across an article by H. David Rosenbloom on International Tax Arbitrage. I found it stimulating and I could really relate to it because arbitrage formed part of my practice. A year after that, I moved to the UK, came to the LSE and registered as a PhD student and started my journey. All this would not have been possible without the help of my supervisor, Dr. Ian Roxan, who managed to challenge me intellectually in ways I had not anticipated. His vast knowledge and intellect made every meeting a challenge that I really enjoyed. Our discussions were inspirational and covered many different subjects, even the proper use of the English language, an area that I as a foreigner found very interesting and challenging. I am indebted to Professor Philip Baker, an inspirational lecturer and a person of many skills who allowed me to participate in his classes on international tax law and EC tax law and who treated me as if I was his student. His knowledge, wisdom and advice have been invaluable. I would like to thank Professor John Avery Jones and the trustees of the Avery Jones Award and the LSE Research Studentship fund for their generous support in my project throughout the period. In addition, I would like to thank IFA for inviting me to present my thesis as a poster during the 2003 congress in Sydney, to IFA London Congress Trust and LSE for their support in financing the trip to Sydney and to the IBFD for inviting me to participate in their second annual PhD in tax students meeting in Amsterdam. I would also like to thank Professor Michael Lang and the members of the Austrian and International Tax Institute in Vienna for giving me the opportunity to participate as a Marie Curie Fellow in International Taxation. During my stay in Vienna I was fortunate to work with Professor Lang and with his colleague Judith Herdin on the general report to the 2004 IFA Congress in Vienna. I would also like to thank my good friend and colleague, Yariv Brauner, for his suggestions and advice regarding my research in US tax law and to George Pitsilis for the discussions on EC tax law. 4 A special thanks also goes to my old professor and friend, Professor Mike Oberst from the University of Florida, who gave me the tools to read, interpret and understand US tax law and inspired me with his dedication and love of teaching. All this would not have been possible without the support and love of my friends and family. I would just mention Tamar who has been by me throughout the process, and my family - my sister, my grandmother and above all, my dear parents to whom this work is dedicated. Without them there would be nothing. In the First Book of the Kings we are told about the story of Saul who went to search for his father’s asses and found kingship. During my journey I have discovered that it is all about the search and less about what we eventually find. Thanks to those I mentioned above, I had a very interesting and challenging journey. London, UK April 2004 Naturally I take responsibility for any remaining errors. For consistency, I have used US spelling throughout, except in quotes from sources using British spelling. “Everything is economics but economics is not everything. ” Paul Krugman 6 Chapter 1 - The Dilemma in its Legal Context The Hypothesis The hypothesis I shall use for this chapter and for the thesis in general is a two-fold hypothesis that was presented by Rosenbloom as follows:1 “International tax arbitrage is the natural response of taxpayers to the normal differences that occur between any two tax systems. As such, it does not represent a problem, or at least no adequate explanation for why it is a problem has yet been given, other than invoking an “international tax system ” that does not exist. Moreover, even if international tax arbitrage were a problem, in the current and any reasonably likely future of the world, no solution is likely to be available. Therefore, tax policymakers should not bother to try to combat international tax arbitrage, and should repeal those provisions (such as the dual consolidated loss rules) that are inspired by the desire to prevent it.”2 The starting point is that there are differences between the different tax systems, differences that are to a large extent, the result of the different background, policies and development of each of these tax systems. For many years these systems evolved separately without any connection between one and the other. To a large extent these systems are based on different sets of principles and policies. Even when some of these principles and concepts may share the same name, often their applications may nevertheless be completely different in each jurisdiction. In addition, since different tax systems are to a large extent based upon and interpreted by different sets of legal and interpretation rules, different attitudes are adopted in different countries with respect to questions of tax avoidance, tax mitigation and statutory interpretation. As a result, similar transactions may be treated completely differently by different jurisdictions.3 The rapid changes in the world’s economy challenge many of the existing concepts of taxation in general and of international taxation in particular. As a result of the growth in international trade and commerce, the deregulation of many of the existing local markets and the globalization of the financial markets, trade and commerce become global issues regardless of whether the different tax systems are able to deal with such development.4 1 As summarized by Avi-Yonah (1999-2000) who commented on Rosenbloom’s article (1999-2000) on the issue. 2 Avi-Yonah (1999-2000). 31 explain this point further in the case studies below. 4 Roxan (2003b). 7 The outcome of such development is an ever-increasing interaction between different tax systems in ways that were not perceived until now. The existing concepts or policies are no longer able to deal successfully with many of the issues that resulted from such development. Some of the problems are new problems but most of them are merely a development of existing problems. The result can be either single, double, triple or no taxation of the same income. This outcome can be achieved either intentionally, in cases where the taxpayer is planning her affairs in a way that will ensure non-taxation of the income, or unintentionally, in cases where the tax outcome is just the normal consequence of the business transaction or activity that took place. ITA, for that purpose, is one of several possible outcomes. Its uniqueness is in the fact that the benefit is obtained from the difference between the tax systems. In this work, I intend to examine the features of ITA and it appropriateness as a “side effect” of the unfinished process of globalization which we are in the midst of. Working assumptions For the purpose of the discussion I shall make certain assumptions to narrow the scope of the discussion to the more interesting elements of ITA. First, while it is possible that ITA will result in double and even triple taxation that in certain cases may not be relieved through the use of the existing tax relief mechanisms, the discussion below is focused on the other side of the coin. That is, ITA that results in double non-taxation or in some other tax advantage, as opposed to a tax disadvantage. Second, while certain ITA situations are the result of inadvertent or unintentional operations, the ITA that I shall focus on in this thesis is ITA that is obtained intentionally (or if to be more blunt - deliberately) by the taxpayers in order to achieve the desired tax advantage. This, however, does not mean that the taxpayer has no other business reason in structuring the transaction. The Case studies The aim of this paper is not only to look at the immediate question of ITA but also to examine existing policy considerations through the use of ITA. To make the discussion more focused I chose to use two case studies that illustrate the dilemma of ITA and to relate the discussion to two jurisdictions, the US and the UK. In addition to the general discussion of 8