Credit vs Exemption: a discussion crossing the Atlantic

Jurisdictions generally adopt two ways of reducing or eliminating the double taxation of income, namely the exemption method, whereby the income is exempted from tax altogether (although income may be taken into account for the purposes of calculation of the tax payable) or the credit method, whereby the foreign income is taxed but the foreign tax is credited against the final tax payable (1). There are jurisdictions, such as the Netherlands, that have been historically strong advocates of an exemption system in direct investment. There are other countries, such as the US, that have backed the idea of worldwide taxation (including their CFC rules) coupled with a credit system. There are several other jurisdictions that just follow the direction of the wind!

A lot of discussion in the tax community is presently coming out of a possible U.S. move from the present credit system to a territorial/exemption system, whereby income from active business operations in foreign countries, whether carried on directly or through a subsidiary would be exempt from US tax. This discussion are linked to the Advisory Panel on Federal Tax Reform recommendations released on 1 November 2005.

A recent paper by Lawrence Lokken "Territorial Taxation: Why Some U.S. Multinationals May Be Less Than Enthusiastic About the Idea (and Some Ideas They Really Dislike)" is a very interesting reading because it provokes a discussion on the current state-of-play of comparing the complex and intricate US credit system with an exemption system. This paper by Prof. Lokken (from whom I learned in Leiden the few things I know about US International Taxation) proposes very practical and plausible adjustments to the current credit system that could perhaps remove some of the existing problems and therefore pose an alternative to maintain a credit system.

But let's assume that the wind changes and the US would go ahead and move towards an exemption system. This move would likely affect or even accelerate a similar shift by other credit countries in Europe, such as the United Kingdom. One thing is granted and that is that the debate on credit/exemption has re-started. Other considerations in Europe are also placing the credit system under close scrutiny. For example, a recent opinion by the ECJ Advocate General suggested that the failure by the UK to extend tax exemption to dividends received by a UK company from a company in another EU Member State would be possibly contrary to EU law. This seems to suggest that only an exemption system of double tax relief may ultimately prove compatible with the EC Treaty. But that is another (long) story with strong crosswinds!

(1) For the ones intersted, I recall reading a UK consultation paper back in 1999 that served as a starting point for a discussion on the policy issues underpinning the systems of double taxation relief. A good reading with somewhat narrow conclusions.