Neither rules nor standards.

• Author: Dean, Steven A.
• Position: Challenge of double taxation.

Specifying the content of a requirement or a prohibition up front--e.g, replacing a "reasonable speed" requirement with a fifty-five miles per hour speed limit--can make life easier for enforcers and citizens alike. Recent efforts to substitute international tax rules for decades-old standards may do just the opposite, jeopardizing the "miracle" that is today's international tax regime. Enhanced information exchange and formulary apportionment will undermine the legitimacy that is essential to the success of any international legal regime. A better solution would overhaul the century-old benefits principle to weave enforcement deep into the fabric of the international tax regime. Only then will it meet today's tests as successfully as it once rose to the challenge of double taxation.

INTRODUCTION

H.L.A. Hart observed that the laws that govern our behavior draw strength from principles that operate unseen in the background. As he put it, the spark of "rules of recognition" can transform a lifeless "regime of primary rules" into a dynamic "legal system." (1) Without more than a mere collection of rules to guide them, he concluded that a community would stagnate, unable to shed outdated requirements or to embrace new constraints when needed. (2)

For international law, Hart concluded that his insight offered grounds for both optimism and pessimism. On the one hand, "the absence of an international legislature, courts with compulsory jurisdiction, and centrally organized sanctions" does not necessarily mean that international law cannot exist. (3) On the other, he suggests that crafting a principle--"a basic rule of recognition"--sufficient to assuage "doubts about the legal 'quality' of international law" would be tantamount to catching lightning in a bottle. (4)

International taxation demonstrates the truth of both perspectives. No World Tax Organization exists, (5) yet a skein of treaties and laws lays claim to the title of "international tax regime" and forms a bulwark against double taxation. (6) As a result, what should be an intractable problem--allocating global tax revenues among sovereign states--has been anything but. (7) The benefits principle (8) may not be the catalyst Hart believed capable of transforming an assemblage of international tax rules into a vital system of laws, but the success and stability of the international tax regime over nearly a century suggests that it comes close. (9)

Unfortunately, unlike a true basic rule of recognition, the benefits principle has not helped the international tax regime evolve over time. (10) The resulting mismatch between the demands made of the international tax regime and its capacity has rendered it impotent in the face of today's challenges. (11) The ongoing struggle to replace the international tax regime's standards with rules will only accelerate that failure. (12)

The international tax regime has no shortage of problems or proposed remedies. (13) Today, the solutions tend to bet on the precision of rules. Transnational enterprises remain square pegs to the round holes presented by national corporate taxes. (14) Formulary apportionment--the chief rival of the more established arm's length method of allocating corporate profits among jurisdictions--promises the clarity and ease of administration transfer pricing has long denied taxpayers and tax administrators. (15) Seeking to dispel the threat posed by tax havens, enhanced information exchange offers tax administrators hope that they may soon receive the same predictable diet of insight regarding the behavior of taxpayers from abroad that they obtain domestically. (16)

Although not characterized in such terms, both reforms seek to replace a standard (the arm's length method and treaty-based information exchange) with a rule (formulary apportionment and enhanced information exchange). (17) In theory, trading standards for rules has much to recommend it. (18) The classic illustration (19) of the ex ante clarity that rules offer is the contrast between a fifty-five miles per hour speed limit and a standard that imposes a requirement of "reasonable and prudent" driving speeds. (20)

In the current international tax context, it is easy to conclude that both taxpayers and tax authorities would find a shift towards rules appealing. (21) Nevertheless, the pivotal role legitimacy plays in eliciting compliance from sovereign states makes such a transition treacherous. Apparent advantages could prove disastrous if the very clarity for which rules are prized exacts a high price in legitimacy. (22)

The allure of rules may merely draw states into legitimacy traps, sapping strength from--rather than lending strength to--the mechanisms that constitute the international tax regime. (23) For example, enhanced information exchange catalogues the information that states should be--but are not--providing to one another, casting a harsh light on the limits of states' commitment to international tax cooperation. (24) Memorializing largely aspirational information exchange requirements in a detailed legal document simultaneously reveals the potential of the international tax regime and exposes its shortcomings. Revealing precisely how far the regime's mechanisms fall from the ideal may do more to discourage states' compliance than improved clarity ever could to promote it. (25) As this Article shows, such legitimacy traps represent a grave threat to the continued vitality of the international tax regime.

The Article begins by describing the headwinds faced by tax authorities in enforcing the corporate and individual income taxes. Part I considers the impact of corporate income shifting and individual tax evasion and the trend towards addressing each with rules rather than standards. Part II shows why efforts to replace standards with rules are misguided. Both offer advantages, but neither rules nor standards can thrive without legitimacy.

Part III considers the importance of legitimacy--and its decline--for the international tax regime and describes the dynamic that produces legitimacy traps. Part IV proposes resolving those legitimacy traps by replacing the benefits principle with the benefits and burdens principle. As its name suggests, the benefits and burdens principle enriches the standard account of what entitles a state to a share of the global tax base. (26) The Article concludes by describing the transactional and aggregate methods of implementing the benefits and burdens principle.

1. DOMINANT STANDARDS, ASCENDANT RULES

   The international tax regime--if one exists at all--consists of a host of disparate elements. (27) Thousands of bilateral double tax treaties and countless provisions of national law that govern the treatment of international transactions can hardly form a seamless whole. (28) Nevertheless, important patterns emerge even in the midst of that diversity.

   This Part highlights one trend notable for its familiarity to legal scholars of every stripe. Recent efforts to replace long-dominant standards with rules evoke a venerable scholarly debate. (29) Unfortunately, recognizing that proposals advancing formulary apportionment and enhanced information exchange tread this well-worn path suggests that they are less fruitful than they appear. (30) Indeed, if the primary distinction between a rule and a standard is whether it "is given content ex ante or ex post," the shift towards rules in international taxation may be beside the point, or worse. (31)

   1. Income Taxes in a Global Economy

      Tax authorities must feel a bit like sea captains trying to navigate a round earth with only flat-earth maps to guide them. In both the corporate and individual context, the environment in which they operate bears little resemblance to the one in which the provisions they enforce took shape. (32) Even a conservative estimate might date the key features of the laws and treaties considered below as a half-century old. (33) The following discussion offers a brief overview of the challenges tax authorities face while administering that aging international tax regime.

      1. Corporate Taxation

         Today's transnational businesses scarcely resemble their predecessors of thirty years ago, let alone what passed for a multinational enterprise in the 1960s. (34) Spanning the globe, they defy the notion that they belong to any particular jurisdiction in a meaningful way. (35) With fundamentally roofless intellectual property making up an increasing proportion of their value, associating their profit with a specific location becomes more difficult. (36)

         It is in that context that tax authorities attempt to regulate the process known as transfer pricing. (37) Transfer pricing involves the allocation of taxable profits among the many jurisdictions in which transnational businesses create, manufacture, and sell. (38) Although the context makes it seem exotic, transfer pricing is no different than a small business owner putting her son on the payroll to take advantage of his lower marginal tax rates. (39)

         The term transfer pricing derives from the process that related entities undertake when they set a price on goods or services that they transfer to one another. (40) For example, take a business that makes and sells contact lenses. If it manufactures and sells all of its products in the same jurisdiction, there will be no international transfer pricing problem. However, if it manufactures the lenses in Ireland and sells them in the United States, tax authorities are left with the puzzle of determining how much of the profit on each lens is U.S. profit and how much is Irish profit. (41)

         Transnational businesses have developed many techniques for maneuvering profit into jurisdictions with relatively low tax rates. A business might take the dramatic step of moving all of its sales, its entire staff and all of its productive assets from a jurisdiction with a fifty percent tax rate to one with a ten percent rate. Doing so would allow its...