Corporate taxation and international charter competition.

• Author: Kane, Mitchell A.

Corporate charter competition has become an increasingly international phenomenon. The thesis of this Article is that this development in corporate law requires a greater focus on corporate tax law. We first demonstrate how a tax system's capacity to distort the international charter market depends both upon its approach to determining corporate location and upon the extent to which it taxes foreign source corporate profits. We also show, however, that it is not possible to remove all distortions through modifications to the tax system alone. We present instead two alternative methods for preserving an international charter market. The first-best solution involves severing the markets for corporate law and corporate tax law through coordination of locational rules under each regime, with a "place of incorporation" rule for corporate law and a "real seat" rule for corporate tax. The second-best solution relies on a properly designed federal structure. The crucial design elements for such a federal system are the allocation of substantive law between the federal and subfederal levels, corporate and corporate tax locational rules, and the taxation of corporate migration and foreign source corporate profits. With due attention to these details, an international charter market can avoid the potentially distorting effects of corporate taxation. In the final part of the Article we apply our analysis to the United States, Canada, the European Union, and Israel, and show how difficult it is, in the real world, to separate corporate charter and corporate tax competition.

TABLE OF CONTENTS INTRODUCTION I. LOCATION, MIGRATION, AND TAX DISTORTION A. Rules for Determining Corporate Location B. Corporate Migration C. A Method for Valuing Tax Distortion to Corporate Location II. CORPORATE TAX LAW AND LOCATION A. The Problem of "New" Profits B. The Problem of "Old" Profits C. Comparing the Old and the New--The Futility of Isolated Tax Law Changes III. SAVING THE INTERNATIONAL MARKET FOR CORPORATE CHARTERS A. The First-Best Solution--Segregating the Market with the Rule of Location B. The Second-Best Solutions--Federal Structures 1. Federal Structure 1: (U.S.-Style Federalism) 2. Federal Structure 2: (E.U.-Style Federalism) IV. THE EVIDENCE A. The United States B. Canada C. The European Union 1. The Evolution Toward International Charter Competition 2. Continuing Distortionary Threats D. Israel CONCLUSION INTRODUCTION

The "race to the top/race to the bottom" debate about competition for corporate charters has gone global. What had been largely a U.S. debate about charter competition among the several states (with the occasional European pejorative reference to the "Delaware syndrome") has increasingly become a serious discussion of international charter competition. The basic thesis of this Article is that the internationalization of charter competition in corporate law requires a greater focus on the influence that corporate tax law has on the market for corporate charters.

Recent experience in both the United States and the European Union highlights the important ways in which these two bodies of law can play off one another. In the United States, several high profile corporate "inversion" transactions have brought to prominence the effect that corporate tax law can have on the international competition for corporate charters. Such transactions, which typically involve reincorporating the parent company of a U.S. multinational offshore, are unabashedly all about tax reduction. But the desired tax benefits require shifting to a different, possibly inferior, corporate law regime. In this way, corporate tax can channel firms into a suboptimal jurisdiction from the standpoint of corporate law.

In the European Union the interaction between corporate law and corporate tax has gained increased salience because of a string of European Court of Justice decisions that provide firms much greater leeway in choosing which member state's corporate law will govern their activities. (1) For existing firms, however, corporate tax consequences of migration can make the cost of choosing the desired corporate law prohibitive. In this way, corporate tax can trap firms in a suboptimal jurisdiction from the standpoint of corporate law. More recent E.U. developments redress this problem but may overshoot the goal of corporate and tax law neutrality.

The world need not look this way. As a conceptual matter, corporate law and corporate tax law do not have to interact at all. Consistent with the evidence just mentioned, though, they often intersect. Both place at least some substantive weight on the determination of corporate location. Where the criteria underlying that determination overlap, the two bodies of law come into contact.

The problem (and likewise the solution) is that because corporations are legal rather than natural persons, corporate location is inherently arbitrary. The dark side of this arbitrariness can be observed in the world around us--a grab bag of corporate and tax locational rules that, as we show, are likely to lead to persistent distortions of the international market for corporate charters. If there is a redemptive side to arbitrary rules, however, it is that once we understand the relationship between their content and their undesirable consequences, we may be able to manipulate the rules with ease, at least relative to legal rules that have a more concrete connection to surrounding facts. With that possibility in mind, we strive in this Article not only to understand the sources of tax-induced distortion to the international market for corporate charters but also to recommend possible remedies.

A variety of people have looked at charter competition alongside taxation. (2) Extant scholarship adopts one of two approaches. The first approach is comparative in spirit. Scholars writing in this mode view corporate law and tax law as creating markets that spur two distinct species of interjurisdictional competition. The question is whether it is possible to understand one species of competition by examining its similarities and differences with the other. This type of inquiry need not consider the substantive interactions of the two fields of law. The second approach, in contrast, begins to tackle the interactive question. Under this approach, commentators have recognized the deterrent effect that exit taxation may have on corporations seeking to relocate to a jurisdiction with a preferred regime of corporate law. (3)

Our approach fits within the second type of inquiry. We make four basic contributions to the literature. First, we undertake a more comprehensive analysis of tax law in the cross-border setting than has been provided to date. For example, in considering tax effects on decisions about corporate migrations (i.e., changes of corporate location), we stress that one must consider the tax effects on both future and past profits, not just on the latter as has been customary in the literature. This simple observation can stand the conventional wisdom on its head. Specifically, although it is common to view exit taxes as necessarily bad from the standpoint of fostering charter competition, we describe how exit taxes can actually have pro-competitive results.

Second, we show that the optimal way to preserve charter competition in a world where jurisdictions compete globally for their tax bases is to coordinate rules across jurisdictions to require distinct locational rules for corporate law and corporate tax purposes. In that case, the markets for corporate law and corporate tax law would be severed from one another in virtue of the substantive rule of location. Although such equilibrium is unlikely to arise spontaneously through domestic law alone, we suggest that one could achieve the required coordination through treaties.

Third, we show that even where the substantive criteria underlying the corporate and tax locational rules continue to overlap, one may still be able to create the conditions necessary for undistorted charter competition with an appropriately designed federal structure. This strand of our analysis suggests that the existence of charter competition in the American system may be serendipitous, resulting in part from the particular type of federal structure present in the United States. It also allows us to understand how E.U.-style federalism can support charter competition.

Fourth, our analysis highlights a long-run efficiency cost of tax competition that has not been previously noted. In the standard account of the "race to the bottom" in the tax literature, the supposed consequence of competition in the long run is distributional, as between the public and private sectors. From this perspective, a "race to the bottom" in corporate taxation should not lead to long-run efficiency costs. (4) To be sure, in the short run tax competition may lead to suboptimal allocations of real capital, as jurisdictions use tax preferences to lure capital away from other jurisdictions. To the extent that governments losing capital enact countervailing preferences, however, capital allocations should revert to their original state. Thus efficiency consequences are removed in the long run, though each jurisdiction will collect less in tax revenue than would have been the case in the absence of any tax preferences. Indeed, proponents of tax competition see the possibility for efficiency gains here, to the extent that one believes that such gains generally follow from a shrinking of the public sector. (5)

By contrast, this Article links the phenomenon of tax competition to a potential long-run efficiency cost. Specifically, we show that tax-motivated corporate locational decisions can lead to an efficiency cost to the extent that corporations are steered into suboptimal legal regimes from a corporate law standpoint. Moreover, unlike the standard tax competition story, we should expect these efficiency costs to...