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Article Excerpt
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 be long-lived, at least under current market structures.
Having introduced claims about "suboptimal" corporate law, we should come clean about our normative commitments at the outset. We take a robust market for corporate charters to be a desirable goal. (6) Lest we lose half our audience before we have even begun, though, we would add that much of the analysis in this Article will be of interest whether or not one shares our normative outlook. Much of our analysis is devoted to the task of understanding how the interactions of two complex bodies of law affect corporate decision making and to the task of identifying which revisions to the relevant legal systems are most likely to dampen the effects of such interactions. That part of the analysis does not hinge upon our normative commitments. Of course, the same cannot be said of the specific recommendations that we espouse, which are crafted with an eye to eliminating the distortions. But the content of the recommendations should be of interest across the board as well. If we devise here a key to show how to revise legal systems to bolster an international market for corporate charters, those with the opposite normative commitments should be quite interested in the analysis, though we would expect them to view the distortions themselves as welcome, and the cure problematic.
Our normative commitments on tax law are less settled. In this Article we are agnostic about the normative arguments for and against conformity of national tax-systems. (7) Rather, we take it as a fixed feature of the discussion that national tax-systems do, and for the foreseeable future will, manifest significant disparities with respect to rate and base. In a world with such disparities, we expect jurisdictions to exploit such differentials to attract capital (i.e., tax competition) and we expect corporate taxpayers to structure their affairs so as to reduce their tax burdens (i.e., tax avoidance). We also expect that, in a dynamic setting, jurisdictions will take countermeasures to reverse the effects of tax competition and tax avoidance so as to protect real capital allocation as well as tax base.
The Article proceeds as follows. In Part I we briefly describe the ways in which legal systems may ascribe corporate location, provide background on the mechanics of corporate migration, and introduce a moderately formal way of describing tax-induced distortions to the corporate charter market. In Part II we explain the ways in which different types of corporate tax systems affect charter choice differently. We also argue that one cannot preserve the international charter market simply by modifying the corporate tax rules. In Part III we offer theoretical analyses of the first-best and second-best approaches for segregating the international market for corporate charters from the market for corporate tax law. In Part IV we turn to real world evidence, applying our theoretical constructs to shed light on the status of charter competition observed in the United States, Canada, the European Union, and Israel.
I. LOCATION, MIGRATION, AND TAX DISTORTION
A. Rules for Determining Corporate Location
Legal systems typically assign corporate location for a variety of different purposes. Two important contexts are corporate law and corporate tax. In corporate law, one needs to know under which jurisdiction's laws a corporation has (or has not) been formed. This is for a variety of reasons. First, because a corporation is a fictional legal person--that is, a creation of the law the fundamental question of corporate existence requires reference to a particular jurisdiction. Have all the requirements of corporate formation been satisfied? Is the corporation properly registered? Has it filed whatever annual reports or forms required to maintain its existence? Because of the practical consequences of corporate existence or nonexistence (e.g., unlimited liability), there must be a single answer to the question of whether the corporation exists.
Moreover, there are all sorts of questions regarding the running of the corporation that need to be answered. How are directors and officers selected? What are their duties? Have the duties been breached? What liability, if any, is imposed for the breach? What limits are there on the conduct of the controlling shareholders? What liability does the controlling shareholder face? On what issues do shareholders vote and what is the decision rule? To what extent can shareholders initiate action? How do they do so? When can dividends be paid? Thus, as both a practical and a theoretical matter, a reasonably definite and unique answer is needed to the question of what law governs these matters, which are often summarily referred to as the corporation's "internal affairs."
In corporate tax, the location of a corporation likewise bears upon a range of important questions. For example, jurisdictions typically seek to tax a broader base of corporate profits for local entities as contrasted with foreign ones. Corporate location can also determine the source of various types of income streams, such as dividends or interest, which in turn can have substantive tax consequences for the recipients of such payments.
Although different jurisdictions determine corporate location in different ways, the range of options is rather limited. Basically, in locating a corporation, a legal system can adopt either the "place of incorporation" ("POI") rule or some version of the "real seat" ("RS") rule. Under the POI rule, the corporation's location is determined by where it was incorporated, a purely formal criterion. Under the RS rule, a corporation's location depends on some combination of factual elements, such as the location of the administrative headquarters or the location of the firm's center of gravity as determined by the location of the employees and assets. The place of incorporation can also bear on this question, but it is not determinative. (8)
POI and RS rules under corporate law and corporate tax law thus look to the same types of factors to locate the corporation. There is, however, one important difference between locational rules in the two domains of law. Under the real seat doctrine, the existence of the corporation, as well as the rules governing its internal affairs, is determined by the law of the state in which the corporation's headquarters is located, not by the law of the state of incorporation. Because every jurisdiction currently views corporate existence as requiring affirmative steps (as distinguished, for example, from the existence of a partnership), an RS locational rule effectively requires that the corporation be incorporated in the jurisdiction where it has its real seat. To see why this is so, consider what would happen if business planners placed the headquarters in a real seat jurisdiction but incorporated the firm in another jurisdiction. In that case, creditors in the jurisdiction of the headquarters could claim that the firm is not properly incorporated and thus the investors are not entitled to limited liability; meanwhile, shareholders might fight over whether significant transactions need to be approved by the majority required in the headquarters jurisdiction or the jurisdiction of incorporation, and so forth. Indeed some jurisdictions, such as Germany, require the firm to be incorporated locally if the real seat is in the jurisdiction. (9)
Corporate tax, in contrast, has more flexibility because it is not constitutive. Unlike the case with corporate law, there is no conceptual or practical barrier to more than one jurisdiction claiming a corporation for tax purposes. Indeed, depending on tax rules, a corporation may even actively seek to claim tax residence in more than one nation. (10) Thus, for tax purposes, one may well observe one jurisdiction applying a POI locational rule to claim a corporation, while another jurisdiction applies an RS locational rule to claim the same firm.
B. Corporate Migration
Corporations are the creation of a particular jurisdiction. How corporations can "move" from one jurisdiction to another will vary with regard to both emigration and immigration and will depend on whether corporate location is determined by formal or factual criteria. (11)
When the criterion is formal, that is, for companies from POI jurisdictions (corporate law or corporate tax), companies migrate by means of several mechanisms. The simplest mechanism permits migration by shareholder vote. For example, in Canada, a corporation can move its jurisdiction while preserving legal personality (i.e., all legal rights and obligations continue), upon a two-thirds vote of shareholders. (12) When a corporation fulfills this straightforward requirement, it ceases to be, for example, an Ontario corporation and starts to be an Alberta or a federal corporation. This is not a taxable transaction. However, this simple, direct approach is highly unusual.
A second mechanism allows a corporation to migrate by merger. In the United States, for example, the simplest mechanism commonly used to change a corporation from being, say, a California corporation to being a Delaware corporation is by means of a merger between the original California corporation and a newly established, wholly owned Delaware subsidiary, with the Delaware corporation designated as the surviving corporation. Shareholders of the California corporation would receive the same percentage of ownership in the Delaware corporation as they had in the California corporation. Under U.S. state and federal tax law, this is a tax-free transaction at both the company level and the shareholder level. Note that this mechanism requires several elements. Both the old and new jurisdictions must have the institution of mergers of corporations, must permit one of the firms to be the "surviving" entity, and must permit cross-border mergers. Although common features of U.S. corporate laws, these are hardly universal elements of corporate laws elsewhere. (13)
A third mechanism is to establish a new corporation in the target jurisdiction, then to sell the assets of the old corporation to the new corporation in exchange for shares of the new corporation to be paid out pro rata to the shareholders of the old corporation upon dissolution. Because this mechanism only needs permission for cross-border sales of assets, it is legally simpler than the merger mechanism. But this sort of migration does not preserve a corporation's legal personality and triggers the winding up of the old corporation, with a variety of unhappy consequences. Existing creditors have to be paid, taxes may have to be paid on accumulated gains, property has to be transferred, licenses may have to be renewed with new license payments, and so forth. There are likely to be similarly unhappy consequences at the shareholder level.
A fourth mechanism is to establish a new corporation in the target jurisdiction, with the new corporation then exchanging its shares for shares of the old corporation in a share-for-share exchange. Once the transaction is complete, the old corporation will still exist but as a wholly owned subsidiary of the new corporation. This may avoid the winding up of the old corporation but may be viewed as a taxable sale of shares by the old shareholders.
In sum, POI jurisdictions permit a variety of legal mechanisms to allow corporations to migrate. The legal transactions may be complex, and avoiding taxable consequences is likely to require detailed attention to reorganization statutes under the tax law, but these hurdles can be, and frequently are, overcome.
By contrast, when the criteria of location are factual, as in RS jurisdictions, changing jurisdictions (for either corporate law or corporate tax) is often so cosily as to be prohibitive. Although there is no conceptual bar to doing so, in RS jurisdictions, typically no provision is made for migration that preserves the legal entity. For example, in Germany, a RS jurisdiction, even if a corporation were willing to incur the costs of moving its real seat to England, that would still technically not result in a migration of the historic entity because, under German law, the movement of the real seat would be deemed a dissolution of the corporation, with all of the consequences that flow from corporate liquidation. (14)
C. A Method for Valuing Tax Distortion to Corporate Location
As the above discussion makes clear, corporate tax and corporate law are relevant to firm decisions regarding both initial incorporation and subsequent migration. The central goal of this Article is to understand how tax law-induced decisions will distort corporate law-induced decisions as we move towards a global market for corporate charters. A preliminary task, then, is to clarify what exactly we mean by a tax law-induced effect on locational decisions.
For these purposes we introduce a stylized example involving two jurisdictions, Alpha and Beta. We assume that a corporation is assigned a location to one of the jurisdictions under each of two regimes of law: corporate law and corporate tax law. These two bodies of law may, but need not, assign the same location to the corporation. Further, we assume that the jurisdictions are identical, other than differences in the two bodies of law under consideration. With these assumptions in place, the next step is to determine how location in one jurisdiction or the other affects the value of the corporation. Because of the assumption that the jurisdictions are otherwise identical, we assume that valuation differences stem strictly from the differences in corporate law and tax law.
Consider corporate law first. Clearly corporate law can affect the value of the corporation. Let us suppose that a corporation located in Alpha has a different value from an identical corporation located in Beta strictly because of differences in the applicable corporate law. We will use the term "corporate surplus" to describe the amount of any such difference in valuation. A couple of clarifying points are necessary here.
First, the corporate surplus is a net concept. That is, we consider both the benefits or value-augmenting features of the corporate law, as well as certain costs. This is in keeping with the corporate law "race to the top/race to the bottom" literature, in which corporate decisions are cast on the demand side as a balancing of the benefits of a given corporate law against the costs of entering and operating under that regime. (15)
Second, some of the costs associated with the application of a specific jurisdiction's corporate law may be termed "taxes." For example, incorporation in Delaware makes a corporation subject to Delaware's business franchise tax. (16) Incorporation in other jurisdictions may render a corporation subject to capital levies. (17) Unfortunately, the reference to such costs as "taxes" is likely to breed confusion in the analysis we discuss here. These taxes are not what we have in mind when we refer to the "tax law" or when we set out to analyze tax-induced distortions to corporate location. We take such levies simply to be a cost of buying into the relevant corporate law regime. Our approach, then, is functional and divorced from whether something is called a "tax" or whether it is codified as part of the corporate law or tax law. Specifically, we count a government levy as part of the corporate law if it is best analogized to a benefits tax, with the relevant benefits deriving from the substantive corporate law and allied administrative or judicial institutions. The Delaware franchise tax is a good example of this type of government levy. By contrast, we count a government levy as part of the tax law if it is best characterized as a redistributive tax. The U.S. corporate income tax is a good example of redistributive taxes. (18)
Finally, we need to say more about the relation between what we call corporate surplus and the market for corporate charters. We take corporate surplus as a quantity that represents increased shareholder wealth. Thus proponents of a "race to the top" theory would expect corporate migrations from one jurisdiction to the second if there is a corporate surplus in the latter jurisdiction. Proponents of a "race to the bottom" theory deny this claim and argue that firms will tend to migrate to those negative surplus jurisdictions which are pro-management.
Although we come at this problem from the "race to the top" side of this debate, we hope that adherents to the contrary view recognize that there is nothing in the analytical structure of our argument that depends upon this commitment. We are interested in identifying cases in which the tax law, as we define it, deters corporations from selecting what strictly from a corporate law perspective would have been the first choice. If the reader thinks that the first choice would have been in the interest of shareholders, and thus produced a corporate surplus in our terms, then deterring that selection will represent a bad result. On the other hand, if the reader thinks that the first choice would have been a locational decision that harmed shareholders, then he or she might be quite happy to have the distortion arise.
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