Outbound taxation: active income
Under the benefits principle active income is supposed to be taxed primarily at source. The residence jurisdiction then has the obligation to eliminate double taxation by granting either an exemption or a foreign tax credit.
Most large OECD jurisdictions and many developing countries grant a participation exemption for dividends from CFCs paid out of their active income. The US, Japan, and the UK are the most recent additions to this trend. The only exception is that sometimes the exemption is limited, for example, to 95 percent of the dividend to substitute for the denial of deductions allocable to the exempt income.
If an exemption system applies, the foreign tax credit becomes much less important, because it typically applies only to direct, in other words, withholding taxes, and those are tending to disappear as explained in Chapter 4. However, the problem with exemption systems is that they result in double non-taxation if the income is not taxed at source, and this leads to an increased incentive to shift income out of both high-tax source countries and high-tax residence countries into tax havens. Existing CFC rules are inadequate to stop this trend toward BEPS, as the OECD has recently recognized.
Thus, it is worth retaining the foreign tax credit, and if the OECD BEPS project results in added limits on exemptions, it may become more important again in the future. Ideally, all the G20 countries which are home to the vast majority of the world’s multinationals,...
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