The Economic Allegiance of Capital Gains
How to ensure that multinational companies are paying their “fair share” of taxes in the countries in which they create value has been the subject of lively debate within the international tax community in recent years. These debates have led to significant and exciting reforms, namely the OECD/G20 Inclusive Framework. While these reforms represent an important step towards creating a more coherent and equitable international tax system, the current conversations have overlooked an essential fact. Value created by a company’s business activities manifests itself in two ways—as business income and as an increase in the overall market value of the company, which then translates into capital gains income when investors sell their shares. Thus far, the conversation has focused exclusively on how to divide taxing authority over company income, missing half the story. A truly comprehensive reform that ensures fairness and equity in international taxation must address the question of how taxing authority over income stemming from the growth in company value should be allocated amongst countries.
This paper fills this gap and assesses how taxing authority over this capital gains income should be divided amongst countries under the normative principles that have guided international tax law for the past 100 years. It concludes that the current international sourcing rules, which allocated taxing authority over capital gains income from the sale of company shares to the investor’s residence country, are at odds with the benefits principle and the related concept of economic allegiance. Not allowing the countries in which companies conduct business (the “source countries”) to tax capital gains income produces an inequitable result whereby a country and its citizens provide benefits and resources that facilitate a company’s business activities without being able to tax income derived from the value created by those business activities.
Digitalization and informational capitalism have revolutionized the global economy in ways that the original designers of the international tax system could never have foreseen when they established international sourcing rules in the 1920s compromise. While granting taxing authority over capital gains income exclusively to the residence country has always been inappropriate and inequitable, this paper argues that certain features of the digital economy have magnified the incoherence and inequities that the current international sourcing rules cause. The first feature is the phenomenon of company growth without income. The drafters of the 1920s compromise worked under the assumption that growth in the value of a company would be accompanied by business income. As a result, even though the source country could not tax capital gains income, it would receive some tax revenue by taxing the company’s business income, thereby providing compensation for the benefits provided. In the digital economy, this is not always the case. Because establishing a robust network of users and customers is essential for many digital business models, particularly platform businesses, digital companies often achieve enormous market capitalizations before ever turning a profit. Digital companies are, therefore, able to create large amounts of value through business activities in a country without ever being taxed there. This broad phenomenon was inconceivable to economists and policymakers in the 1920s.
Additionally, the paper argues that several of the essential drivers of company value in the digital economy have a particularly close economic allegiance to the source country, furthering the unfairness of the source country being unable to tax capital gains income stemming from that growth in company value. These drivers of company value are network effects, data collection, and the free labor of users and customers who create content and data for these companies. The paper analyzes these drivers of value under the same criteria that the 1923 Four Economists’ report used to assess the economic allegiance of agricultural, mining, and industrial activities and finds a strong economic allegiance to the source country. Furthermore, when digital companies are building networks, collecting data, and taking advantage of the free labor of users and customers, they are not only relying on benefits and resources provided by governments to facilitate their business activities and grow their market value. They are also relying on benefits and resources provided by the citizens of the country themselves, in a dynamic that many scholars have highlighted as exploitative and harmful. This reliance makes the violation of the benefits principle caused by not allowing source countries to tax capital gains more acute. Granting taxing authority to the source country is not only needed to directly compensate the government for benefits provided but is also needed to indirectly compensate citizens for the benefits and resources they provide. Allowing the source country to tax capital gains income both realigns taxation of capital gains with the normative goals of the benefits principle and economic allegiance and alleviates some of the exploitative and inegalitarian outcomes we see in the digital economy.
This paper is primarily a proof of concept. But it also presents a policy suggestion to implement this reallocation of taxing authority to source countries—an annual mark-to-market tax at the company level on increases in market value, apportioned amongst source countries based on a set formula. The goal of this policy discussion is to begin a broader conversation about possible global reforms to create an international tax system that is more in line with its underlying normative goals.