Territorial Tax Systems: Motivations and Key Considerations For Effective Change

Territorial Tax Systems:
Moঞvaঞons and Key Consideraঞons
For Eﬀecঞve Change
by Ramon Tomazela Santos
Reprinted from Tax Notes Internaࢼonal, March 5, 2018, p. 925
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SPECIAL REPORTS
Territorial Tax Systems: Motivations and Key Considerations
For Effective Change
by Ramon Tomazela Santos
This article addresses the trend toward the
development of territorial tax systems,
1
a
migration that has included many European
countries and, more recently, the United States
with the enactment of the Tax Cuts and Jobs Act
(P.L. 115-97).
The preference of some countries for a partial
territorial tax system can be attributed not only to
the increasing integration of the global market in
the new era of digital economy, but also to the
fierce competition among countries for tax
revenues, especially following a prolonged global
economic crisis that lasted almost a decade.
This article will first address the main reasons
behind the current wave of jurisdictions opting for
territorial tax systems and then examine the
challenges faced by countries as they adapt their
tax systems to a new international framework.
Ultimately, this article will argue that an effective
transition to a territorial tax system, whether full
or partial, requires (i) the introduction of a
systematic and comprehensive set of source rules,
and (ii) the strengthening of transfer pricing rules.
I. The Shift Toward Territorial Tax Systems
The United States has traditionally led other
developed countries toward the adoption of a
worldwide tax system — one that reaches foreign-
source income earned by resident taxpayers
including both individuals and legal entities.
2
In
1962, during the administration of President John
F. Kennedy, the United States enacted the first
controlled foreign corporation rules, known as
subpart F, and inserted section 956(c)(1)(C) into
the IRC. Several countries, including Germany
(1972), Canada (1975), Japan (1978), France (1980),
and the United Kingdom (1984), followed suit.
However, the scene began to change between
1994 and 2006, when the U.S. government
adopted measures to soften the rigidity of its CFC
rules and made room for “check-the-box”
planning.
For different reasons, Europe took even
stronger steps to change its policies. In the
Cadbury Schweppes case, C-196/04 (CJEU 2006), the
Court of Justice of the European Union declared
Ramon Tomazela
Santos is a partner at
Mariz de Oliveira e
Siqueira Campos
Advogados in São
Paulo, a visiting
professor of
internationaltaxationat
theBrazilianInstituteof
Tax Law (IBDT), and a
PhD candidate at the
University of São Paulo.
In this article, the
author examines why
some countries are moving to territorial tax
systems, suggesting that they will need
comprehensive sourcing rules and a strong
transfer pricing regime to ensure the transition
is an effective approach to the challenges posed
by today’s global economy.
1
This movement to territorial income taxation regimes is confirmed
by noting that 29 of the 35 OECD member countries grant total or partial
exemption from income tax for qualifying foreign-source dividends. See
Stephen Phua, “Putting Territoriality in Its Place: Singapore’s Perspective
on Tax Competitiveness,” 71 Bulletin for International Taxation 53 (2017);
and PwC, “Evolution of Territorial Tax Systems in the OECD” (2003), at
1-15).
2
Reuven S. Avi-Yonah, International Tax as International Law — An
Analysis of the International Tax Regime 25 (2007).

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926 TAX NOTES INTERNATIONAL, MARCH 5, 2018
that CFC rules could only target “wholly artificial
arrangements” or they would violate the freedom
of establishment. Thus, the CJEU started to
impose severe limitations on the application of
CFC rules by European member states. The EU
policy became that CFC rules can only reach
artificial structures that do not reflect economic
reality and can only target arrangements in which
the sole purpose is to obtain a tax advantage.
More recently, the U.S. tax reform package
approved by President Trump represents a return
to a partial territorial tax system. Under the new
regime, U.S. corporations will be entitled to
deduct the full amount of foreign-source
dividends received from 10 percent-owned
foreign corporations. In practice, the effect of the
deduction is that those foreign-source dividends
are exempt from U.S. corporate income tax.
Along with the shift to a partial territorial tax
system, the TCJA directs the reduction of the
corporate income tax rate from 35 percent to 21
percent and the introduction of a mandatory
repatriation of deferred foreign income held
overseas by U.S. multinational enterprises.
Foreign profits earned before 2018 will be subject
to a deemed repatriation regime in which
corporate income tax will be levied at a rate of 15.5
percent on offshore cash equivalents and 8
percent on all other offshore assets (illiquid
assets). To dilute the economic impact of the
measure, U.S. MNEs will be permitted to elect to
pay the tax debt in installments over eight years.
The merits of the TCJA can be easily
identified. The high corporate income tax rate
previously charged by the United States
encouraged international tax planning strategies,
such as corporate inversions, transfer pricing
manipulation, and foreign tax credits schemes, all
of which ultimately led to extremely high
compliance costs in comparison with the tax
revenues actually obtained by the U.S.
government on overseas profits.3
Before the TCJA,
the United States had the highest corporate
income tax rate among OECD countries; average
corporate income tax rates in the OECD vary
between 20 and 30 percent. With the enactment of
the recent tax reform, the United States now has
its lowest corporate income tax rate in almost 80
years.
At first glance, it may seem like the corporate
income tax rate charged by the United States was
not a real problem because some prominent U.S.
MNEs were able to reduce their effective tax rates
to very low levels. The very trigger of the base
erosion and profit-shifting project was public
outrage over the low corporate income tax rates
paid by U.S. MNEs like Apple, Google, GE, and
Starbucks on foreign-source income amid the
harsh backdrop of the economic crisis. Moreover,
some European MNEs paid effective corporate
income tax rates higher than similar U.S. MNEs,
regardless of the partial territorial tax system in
force in many EU countries through participation
exemption regimes.
Regardless, it is undeniable that the high
corporate income tax rate affected the economic
behavior of U.S. companies in a manner
detrimental to the country’s economic growth and
the efficiency of its tax system. The reduction of
the corporate income tax rate, combined with
efforts to remove gaps exploited by taxpayers,
appears to be a reasonable step in trying to help
the U.S. tax system recover. Until recently the U.S.
tax system faced the worst of both worlds — it did
not raise significant tax revenues from the
taxation of foreign profits and, at the same time, it
did not benefit from the socioeconomic benefits
generated by profit repatriation.
Against this backdrop, a move to a partial
territorial system may significantly reduce the
problems caused by international tax avoidance,
aggressive tax planning strategies, transfer
pricing schemes, and corporate inversions, while
also eliminating the alleged negative impact of the
worldwide tax system on the competitiveness of
U.S. corporations.
The main reasons for the global migration to a
territorial tax regime, which will be analyzed in
detail below, are the following:
• international tax competition;
• a growing wave of corporate inversions;
• the negative impact of worldwide taxation
on business competitiveness on the global
scene; and
• the socioeconomic benefits of profit
repatriation.
3
Ramon Tomazela Santos, “US Tax Reform: The Potential Tax
Implications for Brazilian Taxpayers,” 71 Bulletin for International Taxation
82 (2017).

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A. International Tax Competition
International tax competition is inherent in a
world in which countries with autonomous and
diverse tax systems coexist. Globalization and
income mobility have expanded the opportunities
for the migration of production factors and for
capital flight involving the allocation of income to
business units and enterprises in other countries.4
The adoption of practices intended to attract
foreign investments is also becoming more
widespread. For these reasons, countries have
been increasingly feeling the harmful economic
effects of tax competition.
Moreover, the fact that MNEs now carry on
their activities as integrated economic units
located in multiple jurisdictions has made it easier
for businesses to transfer their headquarters to
countries with more attractive tax systems
(including via corporate inversions as is discussed
below).
5
In this environment, several countries began
to experiment with unilateral measures to
mitigate the effects of tax competition and the
changing economy. One measure that stands out
for this discussion is the use of an income tax
exemption granted to foreign dividends. At the
present stage of economic development, with
MNEs experiencing increased mobility and when
the migration of corporate headquarters can
produce positive externalities, the trend toward
territorial tax systems developed through the
softening of CFC rules and the granting of income
tax exemptions for foreign dividends received
from investee companies seems to be a reasonable
tax policy choice.
6
B. Corporate Inversions
Experience tells us a high corporate income
tax rate combined with a worldwide tax system
can encourage the adoption of tax planning
strategies and corporate inversions, which
involve the parent company of a corporate group
being replaced at the top of the investment chain
by a company incorporated elsewhere, preferably
in a country without CFC rules.
Corporate inversions have been a sensitive
political issue in the United States since 2002
when Stanley Works, a leading manufacturer of
industrial tools, announced its move to Bermuda.
7
Since then, companies headquartered in the U.S.
have increasingly attempted to sever that
geographical link in search of tax savings.
8
In
response, the U.S. Congress enacted a specific
antiavoidance rule intended to curb tax-driven
corporate inversions.
9
However, most of the world’s countries have
not adopted rules to prevent corporate inversions.
The lack of rules against corporate inversions,
particularly given the absence of international
coordination among countries as to a minimum
standard for CFC rules, leads to MNEs being
drawn to jurisdictions without CFC rules or that
use milder CFC rules, which only encompass
abusive transactions.
The migration to partial territorial tax regimes
that provide an income tax exemption for foreign
dividends can significantly reduce the incentives
to corporate inversions.
10
C. Negative Impact on Business Competitiveness
The adoption of a partial territorial tax system
allows countries to encourage the
internationalization of domestic companies by
reducing the overall tax burden upon the
repatriation of profits to the parent companies.11
By formally enshrining the principle of capital
import neutrality, the exemption method
recognizes that domestic taxpayers may be
developing economic activities in countries with
different levels of economic development and
4
Marco Aurélio Greco, “Crise do Imposto Sobre a Renda na sua
Feição Tradicional,” in Estudos Tributários 417-431 (1999).
5
Phua, supra note 1, at 54.
6
Avi-Yonah, “Back to the Future? The Potential Revival of
Territoriality,” 62 Bulletin for International Taxation 472 (2008).
7
Daniel N. Shaviro, Fixing U.S. International Taxation 35 (2014).
8
Mitchell A. Kane, “A Defense of Source Rules in International
Taxation,” 32 Yale J. on Reg. 312 (2015).
9
As Avi-Yonah writes, “in the US, this can be shown by the trend of
inversion transactions, in which US MNEs reincorporated in Bermuda in
part to avoid Subpart F. The trend was stopped by legislation in 2004, but
the competitiveness issue continues.” Supra note 6.
10
According to Samuel C. Thompson Jr., territoriality would grant
the benefits of a de jure inversion to all U.S. companies. See Samuel C.
Thompson Jr., “Territoriality Would Make All U.S. Companies De Facto
Inverters,” Tax Notes, Dec. 14, 2015, p. 1404.
11
Jürgen Lüdicke, “Exemption and Tax Credit in German Tax Treaties
— Policy and Reality,” in Tax Polymath: A Life in International Taxation 281
(2011).

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infrastructure, thereby preventing the residual
taxation in the residence state from leveling the
tax burden of taxpayers who are not carrying on
business in similar situations.
12
Hence, a partial
territorial tax system can be considered a form of
support to companies operating abroad,
contributing to their competitiveness at the
international level.
In contrast, the immediate taxation of foreign
profits via an overly strict and comprehensive
worldwide tax regime (full imputation system)
places domestic MNEs at a competitive
disadvantage compared with competitors from
countries with territorial tax systems.
13
The competitiveness issue arises because a
company that carries on economic activity in
another country through a subsidiary or a CFC
will have to pay local income tax based on the
same rules that apply to local companies.
However, if the parent company is located in a
country that adopts a comprehensive worldwide
tax system (full imputation system) and full-
inclusion CFC rules, the parent will also have to
pay corporate income tax in its residence state on
profits obtained by investee companies abroad,
regardless of any actual profit distribution, with a
right to offset the income tax paid abroad if
certain legal requirements are met.14
Notably, the main objection to CFC rules,
which focuses on the harmful consequences for
the competitiveness of domestic companies
operating abroad, only arises because of its
unilateral adoption by some countries. In other
words, the problem caused by strict CFC rules lies
in their isolated adoption by some countries,
which affects their domestic companies operating
abroad. If all competitors were subject to the same
residual taxation of foreign profits at the parent
company level, the effect on competitiveness
would be limited to differences in tax rates across
countries, a problem inherent in the sovereignty
of states. This is why, as a solution to problems in
the international tax regime, Avi-Yonah proposed
full-inclusion CFC rules under which all countries
would tax the global income of MNEs whose
ultimate parent company resides in that country,
with an offset of tax credits for corporate income
taxes paid in other countries by investee
companies in the same corporate group.15
D. Socioeconomic Benefits of Profit Repatriation
In theory, the exemption granted to foreign
dividends can promote the development of the
internal market and economic growth. The
adoption of a territorial tax system and the
reduction of the corporate income tax rate in the
United States is expected to produce additional
socioeconomic benefits because the strengthening
of economic activities may contribute to
improved employment levels and salary
increases. It is no coincidence that President
Trump chose to focus on socioeconomic benefits
when touting the tax reform package.
Any loss of tax revenues caused by the
territorial tax system can typically be offset by
positive long-term results, as usually occurs after
tax breaks. However, as the TCJA also reduces the
corporate income tax rate, tax revenue losses and
impact on government deficits are expected.
In comparison, collecting corporate income
tax on profits earned abroad using a worldwide
tax system with deferral may cause adverse
economic effects, such as the permanent retention
of profits abroad without distribution to domestic
shareholders. Adopting a partial territorial tax
system may prevent distortions in the financial
management of the company caused tax laws,
such as the retention of profits beyond the point at
which reinvestment is (CFC rules aside) the smart
business choice.
It is important to bear in mind that the
retention of profits abroad solely to avoid the levy
of the income tax on repatriated profits can affect
the optimal allocation of financial resources.
Indeed, when foreign profits are kept within the
12
Manuel Pires, International Juridical Double Taxation of Income (1989),
at 176.
13
Avi-Yonah summarizes the argument: “The usual arguments
against abolishing deferral are that it will put US multinationals at a
competitive disadvantage, that it will lead to inefficient outcomes
because less efficient foreign MNEs will obtain projects that should have
been owned by more efficient US MNEs, and that it will lead to
migration of US MNEs to other countries and to the establishment of
new MNEs in other jurisdictions with more favorable tax rules.” Avi-
Yonah, “Back From the Dead: How to Prevent Transfer Pricing
Enforcement,” University of Michigan Law School Scholarship
Repository: Law & Economics Working Papers, No. 85 (2013), at 3.
14
Luís Eduardo Schoueri, “Tributação Internacional das Empresas
Nacionais e Desenvolvimento: Novos Rumos?” in Tributação e
Desenvolvimento — Homenagem ao Professor Aires Barreto 483-484 (2011).
15
Avi-Yonah, Advanced Introduction to International Tax Law 94 (2015).

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company abroad, domestic shareholders cannot
use dividends for other economic purposes.
Finally, according to Joseph E. Stiglitz, profit
retention within a legal entity can reduce
economic efficiency. Directors of an investee
company will have access to more financial
resources than the company would have after the
repatriation and thus be less motivated to focus
on efficiency in administrative and business
decisions.16
II. Problems Raised by Territorial Taxation
Avi-Yonah notes that the migration to a partial
territorial regime may further stimulate the
artificial transfer of profits to foreign companies,
which may then be repatriated from the host
country to the home country without triggering
corporate income tax. According to Avi-Yonah,
the biggest deterrent against the adoption of
profit-shifting strategies stems from the difficulty
of repatriating funds to the parent company or
shareholders, precisely because of the imposition
of income tax on dividends from companies
operating overseas. In his opinion, if tax law
grants an income tax exemption for foreign
dividends, MNEs will have a greater economic
incentive to transfer profits or activities to other
countries since it will be possible to repatriate the
funds at any time without an additional tax
burden in the home state.
17
Thus, the effective migration to a territorial tax
system requires the strengthening of source rules
for some types of income, as well as the tightening
of the current transfer pricing rules.
18
Neither of
these two goals is an easy task.
A classic territorial tax system only taxes
income earned within a country’s borders,
regardless of the seat of the company. Thus, in a
classic territorial tax system, local businesses may
have an incentive to declare that some types of
income were generated abroad, to prevent the
levy of the local income tax. In this scenario,
source rules play an important role in identifying
the tax system applicable to each income.
Likewise, in a partial territorial tax system, which
exempts foreign dividends from the corporate
income tax, MNEs may also have an incentive to
migrate some sources of income and productive
activities overseas and then repatriate the
corresponding amounts as exempt dividends.
Therefore, source rules and transfer pricing
rules are required to counter this incentive for
offshoring income.
A. Lack of Effective, Comprehensive Source Rules
1. Source Rules in General
Generally, the source of income is determined
by legal criteria that define the scope of a
jurisdiction’s tax law based on objective
connecting factors. While the requirement of
residence is rooted in subjective connecting
factors, the requirement of source is based on
objective connecting factors directly linked to the
taxable event.
By adopting source rules, a country can
exercise its right to tax income whose source is
located within its territory. Since earnings stem
from economic events — which are inexorably
linked to a source of income production —
connecting factors demarcate the state’s
jurisdiction to tax.
Conceptually, the source of income can be
analyzed from two different perspectives: source
of production and source of payment.19
On one hand, the source of production has an
economic character since it is identified as the
causal relationship between an economic item
and its productive factors. More specifically, it
refers to the geographical location (territorial
limitation) where income was actually generated
— the place where the act or transaction that
produced the income occurred — tying taxation
to the activities carried out within the defined
territory.
20
16
Joseph E. Stiglitz, Economics of the Public Sector 663 (2000).
17
Avi-Yonah, supra note 6, at 473. See also Avi-Yonah and Gianluca
Mazzoni, “The Trump Tax Reform Plan: Implications for Europe,” 71
Bulletin for International Taxation 11 (2017).
18
According to Avi-Yonah: “This trend has its attendant problems as
well. The main argument against the US dividend exemption proposal is
that, like any move in the direction of territoriality, it puts more pressure
on the source rules and on transfer pricing.” Supra note 6, at 473.
19
Agostinho Toffoli Tavolaro, “Tributação Internacional: Elementos
de Conexão,” in Direito Tributário: Estudos Avançados em Homenagem a
Edvaldo Brito 186-188 (2014).
20
Gerd Willi Rothmann, “Tributação Internacional sem Sujeito
Passivo: Uma Nova Modalidade do Imposto de Renda Sobre Ganhos de
Capital?” 13 Grandes Questões Atuais do Direito Tributário 108-109 (2006).

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On the other hand, the source of payment
establishes a connection with the location of the
funds that were used for the actual payment of the
income. Because financial resources necessary for
the payment of income to a nonresident must be
taken from the asset of an individual or legal
entity, this criterion establishes a connection
between the income and the competent state for
its taxation based on the location of the source of
payment.
21
Although sometimes both elements establish
an objective connection with the same country,
often the source of production and the source of
payment are located in different jurisdictions,
leading to a source-source conflict. Moreover, one
tax system may adopt different connection
factors, depending on the type of income. Each
jurisdiction must select the source of production
or the source of payment as key factors permitting
the taxation of income paid or generated within
its territory. Countries may even require the
cumulative presence of both connecting factors
for some types of income.
The identification of the income source should
be the object of a detailed analysis by the
interpreter of the law based on the particular facts
and the relevant domestic law, recognizing that
many countries do not use a single and uniform
criterion for all types of income. On the contrary,
given the lack of a theoretical and fundamental
doctrine to justify the assignment of income to a
specific geographic location, source rules are
usually a series of arbitrary provisions based on
the categorization of a given item of income.22
Not
surprisingly, Edward D. Kleinbard argues that
source rules are often “meaningless” and “largely
artificial.”23
In most countries, the legislator has the
competence to choose the connecting factors that
bind income to the territory.
24
However, except for
a few specific categories of income, most countries
do not have a clear set of rules for determining the
source of income. This can raise pressing
questions in practice.
To illustrate the effect of source rules in
practice, we discuss below two examples that are
of particular importance in the field of taxation.
2. Example
To clarify the difference between the source of
production and source of payment, imagine a
company in Brazil has immovable property
within the country that it decides to rent to a
nonresident. The rent received by the company in
Brazil will be paid by a source of payment located
abroad, but the economic source of production of
the income is the immovable property in Brazil.
Article 25 of Brazil’s Law No. 9249/1995
provides that profits, income, and capital gains
earned abroad must be computed in determining
the taxable income for the company’s balance
sheet as of December 31 of each calendar year. The
expression “income earned abroad” seems to
indicate that if the source of production of the
income is located abroad, then the income would
only be subject to tax in Brazil on December 31.
For the purposes of applying this legal provision,
it is insufficient that the mere source of payment
is abroad; if the source of income production is
located in Brazil, the amount received will be
subject to corporate taxes in Brazil on an accrual
basis. Thus, the rental income received by the
Brazilian company in our example must be taxed
on an accrual basis in Brazil (that is, article 25 of
Law No. 9249/1995 does not apply). Conversely, if
the Brazilian company decides to rent immovable
property located abroad to a nonresident, the
rental income must be considered as “income
earned abroad.”
Identifying the exact location of the source of
production of income is an extremely
21
Schoueri, “Princípios no Direito Tributário Internacional:
Territorialidade, Fonte e Universalidade,” in Princípios e Limites da
Tributação 336-337 (2005).
22
Stephen E. Shay, J. Clifton Fleming Jr., and Robert J. Peroni, “The
David R. Tillinghast Lecture: ‘What’s Source Got to Do With It?’ Source
Rules and U.S. International Taxation,” 56 Tax L. Rev. 81, 138 (2002).
23
Edward D. Kleinbard, “Stateless Income,” 11(9) Florida Tax Review
699, 752, and 750 (2011) (stating that “stateless income tax planning
compounds the meaninglessness of income tax source rules” and “the
global tax norms that define the geographic source of income or expense
are largely artificial constructs”).
24
The legislator is not completely free to impose source taxation.
Constraints on arbitrary and source taxation include international tax
competition, the threat of reciprocal treatment, a refusal by other
countries to apply double taxation relief for arbitrary source taxation,
and the nondiscrimination principle. Shay, Fleming, and Peroni, supra
note 22, at 112.

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controversial topic.
25
This holds for both
economists and tax scholars; the source of income
is neither a coherent economic concept nor a
normative jurisdictional theory.
3. Royalties, Licensing, and Related Matters
Next, consider the particularly difficult arena
of intellectual property sourcing. Imagine that a
company incorporated in Brazil receives income
arising from a trademark used abroad by a
nonresident under a licensing agreement. Should
the amount received should be considered
income earned abroad?
Most jurisdictions follow a place of
production rule, holding that the primary source
of production for royalties derived from a
trademark license agreement is the country where
the intellectual property was developed. The
royalty is monetary compensation to the owner of
the intangible asset. The brand owner bears
devaluation risks, maintenance costs, marketing
expenses, and legal protection fees, all of which
contribute to the generation of the royalty income.
Thus, the origin of the income arising from
trademark licensing is usually the country where
the brand was developed and registered with the
patent and trademark office, especially because
the trademark licensing would not be possible
without the development of the brand.
Notably,simplyregisteringthe licensed brand
in the country where it is being commercially
exploited by the licensee does not change the
conclusions above; the decisive criterion for
determining the (primary) source of production is
where the brand was developed. Otherwise,
simply changing the registration of the trademark
from one country to another would change its
source of production. That result is not consistent
with the policy of identifying the source of income
and its economic allegiance.
What about income that the nonresident
licensee receives in its own country as a result of
economic activity involving the use of the licensed
brand (that is, the sale of goods or services with
the licensed brand)? This income is business profit
and should not be confused with royalty income
that only remunerates the use of the trademark.
The royalty income will be paid out of the
business profits obtained by the licensee abroad.
The source of production for the royalty income
itself continues to be, at least predominantly, the
country where IP was developed.
On this issue, Eric Kemmeren explains:
the cause of the royalty income received is
the creation of the intellectual property.
Especially with respect to royalty income,
the overwhelming relevance of the
intellectual element in the production of
income is obvious. The state where the
intellectual element is found is the state of
origin of the royalty income. Through
exploitation of the intangible, the
producer of the intangible creates income.
The user of the intangible does not
produce the royalty income, at least not
predominantly. He only uses the
intellectual element of someone else
producing another item of income, for
example, business income if he uses the
intangible in his own enterprise.
26
As Kemmeren highlights, the place of the
intangible’s production is the focal element in the
origin analysis for the royalty income. However,
the use of the trademark contributes — at least to
some extent — to the production of the royalty
income because it is an economic phenomenon
that cannot be completely isolated. The
predominant source of production is where the
brand was developed and the brand owner bears
related costs and risks. Nevertheless, from an
economic perspective, the market may also
contribute to generating the income.
Avi-Yonah suggests that it is commonly
accepted that part of the royalty income should be
allocated to the country where the brand was
developed and part to the market country where
the final product was sold. This shows that from
an economic perspective, both criteria contribute
to generating the income.
27
Still, despite some
areas of agreement, he goes on to emphasize that
25
As explained by Hugh J. Ault and David F. Bradford: “The idea
that income has a locatable source seems to be taken for granted, but the
source of income is not a well-defined economic idea.” Ault and
Bradford, “Taxing International Income: An Analysis of the U.S. System
and Its Economic Premises,” in Taxation in the Global Economy 30 (1990).
26
Eric C.C.M. Kemmeren, Principle of Origin in Tax Conventions — A
Rethinking of Models 452 (2001).
27
Supra note 2, at 44-45.

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“no universal consensus exists about what the
source rule for royalties should be.”28
AsAvi-Yonah notes, one outlier in this arena is
the United States. Domestic U.S. law attributes the
source of production of royalty income to the
country where the intangible was used (place of
use rule). This rule helps some businesses with
their tax planning efforts. For example, U.S.
pharmaceutical companies often do research in
the United States that leads to products that are
sold around the world. If the source of production
was deemed to be where the drug was developed,
U.S. pharmaceutical companies would not have
been able to obtain foreign tax credits for income
tax paid abroad on these sales.
29
4. Source Rules in Territorial Systems
As the foregoing demonstrates, numerous
difficulties can arise when determining the source
of production of an item of income, both from
economic and legal standpoints. The effective
migration to a territorial tax system requires a
comprehensive, organic, and systematic set of
rules for determining the source of income.
Source rules are certainly very important in a
worldwide tax system, since they help to
delineate the proper scope of the unilateral credit
method used for double taxation relief.
30
However, in a territorial tax system, source rules
are a vital necessity because MNEs may have an
incentive to assign the source of income to a
foreign country and then repatriate the amount as
exempt dividends. In a territorial tax system,
source rules are critical to preventing tax planning
strategies that taxpayers may try to use to route
domestic-source income through a foreign
corporation, thereby converting domestic-source
income into foreign-source dividend income.
B. The Need for Strong Transfer Pricing Rules
The second issue that must be considered
when moving to a territorial tax system (total or
partial) is the need for strong transfer pricing
rules.
1. Article 9 of the OECD Model
Generally, transfer pricing rules try to prevent
the artificial transfer of profits through cross-
border transactions between associated
enterprises. Transfer pricing rules based on the
arm’s-length standard
31
are enshrined in more
than 3,000 existing double tax treaties based on
the OECD model income tax treaty, whose
concept attempts to replicate the pricing behavior
of independent parties and is regarded as “the
Holy Grail” of international taxation.32
Article 9 of the OECD model allows
adjustments in the taxable profit of an enterprise
to reflect the true taxable profit that would have
been earned if the transaction occurred between
independent parties.33
In contrast, when
transactions between associated enterprises are
performed at arm’s length, in accordance with
open market commercial terms, article 9 prevents
adjustments in the taxable profits.
34
Article 9(1) of the OECD model provides that
a tax authority can adjust the taxable income of an
entity by adding the portion of income eliminated
by pricing manipulation in a transaction between
associated enterprises to the income to be taxed in
that country.
35
Obviously, the amount of the tax
adjustment can only be determined based on the
domestic tax law of the contracting state because
tax treaties do not have the power to determine
the tax obligation.
Importantly, article 9 of the OECD model does
not give states carte blanche to apply transfer
pricing rules regardless of their compatibility
with the arm’s-length standard. In fact, although
double tax treaties only limit the right to tax and
28
Id., at 44.
29
Id.
30
Shay, Fleming, and Peroni, supra note 22.
31
I use the expression “arm’s-length standard” instead of “arm’s-
length principle” because it is not truly rooted in a direct legal principle,
Rather the “arm’s length” concept is derived from the principle of
equality. See Schoueri, “O Arm’s Length Como Princípio ou Como
Standard Jurídico,” in Estudos de Direito Tributário em Homenagem ao
Professor Gerd Willi Rothmann 216 (2016); and Rothmann, “Standard
Jurídico,” in Enciclopédia Saraiva do Direito, Vol. 70 at 500-501 (1977).
32
Raffaele Petruzzi, “The Arm’s Length Principle: Between Legal
Fiction and Economic Reality” in Transfer Pricing in Post-BEPS World 2
(2016).
33
Luc de Broe, International Tax Planning and Prevention of Abuse: A
Study Under Domestic Tax Law, Tax Treaties and EC Law in Relation to
Conduit and Base Companies 502 (2008).
34
Andreas Fross, “Debt-Equity Ratios, Earning Stripping Rules and
the Arm’s Length Principle” in International Group Financing and Taxes 42-
43 (2012).
35
Geerten M. M. Michielse, “Treaty Aspects of Thin Capitalization,”
51 Bull. for Int’l Fiscal Documentation 568 (1997).

SPECIAL REPORTS
cannot be used to perform profit adjustments
without a legal basis in domestic laws, the
national legislators are not completely free to use
any method they choose to determine whether a
transaction between associated enterprises
follows or ignores the arm’s-length standard.
Rather, to comply with article 9 of the OECD
model, profit adjustment mechanisms in the
domestic law must reflect the market standard —
that is, open-market conditions.
36
If this was not the case, article 9 of the OECD
model would be absolutely superfluous; the end
result would be the same regardless of the
existence of a tax treaty between the two
contracting states. In the absence of a double tax
treaty, domestic tax laws would be freely applied
to adjust the taxable profits because of the lack of
boundaries curbing the right of either contracting
states to tax. On the other hand, when a double tax
treaty was in place, domestic tax laws would still
be free to determine the profit adjustment
according to any criteria in the domestic law that
supposedlyreflectthearm’s-lengthstandard.This
would render article 9 completely inoperative,
superfluous, and insignificant — which makes no
sense.
Therefore, to be compatible with article 9 of
the OECD model, the profit adjustment set by
domestic laws may not lead to an increase of the
tax base above that required by the arm’s-length
standard. The wording of the treaty provision
clearly dictates that the tax adjustment must
reflect “profits which would . . . have accrued to
one of the enterprises.”
2. Transitioning to a Territorial System
The problem is that transfer pricing rules
based on the OECD guidelines have several
structural flaws that make it difficult to transition
to a territorial tax system. The problems include:
• a lack of comparable transactions to use to
identify the transfer price;
• the absence of a single correct result, given
that the arm’s-length price is a range, which
admits fluctuations;
• high compliance and monitoring costs (for
example, the costs of finding comparable
transactions may be higher than the profits
derived the from actual transaction);
• the increasing complexity and
sophistication of cross-border transactions
(for example, difficulties in applying the
rules to digital transactions);
• the vulnerability of transfer pricing rules to
profit-shifting strategies involving
intangible assets and contractual risks;
• a lack of legal certainty for foreign investors
because the results of the application of
transfer pricing rules are unpredictable and
the amounts involved in related tax
assessment notices have significantly
increased;
• the inability of transfer pricing methods to
capture synergy and other effects from the
integration of legal entities into
international corporate groups;
• the reality that MNEs operate in the
international market in an integrated way,
developing a single economic activity,
which can make trying to establish a basis of
comparison with independent parties
illogical;
• a lack of effective coordination among
countries to align transfer pricing outcomes
(for example, mutual agreement
procedures, advance pricing agreements,
and tax rulings);
• the high costs involved in bilateral or
multilateral advance pricing agreements;
• the poor and inadequate alignment between
existing transfer prices rules based on the
arm’s-length standard developed in 1917
and the rapidly changing business
environment;
• the absence of a solid theoretical approach
for the identification of value creation, as
proposed by the OECD during the BEPS
project; and
• the increasing complexity of the arm’s-
length standard and the required functional
analysis that has reached a level that borders
on irrationality.
This list of problems makes it clear that the
need for comprehensive transfer pricing rules is a
severe obstacle to be overcome before moving to a
36
Santos, “As Regras Brasileiras de Subcapitalização e os Acordos
Internacionais de Bitributação — A Incompatibilidade da Lei No. 12.249/
2010 com o Princípio Arm’s Length e com a Cláusula de não
Discriminação,” 234 Revista Dialética de Direito Tributário 110-119 (Mar.
2015).

SPECIAL REPORTS
territorial tax system. Absent strong transfer
pricing rules, it would be possible to manipulate
the rules to claim that specific items of income
were obtained abroad and then repatriate the
corresponding profit to the headquarters in the
residence state without triggering the corporate
income tax due to the exemption for foreign
dividends.
As long as the transfer pricing problems
remain, the mere move to a territorial tax system
(without the reduction of the corporate tax rate)
would increase the problem of aggressive tax
planning structures being exploited by MNEs.
The reduction of the corporate income tax rate
mitigates the incentive to divert profits to related
companies abroad, as tax savings obtained
through artificial arrangements between the
parent company and its subsidiary abroad will
reduce accordingly. Thus, as long as income
diverted to low-tax jurisdictions continue to be
taxed by the CFC rules, the trade-off between
costs and benefits in profit-shifting strategies
become less attractive after the reduction of the
corporate income tax rate. Disparities in tax rates
will continue to exist, but the benefits derived
therefrom will decrease in line with the tax rate
cut. In any case, as long as transfer pricing rules
remain low, the adoption of full-inclusion CFC
rules (full imputation system) to tax the profits of
the international corporate group in the residence
state of the parent company would be a feasible
solution.37
These rules can act as a backstop to the
transfer pricing rules, capturing profits artificially
shifted to other countries through cross-border
transactions that were not properly valued
according to domestic transfer pricing rules.
In light of the foregoing, it is evident that
transfer pricing rules based on OECD guidelines
have several structural flaws, which significantly
complicate the process of migrating to territorial
tax systems, despite the efforts by U.S. lawmakers
to follow the trend.
III. Conclusions
Key reasons for the recent migration toward
territorial tax regimes include pressure from
international tax competition, the desire to
combat aggressive tax planning structures, an
effort to prevent corporate inversions, global
competitiveness issues, and the socioeconomic
benefits of profits repatriation.
However, the adoption of a territorial tax
regime may lead MNEs to increase their adoption
of profit-shifting strategies because the foreign
profits could be repatriated without taxation.
Traditionally, such as in the U.S. before the
TCJA, the biggest disincentive to engage in profit-
shifting strategies has been the difficulty of
repatriating foreign profits to domestic
shareholders, precisely because of the levy of
income tax on dividends distributed. If a country
starts to grant an income tax exemption to foreign
profits, MNEs may have a greater economic
incentive to transfer profits, production, or
business activities to other countries because it
will be possible to repatriate the income earned
abroad without triggering additional taxation in
the home country.
Moving to a territorial tax system without
triggering profit shifting requires building and
enforcing a comprehensive set of source rules and
strengthening the traditional system of transfer
pricing rules.
Most countries do not have a comprehensive
set of source rules. Determining the proper source
of income is extremely challenging for economists
and tax professionals. Although coordination is
desirable since source rules can play an important
role in balancing the taxing claims of various
jurisdictions,
38
the legislature of each country
must establish a consistent set of rules to regulate
the subject. Absent that step, migrating to a
territorial tax system can be extremely risky. This
even applies to a quasi-territorial system in which
the exemption is limited to foreign profits.
Strengthening transfer pricing rules is also an
essential step in a move to a territorial tax system.
Otherwise, MNEs could manipulate transfer
37
According to Avi-Yonah: “Thus, in the foreseeable future, transfer
pricing problems will remain, and solutions to the massive double non-
taxation permitted under current rules are more likely to come from
residence-based taxation of corporate groups, despite the uneasy nature
of corporate residency determinations.” Avi-Yonah, supra note 15, at 33.
In the same sense, see Samuel C. Thompson Jr., “An Imputation System
for Taxing Foreign-Source Income,” Tax Notes Int’l, Feb. 28, 2011, p. 691.
38
As Kane argues, “the basic function of the source principle (and the
source rules that are supposed to reflect that principle) is to coordinate,
alongside the residence principle, taxing claims of various jurisdictions.”
Supra note 8, at 323.

SPECIAL REPORTS
prices to claim that income was generated abroad
and then repatriate the profit without taxation by
virtue of the exemption granted to profits
obtained abroad. Here, the main problem stems
from the fact that international transfer pricing
rules based on the OECD guidelines have several
structural flaws — shortcomings that were not
resolved by actions 8, 9, and 10 of the BEPS
project, which was the OECD’s attempt to align
transfer pricing outcomes with the value creation.
This further confirms the need for major
adjustments before a move to a territorial taxation
system can produce the desired results.  

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