ICC Policy Statement

Tax Exemption versus Tax Credit Systems for Foreign Dividends: Comparison
and International Trends
Prepared by the Task Force on Tax Exemption versus Tax Credit Systems

Introduction
A discussion on the merits of an exemption or credit system is typically a discussion dealing with the
essence of international taxation, i.e. the methodologies used for the recognition of forei gn income
and taxes on such income.
The economies of developed countries of the world are in the process of becoming truly global.
Multinational enterprises (MNEs) must be able to compete in today's global marketplace and a system
of international tax rules should not disadvantage them in that competition. Therefore it can be said
that if a country allows its international tax rules to act as an impediment to successful competition, the
cost will be measured in lost opportunities and lost jobs.
The following discussion on tax credit and tax exemption systems focuses on a worldwide versus a
territorial tax system applied to foreign dividends. Within the OECD, roughly one half of the countries
use a worldwide system and the other half use a territorial system. Countries like US, UK and Japan
have a worldwide tax system, whereas Canada, Germany, France and the Netherlands generally use
a territorial system. Countries with a territorial system often tax passive income on a worldwide basis
and use a credit system to avoid double taxation (e.g. under bilateral tax treaties). A debate on the
merits of a credit versus an exemption system can contain emotional elements.
For the purpose of this policy paper,
a. An exemption system is described as exempting dividends received by a corporate shareholder in a
multinational enterprise from a foreign subsidiary.
b. A credit system prescribes that a corporate shareholder, for any dividends received from a foreign
subsidiary, adds to its taxable income the business profits from foreign operations and deducts from
tax due thereon any corporate income tax, and source tax on dividends paid abroad.

Global environment
Recent years have seen an increased attention being paid to competitive angles of tax systems.
Globalization is the new economic environment within which tax systems operate.
In 1998, the OECD published its report on Harmful Tax Competition, An Emerging Global Issue, and
has since followed it up with publications in 2000 (Towards Global Co-operation) and in 2001
(Progress report).
The European Union started in 1997 with its Code of Conduct group aimed at the elimination of
harmful taxation within the EU.
The Monterrey Consensus of March 2002 of the International Conference on Financing for
Development calls attention to the tax position of developing countries and countries with economies
in transition.

Within the framework of Sustainable Development, a level playing field is viewed as necessary to
allow an effective encouragement of export and trade by the businesses in developing countries.
As a result of these developments, more attention is being paid to the various systems in use by
countries to not only develop their own existing businesses but also to att ract foreign investment. An
integral part thereof is the methodology for the recognition of foreign taxation relating to dividends. A
global level tax playing field is developing. International tax competition, with clearly defined rules, is
considered as beneficial to all.

Global trends
The globalisation drive has led to an increased knowledge and understanding of the various taxation
systems in countries around the world.
Such knowledge points to a blurring of differences between exemption and credit systems on account
of increasingly sophisticated anti-abuse legislation.
Parameters to measure the purported harmfulness of tax systems are being developed by both the EU
and OECD. The implementation of the exemption and credit systems is an important factor, especially
the details thereof.
Another recent feature in the discussion on global tax trends is the attention paid to the cost of
complying with tax rules. MNEs have to comply with a variety of tax systems and practices and hence
begin to ask for a minimum of standardization, in particular regarding transfer pricing documentation.
Some commentators mention that because of such costs, consideration may be given to "alternative
tax bases other than income" . Tentative conclusions on the cost of compliance indicate that a level of
some 2% of tax revenue is paid to cover the costs of compliance by businesses. It is likely that costs
related to cross-border business activities are higher than those for purely domestic operations.
In discussions on transfer pricing, the tax framework of countries starts to play a role. This includes the
methodologies to recognise foreign taxation paid, such as exemption and credit systems.

Characteristics of the tax exemption system

Exemption systems typically do not tax dividends from foreign business operations. Dividends
transferred from abroad to the shareholder are typically taxed with a withholding tax, in addition to the
corporate income tax on the original profits.
An exemption system allows resident companies to venture outside their domestic environment and
compete on a level playing field with their foreign competitors. Hence the frequently used term of
capital import neutrality (CIN).
An exemption system may lead to tax planning structures that could be viewed as abuses of this
method. Exemption countries therefore use various approaches to combat such structures including
general anti-abuse rules. Such rules appear to work efficiently and effectively.
Exemption systems have the advantage of being fairly simple. Compliance costs are relatively low.
Such systems do not require elaborate calculations, allocations, detailed characterisations of foreign
activities and foreign tax frameworks. Government tax audits can also be fairly short.

An exemption system encourages businesses in developing countries to venture outside, to export

and trade abroad. The system is simple and a level competition playing field is maintained in the
foreign country. Likewise, it encourages investments into developing countries.
Tax incentives granted by such countries go to the investor and not - as in a credit country - to the
revenue of the investor's country.
In general, it can be said that a tax exemption system encourages businesses to trade outside their
home country, thus accelerating the trends towards globalisation and increase of global welfare.

Characteristics of a tax credit system

The philosophy behind a tax credit system for foreign dividends is to allow international businesses to
operate under the same conditions as domestic enterprises. If a business ventures abroad, it must pay
tax on foreign and domestic business income domestically at the same tax rate and tax basis. Foreign
tax paid (dividend withholding tax and corporate income tax on the original profits) can be deducted
against domestic tax due, but usually without refund in the event that foreign tax exceeds domestic
tax. This system is also called a capital export neutral system (CEN).
A credit system does not create a level playing field abroad when a domestic business expands its
horizon. The company venturing abroad must pay attention to the tax consequences domestically. Its
competitive position in the foreign market can be considerably affected.
The effects of a foreign tax incentive regime for a capital investment abroad are negated; an incentive
simply lowers the amount of foreign tax credit the country of the investor has to recognize.
The cost of compliance with a tax credit system is relatively high due not only to the calculations that
are required to comply with the domestic tax rules but also due to the information gathering process
required to obtain the necessary data from abroad.
Abuses of the system for avoidance of double tax appear to be easier to monitor in tax credit systems
because much information related to foreign activities must be included in domestic tax returns. One
of the advantages of the credit system frequently cited is indeed the ability to combat abuse through
abundance of information. The fact that much attention is paid in major credit countries like the US
and UK to combating tax abuses does not, however, indicate a strong support for such an assumption.
In general, it can be said that credit systems do not encourage businesses to trade outside their home
country and are often seen by enterprises as a disadvantage in competition on the global marketplace.

Conclusions
The current environment and future trends appear to indicate that countries should look seriously at developing a
consistent approach to the recognition of foreign taxation for the avoidance of double taxation on international
dividend flows.
The tax exemption method is simple and does not require significant numbers of expert revenue
officials and auditors, which is troublesome for any country but especially for developing countries.
A tax exemption system is less costly to comply with, which is a major advantage for enterprises
engaged in international business.

A tax exemption system encourages businesses to trade outside their home country, thus accelerating
the trends toward globalisation and increase of global welfare.
A tax exemption system makes tax competition rewarding both for the business community and for the
countries. Such a win/win situation is an attractive proposition for everyone.
The tax credit system is well established in a number of countries, and enterprises resident in those
countries are familiar with its operation and have organised their affairs on this basis. For such
countries, moving from a credit to an exemption system would incur significant costs.

Recommendation
The international business community believes that both the exemption system and the tax credit
system are useful approaches to avoiding double taxation on cross border dividend flows.
On balance, however, the ICC favours an exemption system on foreign dividends primarily because:
- the exemption system supports the trend towards a truly global business environment, encouraging
businesses to export and trade abroad;
- it preserves the impact of domestic tax policy, particularly in developing countries; and
- the costs of compliance for foreign dividends are considerably reduced as compared to a tax credit
system.
.-.-.-.-.-.-.-.-.3 October 2003

Document 180-50/1rev.5Final