3 - Some shortcomings of the tax treaty system

Summary

Introduction

This chapter surveys two aspects of the current taxation of cross-border transactions: international tax avoidance, and problems in the operation of bilateral tax treaties. The chapter argues that there is a need for international tax reform in response to the globalization of international trade. The chapter focuses first on international tax avoidance, and outlines the ability of international enterprises to avoid taxation through sophisticated tax planning techniques. A major form of international tax avoidance by international enterprises is transfer pricing manipulation by associated enterprises. Transfer pricing anti-avoidance measures, in tax treaties and domestic legislation, are based on the arm's length principle. The chapter considers transfer pricing manipulation and examines the difficulties of applying the arm's length principle to transactions between associated enterprises. While the appeal of the arm's length principle is that it is theoretically straightforward, it has proven very difficult to apply in practice.

The chapter considers some of the problems created by the current international tax measures. The main flaw with these measures is that they do not provide a framework for the coordinated and measured implementation of tax policies and practices developed through the multilateral negotiations of countries. The current international tax treaty system is focused on removing obstacles to international trade and investment by, inter alia, allocating taxing rights between two countries. As the network of tax treaties has expanded, it has proved to be unwieldy and exceptionally difficult to reform. Meanwhile, international enterprises operate integrated global businesses and are able to exploit the current tax treaty system to avoid taxation. The chapter concludes with a brief consideration of the obstacles to international tax reform.