Tax Exemption versus Tax Credit Systems for Foreign Dividends: Comparison and International Trends

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.