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What are the implications of the explosive growth in the market for derivative financial instruments for international taxation? As Rosenbloom (1996) has pointed out, derivatives do not pose a particular international tax problem as long as one focuses on residence-based taxation. In that context, the issues raised by derivatives are the same as in a purely domestic context, which have been discussed extensively elsewhere (e.g., Warren, 1993). However, when the focus is on source-based taxation, and in particular source-based taxation of passive income (i.e., withholding taxes), the rise of derivatives has far-reaching implications. In 1994, then U.S. International Tax Counsel Cynthia Beerbower was quoted as saying that "opportunities for synthetic investments, as opposed to real investments, are so prevalent that withholding taxes are no longer real." The purpose of this paper is to explore the implications of this statement not just for the tax treatment of derivatives but also for the international tax regime as it relates to source-based taxation of passive investment. In particular, the paper will address the following questions. Is Ms. Beerbower's statement true? If so, what can (or should) the United States do about it?


Copyright 1996 National Tax Association. Published as Avi-Yonah, Reuven S. "Virtual Taxation: Source-Based Taxation in the Age of Derivatives." Proceedings of the Annual Conference on Taxation Held under the Auspices of the National Tax Association-Tax Institute of America 89 (1996): 269-274.

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