International tax law for MNEs

Class 2 - Introduction to International Tax

Prof. dr. T. Bender

Leiden University
Faculty of Law // Department of Tax Law
Fall semester 2019

September 5, 2019
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Agenda

- Introduction (recap class 1)

- Why and how do countries tax cross-border income (domestic law)
- Concepts of ‘residence’ and ‘source’
- Objectives of tax treaties and their relationship with domestic law

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1. Introduction
In class 1 we talked about:
General concepts of corporate taxation in a domestic context:
Why and how do countries tax income of businesses?

- Corporate Income Tax

* Tax on companies
* Based on net income
Country A * proportional / progressive tax
rate
Company - Withholding Tax
* Tax on recipient
* Tax on payments
(typically: interest, dividends,
royalties)
* Based on gross payments
* proportional tax rate
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Withholding tax: example

Company B Amount due = 500

WHT = 75
Net interest paid to lender
= 425
Interest = 500

WHT rate = 15%

Company A

Taxable base Tax rate Withholding Tax

500 x 15% = 75

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2. Domestic rules for cross-border situations

Domestic law contains two types of rules for cross border situations:

1) How to tax as the Source 2) How to tax as the Country of

Country Residence (US: citizenship)
Non resident with domestic Resident (citizen) with foreign
income income
“Inbound” “Outbound”

Company

Company

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Domestic rules - source countries

Generally, according to the domestic rules of country S non-residents

are taxed
- By a corporate income tax sourced in country S
- By a withholding tax on dividends (interest and royalties)

Company

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Domestic rules - residence countries

Generally, according to the domestic rules of country R residents

(citizens) are taxed
- By a corporate income tax on their worldwide income
- (However, usually country R has domestic rules for the avoidance of
double taxation (exemption or credit))

Company

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Example 1

Company A, a resident of country X owns and rents out real estate in country Y.
Company A has its primary business activities in country X.

Why would country Y want to tax the rent and/or

Country X
the business profits? Company A

- Entitlement level
- Practical level
- What would be the tax base?

Why would country X want to tax the

rent and/or the business profits?
Country Y
- Entitlement level
- Practical level
- What would be the tax base? 8
Bases for jurisdiction to tax

- Residency
Tax on worldwide income, regardless of source of the income/assets
or of citizenship
- personal connection , usually also political allegiance
- best positioned to assess a person’s overall capacity to pay
- can require him to aggregate and report entire income from all
sources (and enforce it)

- Citizenship
Tax on worldwide income, like for residents. For individuals: only
used by the US! For companies (incorporation): more common
- citizenship brings benefits
- historical 9
Bases for jurisdiction to tax

- Source
Tax on income located within the border, regardless of residency or
citizenship of the owner
- Source State has contributed to the creation of the economic
opportunities that allow the taxpayer to derive income generated
within the territorial borders of the State
- Practical ability to tax, before the income is remitted to the
owner abroad

- (Destination)

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3. What is Residence in domestic laws

Corporations
- Most countries: place of effective management
- Some countries: place of incorporation

Individuals
- Rules differ from country to country
- Simplicity/legal certainty vs possibility to look at facts and
circumstances of the case

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What is Source in domestic laws

Rules differ from country to country

Some examples:
- Income from real estate located in the country
- Owning a substantial interest in a company resident in the country
- Profits made by a factory, office etc. in the country and directly
owned by a non-resident (otherwise the taxation would be on the
basis of ‘residence’). The threshold typically applied for this type of
taxation is called “permanent establishment”

‘Source’ does not only play a role for the levying of income taxes, but also
for the levying of withholding taxes

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Withholding tax - Example 2

Company B, a resident of country R has a bank account in country S which produces

EUR 500 interest. Company B’s other income is entirely sourced in country R.

Would country S want to tax the interest? Country S Country R

- Entitlement level
- Practical level
Company B
- What would be the tax base? interest
EUR 450
- How would the tax be levied?

Why would country R want to tax the interest?

- Entitlement level Withholding
tax EUR 50
- Practical level paid to tax
authorities
- What would be the tax base?
- How would the tax be levied? 13
Corporate Income Tax - example 3a

- Company A, resident in state R

- produces bicycles in a factory in state S
- which are sold to customers in state D
- at a profit of EUR 1.000.000
A

Q: Which country is entitled to tax? Country R

Country S

Country D
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Corporate income tax - example 3b

- Company A, resident in state R

- owns a subsidiary company, resident in
State S, which produces bicycles in a factory in
state S
- which are sold to customers in state D A
- at a profit of EUR 1.000.000
Country R

Q: Which country is entitled to tax? Country S

Country D
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Example 4

Q: Which country is entitled to tax?

A: This depends on systems chosen by the

individual countries. Suppose, alternatively
• All three only apply a sales tax/VAT A

• All three only apply a corporate income tax

Country R
• All three only apply an individual income tax
(but then, in real life, all countries apply all taxes Country S
mentioned)

Country D
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Example 4

Suppose all three countries only apply an

individual income tax.

Then taxation can be deferred:

- Dividend income paid by A to shareholders A
- Capital gains on sale of shares
Country R

Country S

Country D
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Example 4b
A closer look at the corporate income tax
- Who makes a profit?
- Who is enriched?

Q: Would country R tax?

A
A: This depends on the system chosen by country R for
taxation of multinational enterprises: Country R dividend
- Country R taxes on a worldwide basis
Country S
- Country R taxes on a territorial basis

Country D
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Example 4b

Suppose country R taxes multinationals on a

worldwide basis
- Usually R will wait until the S-profits are
remitted (dividend) or until the shares are sold at
a gain (capital gain)
A
- Consequences
1. “Deferral” is advantageous Country R dividend
2. When the dividend is paid, there is double
taxation Country S

Country D
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Back to bases for jurisdiction to tax

Most countries apply both residence and source in their domestic laws. They
tax both
• The domestic and foreign income of their residents
ánd
• The domestic income of nonresidents

Overlapping claims double taxation

• Q: Is this a problem?
• A: It is (1) unfair, and (2) it disturbs economic efficiency

Solution for double taxation

• Domestic rules
• Tax treaties
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4. Tax treaties for the avoidance of double
taxation

- Double tax conventions/agreements/treaties, income tax treaties

- Facilitate cross-border trade and investment by eliminating the tax
impediments to these cross-border flows caused by overlapping
claims in domestic laws
- Main purpose: avoidance of double taxation
• Allocate taxing authority over specified types of income to the treaty
partners
- But also avoidance of double non-taxation
• Tax evasion, tax avoidance
• Increasingly important
• Exchange of information between tax authorities
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Tax treaties for the avoidance of double taxation

- Bilateral
- Over 3,000 existing tax treaties
- OECD Model, UN Model
- Commentaries

Countries conclude treaties but taxpayers are dependent on their

functioning

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Tax Treaties: allocating taxing authority

- Per income category it is decided which of

the two countries is allowed to tax:
• Italy (residence country), or
• France (source country)
Company
- Usually active income may be taxed in the
source country, and passive income in the
residence country

- Income categories: real property, business profits, dividends,

interest, royalty’s, capital gains, employment income, directors’
fees, entertainers and sportsmen, pensions, government service,
students

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Two layers of rules

Relationship between tax treaties and domestic law for most countries:
a. Tax treaties limit a contracting state’s tax jurisdiction in order to
avoid double taxation
b. Treaties generally cannot enlarge the taxing authority of countries
c. Once a treaty has allocated taxing authority to a treaty partner, the
domestic laws of that partner govern the ultimate tax treatment

For illustrations of rules a. and b., see example 5.

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Example 5

Company A, a resident of country X owns real estate in country Y. They sell the
property at a profit of EUR 200,000. In addition, the company earns EUR
100,000 from business activities in country X.
1. What amount do you think country X will want to tax according to its
domestic law? What assumption do you make when answering this question?

Suppose there is a tax treaty X-Y with an Art. 13(1) cf the OECD Model: ‘Gains
derived by a resident of a Contracting State from the alienation of immovable
property … situated in the other Contracting State may be taxed in that other
State.’
2. What is the effect of this provision? (Illustrating point ‘a’ on previous slide.)

Let’s assume the domestic law of country Y does not contain a taxing provision
for capital gains on immovable property.
3. Will country Y be allowed to tax the EUR 200,000 capital gain, now Art. 13(1)
Treaty X-Y says so? (Illustrating point ‘b’ on previous slide.) 25
Assignment next class

We will discuss the following statement:

‘Which method for the avoidance of double taxation has your

preference: exemption or credit?’

- Be prepared for a class discussion about this question

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