Advanced Taxation (AcFn

522)

Part III – International

Taxation Issues
 International Taxation – imposing
taxes on taxable activities abroad by a
person or company subject to taxes;
• It may include sales between companies in
different countries;
• Individuals travel from one country to the
other for business;
• Generation of income in one country as a
result of investments made by individuals or
corporations of another country; or
• Services rendered by residents of one country
to persons in another country etc.
 Domestic taxation concerns with the
various kinds of taxes imposed on
bases that a given tax law identifies as
proper bases;
 International taxation deals with the
taxation of income originated in
different countries;
 Countries involved in international taxation
are source and residence countries;
•The state where the income is generated is
the source country (State);
•The state where the taxpayer resides is the
residence country (State);
  Residence rules;

 Companies residency rules usually

consider:
• Where the headquarter is,
• Where the ownership is,
• Where the effective (central)
management is etc.
 Countries have specific rules pertaining
to the determination of the resident of a
company;
 For example UK company residency
rules:
• if it is incorporated in the UK or,
• if not incorporated in the UK, if its central
management and control is exercised in the
UK.
 Ethiopia company residency rules:
• Has principal office in Ethiopia;
• Effective management in Ethiopia;
• Registered in the trade register of the
concerned government office;
 Who should tax foreign source income?
Residence or Source country?

• both countries have the sovereign right to

impose tax;
• every country has the right to tax income
accruing, arising or received in it, on
account of the activity carried on in its
territory.
Residence and source based taxation
 Residence based taxation
• All incomes (both foreign and domestic
sourced incomes) are taxable in the country
of residence only;
• No tax in source countries;
• Foreign source income is exempted in the
country of source;
• Likely to give advantage to developed
countries at the cost developing countries;
  Source based taxation
• Foreign source income is taxed in the country
of origin and exempted in the country of
residence;
• No taxation on foreign source income in the
country of residence;
• Likely to cause distortions – excessive capital
export
 Specifically, excessive capital outflow to
countries where the tax rate is low;
 Global and Territorial Systems of Taxation
 Global system (worldwide) the total
–
amount of tax payable should be roughly
independent of whether the income is earned at
home or abroad;
• It taxes residents of a country on their
worldwide income no matter in which country it
was earned;
 Examples of countries using WWT
method:
• A resident in the UK or US is liable to tax on
worldwide income;
• A resident of Ethiopia is also subject to tax on
worldwide income;
 Territorial system – an individual (a
company) earning income abroad needs to
pay tax only to the host government;

 Territorial taxation – taxes income in the

country it is earned; does not tax foreign
source income;

• any business income earned in a territory is

subject to income tax in that territory,
regardless of whether the business is owned
by foreigners.

• Follows taxing at source approach instead of

at destination.
 Example Mr X a resident in the US earned
income of $10,000 from work performed in
the UK (in the year 2008). He also earned
$120,000 in the US (same year).

• Home country (country of residence)= USA

• Host country = UK
• Income generated in the home country =
$120,000
• Foreign source income = $10,000

 Taxation in the UK (host country) – is non-

resident taxation.

 Mr. X is liable for income tax on $10,000;

  Taxation in the US (home country)
resident taxation (WWI)
 Residents are taxed based on their worldwide
income;
 Worldwide income in the example=
• Income in home country + income host
country
=$120,000 + $10,000 = $130,000;

 The foreign source income =$10000 is taxed

twice (double taxation of the same base);
 One of the problems in taxation of foreign
source income is the existence of double
taxation;
 Double taxation has effects on the cost of
operations and may act as a hindrance to
cross border activities (investments);
 International taxation system deals with how
to tax international activities and avoid unfair
treatment of taxpayers (double taxation);
• in international taxation regime, the source
state (country) is granted the prior right to
tax all income and
• the residence State (country) has the
primary obligation to prevent double
taxation;
 Avoiding Double Taxation
 The principle underlying avoidance of double
taxation is to share the revenues between the
countries involved;
 Double taxation is usually avoided through a
Double Taxation Avoidance Agreement (DTAA)
entered into by two countries for the
avoidance of double taxation on the same
income.
 The DTAA eliminates or mitigates the
incidence of double taxation by sharing
revenues arising out of international
operations by the two contracting states to the
agreement.
Objectives of a tax treaty include:

• Prevent double taxation;

• Facilitate cross boarder activities

(investment etc) by removing tax
impediments;

• Eliminate (reduce) tax avoidance;

• Exchange of information; and

• Determine dispute resolution

mechanisms.
 There are at least three DTAA models;

 The OECD Model Tax Convention

(Treaty) (emphasis is on residence
principle);

 UN Model (combination of residence and

source principle but the emphasis is on
source principle);

 US Model (it’s the Model to be followed

for entering into DTAA with the U.S. and
it is particular to the US);
 Methods for preventing double taxation
 Different methods for providing relief
from double taxation –
• Exemption and credit methods

 Exemption method – the residence

country exempts income that has arisen
and taxed in the source country;
• Foreign source income is taxed only in the
country of origin (source);
• Example - Netherlands
 Credit method – residence country
grants credit for taxes paid by its
resident in the source country;
• The tax paid in the source country is
credited against the total tax liability
in the resident country;
• Countries using this method include
the US, Ethiopia etc
 Mostly the credit method is adopted in
the DTAA for providing relief from
double taxation;
 Multinational Enterprises (Companies);
 MNE/C is an entity that conducts business in
more than one jurisdiction;
• Home office in one country – branch in another
country.
• Parent Company in one country – Subsidiaries in
other countries.
• Affiliated companies … Sole agent, Distributor etc

 Multinational corporations are subject to tax in

their home country depending on the specific
multinational taxation system adopted by the
home country.
  Taxation and MNE

 Strategies used by MNE in reducing tax

burdens:

• Affiliates – subsidiaries

• Tax havens

• Payments to and from foreign affiliates

(transfer price) etc

 Branch and subsidiary income

 An overseas affiliate of MNE can be organized as a

branch or a subsidiary;
 A foreign branch is not an independently
incorporated firm separate from the parent;

 Branch income becomes part of parent’s

income;

 A foreign subsidiary is an affiliate

organization of the MNC that is
independently incorporated;

 Taxation of the income from a foreign

enterprise can be excluded if the operation
is a subsidiary;
 Profits earned by a subsidiary are
included only if returned (repatriated)
to the parent company;

 Thus, for as long as the subsidiary

exists, earnings retained abroad can
be kept out of reach of the resident
country’s tax system;

 By doing so multinationals companies

defer the payment of the tax;
 Tax Havens
 A tax haven serves as a means by
which firms and individuals resident in
other jurisdictions can reduce the taxes
that they would otherwise be obliged to
pay there;

 Tax havens may be identified by

reference to the following factor:

 Tax competition – governments compete

for taxes;
 Tax competition occurs when countries
adapt their tax policies strategically to make
themselves attractive to new enterprises or
to keep themselves attractive for existing
ones;

 Perhaps the best known case of a successful

country in tax competition is Ireland;

 Low taxes in Ireland attracted considerable

foreign investment and thus contributed to
the rapid economic modernization of the
country (Genschel, 2002);
 The new East European accession countries
tried to copy this success and thus
attracted investors and got complaints from
old EU member states;

 Large EU member states’ complaints are

understandable because the low tax
strategy of the small countries is openly
aimed at capturing their capital and
productive businesses.
  Small countries – large countries
winners and losers in tax competition
 Small countries benefit from reducing tax
because the resulting tax deficit on ‘home’
capital can be over-compensated by the
attraction of foreign capital;
 From the perspective of small countries,
reducing the tax rate leads to the inflow of
foreign capital, especially from large
countries and leads to an income and welfare
gain for them;
 In a situation of tax competition, the welfare
of small states rises while that of large states
falls.
 In general, a very popular public opinion is
that if a state has a higher corporate tax
rate than others, then for tax reasons large
companies will move their production and
jobs to low taxation countries;

 Relocation takes a number of factors into

account – access to market, factors of
production etc;

 A company does not relocate solely

because of tax burdens (EC, 2001);
 However, the above point does not apply to
all industries;

 Surveys show that companies choosing a

location for a financial services centre clearly
focus their attention on tax factors (Ruding
Report, 1992);

 An important reason for the stiff competitive

pressure in corporate taxation is that
multinationally integrated companies can
perform ‘tax arbitrage’;

 They can avoid taxes by transferring ‘profits’

from high to low tax jurisdictions;
 ‘Profit shifting’ happens through
various techniques such as the skillful
choice of financial structures,
especially debt rather than equity
financing;

 In this way multinational companies

can book the profits in low tax
countries and their losses in high
taxation countries.
 Many empirical studies have investigated
whether and how strongly tax differences
between countries influence decisions on
where companies transfer their ‘profits’;

 Despite different approaches, all the studies

come to the same conclusion: the transfer
of taxable profits is very sensitive to
taxation;

 Having foreign affiliates offers tax arbitrage

strategies (for shifting the profit);
 Transfer pricing

 The transfer price is the accounting value

assigned to a good or service as it is
transferred from one affiliate to another;

 Transfer pricing refers to the prices that

related parties charge one another for goods
and services passing between them;

 For example, if company ‘X’ manufactures

goods and sells them to its sister company ‘Y’
in another country, the price at which the sell
takes place is known as the transfer price;
 These prices can be used to shift profits to
preferential tax regimes or tax havens;

 If, a subsidiary in a high-tax jurisdiction

charges a price below the “true” price (i.e. it
transfers at a price below the actual price),
some of the group's economic profit is shifted
to the low-tax subsidiary;

 Consequently, the assessee is able to escape

tax or mitigate it but at the same time the tax
base of high-tax jurisdiction is eroded;
 Hence, unless prevented from doing so,
corporations or other related persons engaged
in cross border transactions can escape from
paying tax by manipulating the transfer
prices;

 If one country has high taxes, do not

recognize income there - have those affiliates
pay low transfer prices to the co. located in
high tax jurisdiction;
 If one country has low taxes, recognize
income there – have those affiliates pay high
transfer price to the co. located in low tax
jurisdiction;

 Most countries have transfer pricing rules

which regulate the prices charged by related
parties.
 Most tax systems, including the U.S. transfer
pricing rules, follow the arm’s length principle;

 Under the arm’s length principle – transfer

price should be the price that would have
been set if the parties (to the transaction)
were unrelated enterprises acting
independently;

 The underlying principle is that the prices

charged by related parties (mostly units of an
MNC) to one another should be consistent
with the price that would have been charged if
both parties were unrelated and negotiated at
arm's length;
 Methods of determining the arm’s
length price (Reading Assign.);

• Comparable Uncontrolled Price Method,

• Resale Price Method,

• Profit Split Method,

• Comparable Profits Method ,

• Cost Plus Method.

The End