Income Tax

Lecture 3: Income Tax Jurisdiction and the

Foreign Tax Credit
Introduction
 Income tax is one of the most known tax base that is levied and
collected by almost all countries of the world.
 However the detailed rules of income tax employed in one
country may be quite different to the one in another country.
 The difference may be explicated in terms of a number of
considerations such as the definition given to some key
terms may vary from state to state; the difference may also
lie on the subjects who bear the burden of this tax and the
manner of calculation of this tax.
 In federal arrangements differences may also exist between
the regional states’ tax laws on one hand and the federal
government’s income tax law on the other hand, or between
the income tax laws of the various regional states.

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Income Tax Jurisdiction
 The issue of tax jurisdiction is a part of the
discussion on international tax law. And the purpose
of International tax law is to fix the conditions on
taxation of cross border transactions.
 A transaction made in one state by an individual
or a company resident in another state should be
taxable in which state?
 The first state would claim the right to tax this
transaction under the “residence” principle and
the other state would claim the right because
the transaction has taken place within its
“territory”.
 Note -This simple example demonstrates the two main principles
of international tax for both individual and corporate taxation:
the principle of source and the principle of residence.

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 A state may follow the nationality principle where every
citizen of that country should pay income taxes on their
world wide income.
 For example, Mr. Ben is Canadian by nationality and does some business in
Ethiopia, France and Greece. If Canada adopts the principle of nationality
for income tax purpose, Mr. Ben has the obligation to pay income tax on
his incomes from Ethiopia, France and Greece.
 USA is the most exceptional example of nations following this
principle.
 It is argued that the justification for taxing citizens abroad
remains valid today and has even been strengthened by economic
developments involving increased globalization.
 Some authors reviewed the benefits afforded to citizens
residing abroad, such as "personal protection," "property
protection," "right to vote," "right to enter," and "past benefits,"
and concludes that these benefits "provide a basis for concluding
that the United States is justified in exercising some type of
taxing jurisdiction over those citizens."
 All this can be generalized as belief that the benefits of citizenship
are worth the tax cost.
 Also it has been argued that such taxation serves the goal of
neutrality by "minimizing the role of taxes in a citizen's
residency decision."

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 As noted above a state may also follow the principle of
source for the levying and collection of tax. In this case a
person is held liable to pay income tax from his incomes
that he gets from that state irrespective of the tax
payer’s nationality.
 Suppose that Canada follows this principle. It means that any one
that gets income from different sources within that state is
liable to pay income tax no matter what that person is not a
Canadian.
 Often frequently recalled justification for following this
principle is state’s relationship to the income.
 i.e. state’s contribution to the generations of the
income.[ …theory of partnership which states that a
state is an inevitable partner in every affair]

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 On the other hand, their are states which adopt the
principle of residence as far as their income tax
jurisdiction is concerned.
 In these countries a person is liable to pay income tax
from his worldwide income. i.e. sources elsewhere in the
world, so far as the tax payer is a resident of that state.
 For example, Assume that Mr. X is an Ethiopian by nationality living
permanently in Denmark. If Denmark follow the resident principle,
Mr. X is liable to pay income tax from his income that he gets from
sources in different countries.
 As a mater of fact, this principles is followed world wide and
this is due to one major reason.
 i.e. the theory is based on the fact that residents
always enjoy the protection of the state in which
they are residing and they pay for this protection.
 In some instances, countries adopt any two of these principles, or
even all of them.

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 Up until 2002 Ethiopia used to follow source based
jurisdiction. The income tax proclamation of 2002
introduced the concept of residence based taxation.
 According to Article 3 of the Income Tax Proclamation,
every resident of Ethiopia shall pay income tax with
respect to their world wide income.
 Further more, this provision is applicable both to natural
and artificial persons within the meaning of Article 2(1)
of the proclamation.

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 How do we establish source and residence?

 After going through the above discussion, an obvious

question that is going to arise is:- Who are residents of
Ethiopia?
 Should we follow the definition provided under Article 174
of the Civil Code?, or we need to define it especially for
tax purpose?
 To answer this question we need to read Article 5 of the
proclamation. It reads:
1. An individual shall be deemed to be resident in
Ethiopia, if he
a) has a domicile in Ethiopia,
b) has an habitual abode in Ethiopia,
c) is a citizen of Ethiopia and consular, diplomatic
or similar official posted abroad.

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 Sub article (a) seems to suggest that the civil codes
concept of residence is adopted to determine who is
a resident for the purpose of income tax liability.
 The provision, however, broadens the scope to
include those persons who have abodes in Ethiopia,
[this signifies principal dwelling places] and those who entirely
live abroad for the purpose of carrying out their
consular or diplomatic mission.
 Sub-article 2 of article 5 further defines who else
can be said resident of Ethiopia. This provision reads:
An individual who stays in Ethiopia for more than 183 days
in a period of twelve (12) calendar months, either
continuously or intermittently, shall be resident for the
entire tax period.

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 This provision has the message that even if a person is not
resident for the purpose of the civil code, or he/she does
not have an abode in Ethiopia, he is a resident in so far as
he happens to be in Ethiopia for 183 days in a year.
 It does not matter whether his stay is continuous for the
whole 183 days or irregular in the sense that he
occasionally appear in the country.
 For example, Mr. X is a Sudanese and his uncle resides in Gondar. He
visits his uncle once every two weeks and stays with him for a week
time. If Mr. X ’s stay in Ethiopia counts 183 days in total, he is
considered as a resident of Ethiopia, though he permanently reside
in Khartoum.
 Also a concern may arise here as to the issue of whether we
start counting from the time the person arrives or according to
the time table of each calendar year. Were in both cases we
reach at a different conclusion.
 E.g. Mr. Rodriguez arrived in Addis on Tikimt 10, 2002 and left
on Tir 9,2002 and he came back again on Nehase 8, 2000 and
left again on Hidar 12,2001… …
 Perhaps the first proposition is in line with international precedence.

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 Also it is good to know that different countries set
different standards to determine tax residence, but
broadly, one becomes resident in a country if one is in
that country for more than a certain number of days.
 The following list specifies the number of days (or
months) in a variety of countries:
 France: 180 days
 Germany: 6 months
 South Africa: 91 days
 United Kingdom: 91 days
 United States: 122 days

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 On the other hand, Article 5(3) deals with the income
tax liability of legal persons (bodies) by defining
which bodies are residents of Ethiopia.
It reads:
A body shall be resident in Ethiopia, if it:
(a). has its principal office in Ethiopia;
(b). has its place of effective management in Ethiopia
(c). is registered in the trade bureaux of the
regional government as appropriate.

 The term ‘body’ is defined under article 2(2) as: any company,
registered partnership, entity formed under foreign law resembling a
company or registered partnership, or any public enterprise or public
financial agency that carries out business activities including body of
persons corporate or unincorporated whether created or recognized
under a law in force in Ethiopia or else where and any foreign body’s
business agent doing business in Ethiopia on behalf of the principal.

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 According to Article 5(3) therefore, a body is
deemed to be a resident of Ethiopia if its principal
office is in Ethiopia.
 Here you should take a note of the fact that principal office
is distinguished from subsidiary office.
 Assume that Ethiopian air lines has an office in Brussels to facilitate
its business in Europe. The main office (head quarter) of Ethiopian
air lines, however, situates in Addis Ababa. With in the definition of
this article, therefore, Ethiopian air lines resides not in Brussels,
but in Ethiopia.
 By the same token if Kenyan air ways has an office in Addis Ababa
simply to facilitate its business in Ethiopia, it is not deemed to
reside in Ethiopia so far as its main office situate elsewhere.

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 The same article defines resident bodies
alternatively as those whose effective management
exists in Ethiopia.
 The term effective management is defined no where in the
proclamation and its regulation. In the absence of any definition, the
term is susceptible for different interpretations. …[would the place
of seat of board of directors be considered as a test ? May
be…]
 One thing which must be clear is that a body is a resident of
Ethiopia even if its main office situate else where so far as its
effective management, what ever definition this word is given, exist
in Ethiopia.
 Article 5(3) again define a resident body alternatively as those
bodies which are registered either in the ministry of trade
and finance at the federal level, or in the appropriate
regional bureaux.
 From the reading of this provision, one can conclude that a mere
registration in one of the above organs automatically gives rise to
residence as to bodies.

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 Finally, a resident person under Article 5(4) includes a
permanent establishment of a non-resident person in
Ethiopia.
 The key term here is what “a permanent establishment”
constitutes.
 Article 2(9) provides an illustrative list of examples
considered permanent establishments. This provision reads:
“Permanent establishment” shall mean a fixed place of
business through which the business of a person is wholly or
partly carried on. The following shall, in particular, be
considered to be a permanent establishment:
(a). an administrative, branch, factory, workshop, mine
quarry or any other place for the exploitation of natural
resources, and a building site or place where
construction and/or assembly works are carried out… etc

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 Therefore, the ultimate effect of these provisions is to
determine the scope of Ethiopian income tax law.
 i.e. as opposed to citizenship, the Ethiopian income tax
proclamation applies the principles of residence which
considers residential status of a taxable person as a
criterion.
 As a result, the residents of Ethiopia pay tax to the
Ethiopian government on their worldwide income.
[income derived in Ethiopia and from abroad]
 Whereas, non residents of Ethiopia are taxed on their
Ethiopian source income only.
 Finally, the reading of article 3 makes you conclude that a
person is not subject to income tax merely because of the
fact that he is Ethiopian by nationality.

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The Foreign Tax Credit
 With the possibility of many states, including Ethiopia,
following a combination of all principles of tax jurisdiction
(nationality, source or residence) the situation of double
taxation comes in to picture.
 Double taxation is an instance where a person is subjected
to pay income tax for more than one jurisdictions from
essentially the same income.
 For example, Mr. X is an Ethiopian resident doing business in England.
Assume that England follows “source” principle with respect to
income tax. Mr. X is, therefore liable to pay income tax in England.
He is also liable to pay income tax to Ethiopia according to article
3(1) of the income tax proclamation because he is a resident of
Ethiopia.
 Unless there is a mechanism to exempt Mr. X from the payment of
income tax to one of these jurisdictions, the situation of double
taxation will occur.

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 Thus, many countries devise mechanisms to avoid the ill-
effect of double taxation.
 One possible solution for this problem is tax treaty among
the concerned states.
 Such treaties usually contain “tie-breaker” provisions.
 i.e. for example, if a person is subject to double taxation of state A&B
and if the two countries have tax treaty they may agree that in such
cases of double taxation nationality be the tie-breaker. Which means if
the person is the national of A he will be taxed by state A only. The same
works if he is the national of B.
 Another mechanisms is what is provided under Article 7 of
the proclamation. [i.e. the Foreign Tax Credit]
The provision reads:
7. Foreign tax credit
1. if during a tax period a resident derives foreign source income, the income
tax payable by that resident in respect of that income shall be reduced by the
amount of foreign tax payable on such income. The amount of foreign tax shall be
substantiated by appropriate evidence such as a tax assessment, a withholding
certificate or any other similar document accepted by the tax authority.

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 The provision stipulates that, once a person pays an income tax
in a country where the income is derived, his income tax liability
in Ethiopia shall be reduced to the extent of the payment he
made to the foreign jurisdiction.

 Therefore, FTC is a credit for foreign income taxes paid against

Ethiopian income tax due on foreign income.
 It is a direct consequence of residence based tax jurisdiction.

 An important notion that you have to bear in mind is that Article

7(1) is making a reduction, not an absolute exemption from
income tax liability.
 For example, Ms. X gets an income of 300,000 birr in England in a certain
calendar year; further assume that Ms. Xs income tax liability in Ethiopia
is 5000 birr; if she pays 4000 birr as an income tax in England on that
income, Ms. X will pay 1000 birr in Ethiopia.
 It in effect means that the 4000 birr that she pays to the foreign
jurisdiction is deducted from her 5000 birr income tax liability that she
would have paid to Ethiopia.

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 A related question may arise as to what will happen if
a person pays more income tax in the foreign
jurisdiction than he would have paid to Ethiopia.
Does the Ethiopian government have the
obligation to compensate him the excess?
 For example, in the previous example Ms. X paid 6000 birr
to England while her obligation under the Ethiopian
jurisdiction was only 5000 birr. Can she claim a
compensation of 1000 birr from Ethiopia?
 Sub article 2 of Article 7 makes it clear that the
reduction of income tax provided by sub-article (2) shall
not exceed the tax payable in Ethiopia that would
otherwise be payable on the foreign source income.
 Therefore there exists no right of substitution for excess
payment made to a foreign jurisdiction.

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 Other issues may still arise in connection with multiple
sources of income from a number of foreign countries.
What would be the manner of reduction of income tax
liability in case where an Ethiopian resident gets incomes
from different sources in a number of foreign jurisdictions
where there are differences on the extent of income tax
liability?
 Article 7(4) tries to resolve this issue. It reads:

The reduction of tax prescribed by this article shall be calculated

separately in respect of each foreign country from which income or
profit is derived.

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 For example, X is an Ethiopian resident who makes money in
England and Kenya where the extent of tax liability of a person is
different in these states. His incomes in these countries, during a
calendar year, are 200,000 and 40, 000 birr respectively. Suppose
that a person’s income tax liability from 200, 000 birr is 3000 in
Ethiopia while it is 4000 birr in England; from 40,000 birr income,
the income tax in Ethiopia is 1000 birr while it is only 500 birr in
Kenya. This means that X aggregately pays 4500 birr to the
jurisdiction of England and Kenya.
 However, the reduction in his tax liability to the Ethiopian
jurisdiction shall not be in an aggregate manner. That means, X
does not have any income tax liability in respect of his income from
England because he paid income tax to this foreign jurisdiction
even in excess of what he owes to Ethiopia. However, he has to pay
500 birr income tax to Ethiopia in relation to his income from
Kenya because he paid only 500 birr to that jurisdiction.
 Had not the calculation been made separately, X should not have paid
the 500 birr income tax to the Ethiopian government.

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