Chapter 3

International
taxation issues
 International taxation imposing taxes on
taxable activities abroad by a person or
company subject to taxes;
may include sales between companies in
different countries;
individuals travel from one country to the
other for business or any other purpose;
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.
 International taxation deals with the taxation of
income originated in different countries;
Countries involved in international taxation are
colled 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;
Countries have specific rules pertaining to the
determination of the residence of individuals or
a company;
 Cont
Individuals residence number of days /months
supplemented by other requirements
France 180 days;
Germany 6 months;
USA 122 days; UK 91 days,
Ethiopia 183 days (and other requirements like
has a domicile within Ethiopia; etc)
Companies residency rules usually consider:
where the headquarter is,
where the ownership is,
Where the effective (central) management is etc.
 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 autonomous 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
source 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 of 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;
What about income of nonresidents? Taxed or not
taxed?
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 -a citizen (a company) earning
income abroad needs to pay tax only to the host
government;
Territorial taxation taxes income in the country
it is earned; the home country 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.
any foreign source income earned by residents
are exempt from taxation.
 Cont.
Follows taxing at source approach instead of
at destination
Does not entail double taxation
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 (WWT)
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 =$10,000 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 effectively may act as a
hindrance to cross border activities
(investments);
International taxation regime 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.
 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 (its the Model to be followed for
entering into DTAAs with the U.S. and it is
peculiar to the US);
Objectives of a tax treaty include:
prevent double taxation;
facilitate cross boarder activities (investment
etc) by removing tax impediments;
eliminate tax avoidance; if one country (A)
has adopted resident based taxation & another
(B) source based, what would happen to
foreign source income of residents in these
countries?..
exchange of information; and
determine dispute resolution mechanisms.
 Methods for preventing double
taxation
Three methods of providing relief from double
taxation
exemption, credit and deduction 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);
Income earned abroad is exempted
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 include the US, Ethiopia etc
Deduction method resident countries allow
residents to deduct tax paid to a foreign country in
respect of foreign income;
Mostly the credit method is adopted in the DTAA
for providing relief from double taxation;
Multinational Companies(MNCs)
MNC 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 MNC
Strategies used by MNC in reducing tax burdens:
Affiliates subsidiaries
Tax havens
Payments to and from foreign affiliates (transfer
price) etc
Branch and subsidiary
An overseas affiliate of MNC 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 parents income;
 A foreign subsidiary is an affiliate organization
of the MNC that is independently incorporated;
In the case of the US for example, a foreign
subsidiary is a company owned by a US
corporation but incorporated abroad and hence a
separate corporation from a legal point of view;
Taxation of the income from a foreign enterprise
can be deferred 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 countrys tax system;
 Tax Havens
A tax haven is a jurisdiction which 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 factors:
No or only nominal taxes (generally or in special
circumstances);
Laws or administrative practices which prevent the
effective exchange of relevant information with other
governments on taxpayers benefiting from the law or
no tax jurisdiction; Lack of transparency
 Tax competition Why 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 and
the long 1990s boom (Genschel 2002);
 The new East European accession countries
tried to copy this success and thus attracted
resentment from old EU member states;
Germany and France were particularly critical
of the East European low tax strategy;
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.
 So, as a country, should one impose large tax or
small tax? .increase taxpayer base
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.
 Overall, the welfare loss of large countries is
greater than the gain experienced by small
countries
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
 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
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;
 Through this they can benefit from the good
infrastructure and other locational advantages in
high tax countries and the tax advantages offered
in low tax countries or tax havens;
Profit shifting happens through various
techniques such as:
1.The (legal) manipulation of internal transfer
pricing for products or
2.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, without changing their
location of real production;
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;
 Payments to and from foreign affiliates for the
purpose of shifting profit;
Having foreign affiliates offers transfer price 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 sale 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- pay high transfer prices; Charge low
transfer price
If one country has low taxes, recognize income there
have those affiliates pay high transfer price to the
co. located in low tax jurisdiction; Charge high
transfer price; pay low transfer price
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 arms length principle;
Under the arms 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 arms length price;
Comparable Uncontrolled Price Method,
Resale Price Method,
Profit Split Method,
Comparable Profits Method ,
Cost Plus Method.
End of Chapter
3