CHAPTER THREE

INTERNATIONAL TAXATION ISSUES

CONT…
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.
CONT….
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);
CONT…
Residence rules;
•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.
•Countries have specific rules pertaining to the
determination of the resident of a company;
CONT…
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;
CONT…
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 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 developing countries;
CONT…
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;
CONT…
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; 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.
◦ Follows taxing at source approach instead of at
destination
CONT…
Example Mr ABC 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. ABC is liable for income tax on $10,000;
Taxation in the US (home country) resident taxation (WWI)

Residentsare 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;
CONT…
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.
CONT…
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 DTAAs with the U.S. and it is peculiar to the
US);
CONT…
objectives of a tax treaty include:
◦ prevent double taxation;
◦ facilitate cross boarder activities
(investment etc) by removing tax
impediments;
◦ eliminate tax avoidance;
◦ exchange of information; and
◦ determine dispute resolution
mechanisms.
Methods for preventing double
taxation
threemethods 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);
◦ Example Netherlands
CONT…
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
CONT…
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 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
Worldwide tax saving-profit maximization
Multinational corporations are subject to tax in
their home country depending on the specific
multinational taxation system adopted by the
home country.
CONT…
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;
CONT…
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;
CONT…
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;
Example on the use of multinationals to
defer the payment of the tax;
CONT…
Controlled foreign corporations (CFC)
rules
In the US, CFC is a foreign subsidiary that
has over half of its voting stock held by US
shareholders;
The undistributed income of minority foreign
subsidiary of a US MNC is tax deferred until
it is remitted via a dividend;
This is not the case with a CFC- the tax
treatment is much less favourable;
CONT…
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);
CONT…
laws or administrative practices which
prevent the effective exchange of relevant
information with other governments on
taxpayers benefiting from the low or no
tax jurisdiction;
Lack of transparency;
Tax competition – governments compete
for taxes;
CONT…
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;

Perhapsthe 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);
CONT…
thenew 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.
CONT…
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.
CONT…
Overall, the welfare loss of large countries is greater
than the gain experienced by small countries
(Bucovetsky 1991; Wilson 1991; Dehejia/Genschel
1999);
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);
CONT…
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;
CONT…
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 the (legal) manipulation of
internal transfer pricing for products or the
skillful choice of financial structures,
especially debt rather than equity financing;
CONT…
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;
CONT…
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;
CONT…
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;
CONT…
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 high transfer prices;
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.
CONT…
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;
CONT…
Methods of determining the arm’s
length price;
◦ Comparable Uncontrolled Price Method,
◦ Resale Price Method,
◦ Profit Split Method,
◦ Comparable Profits Method ,
◦ Cost Plus Method.
…..

THE END