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2Class Notes on Taxation:

A. PURPOSES OF TAXATION:

(a) to raise revenues for government;

(b) to encourage, regulate of restrict local or foreign investment, generally, or by particular industry;

(c) to protect consumers or local industry; and/or

(d) to ensure a more equitable distribution of income and wealth.

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Direct Taxes v. Indirect Taxes

A direct tax is one paid directly to the government by the persons (juristic or natural) on whom it is imposed (often accompanied by a tax
return filed by the taxpayer). Examples include income taxes, corporate taxes, and transfer taxes such as estate (inheritance) tax and gift tax.
This is often contrasted from indirect taxes which are transferred to government by persons/juristic entities who ultimately may not be the
persons on whom the burden of the taxation falls. Examples include: sales taxes, VAT etc. Some commentators would essentially write the
difference between direct and indirect taxes as to whether the burden can be shifted to another person or not. (Income Taxes are owed and due
by the person/juristic entity earning an income and cannot be shifted to someone else, whereas in the indirect taxes case the person/juristic
entity maybe acting only as in intermediary.

The concept of progressive v. regressive taxes: Taxes that progressively increase the rate of taxes as the wealth (income and assets) rises are
called as progressive taxes. Most countries in the world would impose different tax rates, based on the slab levels of income, and such rates
increasing as the level of slab of income rises. Progressive income taxes are often imposed with the intent of ensuring (a) higher tax revenues;
and (b) of ensuring that the burden of taxes is equitable as between various income and wealth groups of the country. (Concept of Marginal
Utility/Marginal Cost and social justice notions). Where the burden of taxes is uniform as between income/wealth levels across the
population, they would be classified as regressive taxes. For instance in the case of sales tax, the rate of taxes is typically uniform, and is
imposed on the buyer irrespective of his/her level of income/wealth. Some economists argue that very high progressive taxes would tend to
act as a disincentive to bright, creative individuals from taking risks – where there is a direct relationship between risk taken and rewards –
thereby lowering the overall levels of economic activity, starting of new economic/commercial activities. Moreover, some have also argued
that where tax rates are high and progressive, they tend to promote parallel economy, and thereby reduce the amount of revenues actually
collected by governments.
While one would expect purely economic rationale to underlie particular tax schemes, political necessities also compel imposition of taxes or
extend tax breaks to particular political constituents, particularly local industry groups: subsidies for farmers in US, wine makers in France
etc.

B. INCOME TAXES

• Worldwide taxes on personal (individuals) income1 and profits of the company (also treated as income of the juristic person - the
company) are the most widely used.

• Two Models based on how governments collect income taxes: SCHEDULER TAX MODEL; and GLOBAL TAX MODEL.

o Scheduler Model: imposes tax at flat (uniform or same) rates on different sources of income. So, for instance, income
from manufacturing, retail sales, agriculture, employment income etc., may be taxed at flat rates specific to each source of
income. So within that source group, all taxable persons could be charged at the same rate.

 Advantages of scheduler model: simplicity in calculations, and its ability to encourage or discourage development
of particular sectors within a country;

 Substantial shortcoming: It is regressive – because it will end up imposing less of a burden on richer individuals
than on poorer individuals. It could also work in an anti-entrepreneurial fashion – if the sector is well developed,
and it already has big players, the same tax rate on the well established and high profit earning entity would mean
that they would have a lesser burden (marginal utility wise) – and that could dissuade newer entrants, and only the
already well-to-do are encouraged to take risks – and once the threat of new entrants is substantially eliminated –
stop taking those risks (of innovation)..

o Global Tax Model: imposes uniform rates on all sources of income, but those rates could vary as between the levels of
total income from all sources – using the slab system.

 Advantage of not being regressive, and depending on the circumstances may also not be anti-entrepreneurial
(remember, a new entrepreneur is typically likely to be smaller in size and resource capacities than a well
established entity);

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which generally may be deemed to be _______, _______ and ____________ . Note should be made of the fact that different jurisdictions/countries have different ways of
deeming what is income, and what are the standard deductions/exemptions
 On the other hand, it will not be possible to encourage development in particular sectors (Is the software industry in
India getting to that stage?)

Now Ray August, use these two models as “ideal types” – analytical constructs that may or may not exist in their pure forms. Schaffer
et. al., go on to say that the scheduler model is seldom adopted in its pure form, with the exception of Libya for instance. According to
Schaffer et. al., the Global Tax Model is likely to be adopted. 1/3rd impose a relatively straightforward global income tax on resident
companies, and nearly 90% impose a straightforward global income tax on individuals. Other variations noted by Ray August: some
countries vary this by imposing different tax rates on different industries/activities or by varying the tax rates depending on the nature
of ownership (private or public, domestic or foreign etc).

If we look at India closely, we would see that both the Scheduler Tax Model and the Global Tax Model are used. Some sectors are not
taxed at all (agriculture) and some are taxed at a lower rate (almost negligibly for a long time) (software/IT sectors).

So for a business: it is crucial to figure out what kind of a tax structure exists in a country, and the extent of inter-mixing as between
the Scheduler and Global Tax models – this would lead to different assessments regarding the overall potential health of the political
economy, the attitudes and potential problems/prospects in various sectors.

C. TAXPAYERS:

In most jurisdictions (countries), both individuals and juristic entities (i.e., organizations and other legal entities, that are not human beings, are also
treated as equivalent to them – for various legal purposes) are treated as taxpayers.

Juristic Entities 2

- Most commonly taxed entity is the corporate or the company form (joint stock being the most common form) and the
shareholders who receive dividends are also subsequently taxed on those dividends under their global tax.

- In some jurisdictions even LLP’s and partnerships could be taxed, unless certain requirements are met. In US, on the other
hand generally such partnerships are not taxed (though they may be under the obligation to withhold taxes at the source on
behalf of partners who receive share of profits).
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Ray August uses the word Company to denote any form of business organization. I think that it is misleading, because the better word could have been firm – as many other
forms of juristic entities in many jurisdictions are not subject to taxation – say general partnerships and LLP’s – because income goes to the partners. In India, one needs to be very
careful: while a partnership can be formed without registering the deed of partnership, for purposes of income taxes, the partnership would be liable to pay income taxes on “its
income” and then the partners also end up paying taxes on their share of the profits.
- Depending on the form of the company, and depending on the jurisdiction, both company and shareholders could be taxed at a
general rate, or at a special rate. US v. Thailand e.g., in text.

- E.G: Company X is incorporated in Country A, and then begins doing business in Country B. How would country B treat
Company X? This varies considerably and each country classifies and treats that company according to its own rules. The
classification in some countries is done by a central registrar (which is not the same as the taxing agency). In UK – Registrar
General of Companies; In India by RBI and in Korea by its central bank. In other countries, irrespective of how such
classification is done, the taxing agency could take its own decisions.

- Use of Analogy for classification: Now because each country may have different set of rules regarding what the form of
business organization is – Country B would then most properly look at the closest form in B and classify A in that group. Ad-
hoc basis in some countries (espe. Where all entities are taxed).

- Subordinate Business Structures: Apart from the decision to do business, the entity must also decide what should be its
business form in the foreign country: Representative Office (Liaison Office – generally advertising etc., but no commercial
activities); Agent: individual or local company, acting on behalf of and supervision of the main company, and conducts
business (taking sales orders, making sales and collecting debts); Branch: unit of the foreign entity that is set up, generally, to
offer some service or expertise not available locally. But it could also involve warehouses to supply products produced abroad
locally, establishment of other facilities (assembly plant, mining operations etc.)

o A Subsidiary: locally established and incorporated company that is owned 100% by foreign company, or majority is
owned by foreign company or (in some jurisdictions- if management is controlled by foreign company).

o To what extent a Branch or a Subsidiary can engage in particular activities would depend upon the host countries
regulations: for instance in India, certain areas of operation are reserved only for Indian companies, and in certain other
areas, there are restrictions on the extent of foreign ownership etc. (FEMA).

o So how are they likely to be treated? Again varies considerably. But broad generalizations (with explicit understanding that
specific tax laws have to be consulted):

 Agencies (if they actually do conduct business and derive income) and Branches are treated the same manner for
tax purposes – and with some disadvantages – higher tax rates, ineligibility for deductions etc., attribution of
income earned abroad to activities in domestic jurisdictions, requirements to disclose parent company’s income
assets betc, when first registering and subsequently also etc. The main advantage of agency/branch is that
registration requirements could be less onerous, and if no substantial assets are created/brought in to the domestic
country – risks also go down (See Risks in Schaffer in Chapter 1).

 Tax laws in many countries encourage establishment of subsidiaries. Possible Advantages with subsidiaries: (a)
lower tax rates than on agents/branches, (b) limited liability of foreign partner (in partnership situation); (c) equity
financing; (d) increased rights to participate in certain activities restricted to purely branches etc., (e) eligibility for
same deductions as domestic companies etc. Possible Disadvantages: (a) risk level goes up substantially; (b)
incorporation also means greater administrative work and reporting requirements, in addition to complex tasks of
incorporation; (c) mandatory laws requiring a certain percentage of board of directors to be citizens of host country;
(d) extensive audits; (e) more detailed filings with tax agensies (including, if asked - generally, filing of various
aspects of parent company’s income etc.)

 Theoretically the greatest advantage of formation of a subsidiary is insulation of parent company from the legal
risks arising from operations of subsidiary company and vice-versa. Theoretically, because it could depend on the
extent of control and management by parent company abroad.

D. BASES OF INCOME TAXATION

Answers the question as to whether an individual or a juristic person is subject to the income tax or not. 4 principal modes of
determination: (a) nationality; (b) residence of the tax payer; (c) the source of taxpayer’s income; and (d) some combination of these
variables. (!)

a. Nationality Principle: Taxes typically imposed on worldwide incomes no matter where he/she or the juristic person resides. See Cook v.
Tate US Reporter, vol. 265 (1924) – held that neither the US Constitution nor international law was violated if tax is imposed by US on a
citizen of United States, even though he/she/it may be residing mostly or completely abroad. US CITIZENS ARE REQUIRED TO FILE
RETURNS ON THEIR WORLDWIDE INCOMES, AND TO AVOID DOUBLE TAXATION, TAXES PAID ABROAD MAYBE
DEDUCTIBLE. This is very important when a business is seeking to employ US citizens in India, so that the total emoluments/packages
are calculated properly. Further, it also affects corporations etc.

b. Residency Principles: Broad Rule (as a first assumption): Taxation on worldwide income of juristic entities resident in that tax
jurisdiction. Residence is however determined in one of three ways (or a combination):

(1) length of time one resides within the borders (objective test);
(2) the intent to make that place his/her permanent domicile; (subjective test); or
(3) obtains admission to a country as a resident (declaratory test).
India3, Indonesia, Japan, Panama etc., objective test (generally 6 months of physical presence). Belgium – subjective test. Brazil –
declaratory test and those without a permanent visa – resides for more than one year.
o RESIDENCY OF COMPANIES?

2 tests: (1) where the company is organized (nationality test like) (United States uses this principle; or (2) where
company is managed and controlled. UK, and most of its former colonies follow this rule. Germany, Fance and most civil
law traditions – both principles are used! (should really be under the mixed lot)

c. Source Principle: Start with the Broad rule: tax only income from within the country and generally not income from abroad. BUT 91
countries that impose taxes on worldwide income of domestic and resident tax payers, also impose taxes on domestic income of non-
residents!!!!

How is domestic income determined? Accruing, deemed to be accruing or derived or deemed to be derived from sources within the
country. 3 kinds: (1) derived from property within the country; (2)income derived from trade/profession carried on through a branch
within the country; (3) from employment within that country.

Accrued/Derived Income of Trade or profession carried on within a country: (1) fixed place of business/trade; (2)
manufacturing/assembly; (3) regular/continuous employees; (4) after-sale support; and (5) active management of local real estate.
Additional factors? Gain was from assets located in host country used in conduct of trade or business? And whether activities of trade
or profession were material factors in realizing the gain?

What about DEEMED INCOME?

Rules to determine “where certain kind of activities take place” to deem the income generated from that as deemed
accrued/derived income. Most Important to Sale transaction!!!

General principle: sale deemed to have happened when buyer takes control or possession. So Costa Rican seller – 1,000 tonnes
– FOB London – for a buyer in Portugal – deemed to have taken place in London. Two issues: Costa Rica could deem the income to
have occurred in UK (and if no Double Taxation protection - hypothetically) claim taxes on it (as opposed to Poland – with which
assume –hypothetically – double taxation treaty)!

Interrelationship of Taxation Bases

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In more detail below.
In countries where more than one of above rules is used: generally use one as a default rule, and the others as secondary rules. Most common
default rule: source. In that case, nationality/residence are treated as secondary rules – and used to either exclude or include the income! (Remember
taxation is a purely public policy tool and relates to something vital for all governments – revenue).

Persons Immune from Taxation

The only ones normally – diplomats, foreign government entities, int. organization etc. Governmental entities – sovereignty and sovereign
immunity – but generally sovereignty – only for non-commercial activities – so sovereign immunity argument need not work for commercial
activities – some countries choose to not tax or exempt. Foreign diplomats/employees of missions – exempt Vienna Convention on Diplomatic
Relations.

International Organisations: exemptions not by matter of course, but depending upon the instrument creating the org (whether for commercial
or non-commercial purpose chiefly); agreement between that org. and the country; applicability of any multilateral tax treaty; local tax laws; general
principles of int. private law.

E. INCOME

Income Categories:

(Broad): Personal Income (earnings) or Business Income (profits) or Capital Gains Income (increases in value of underlying capital
owned/invested by ind. And businesses.

The treatment of three maybe distinguished from each other. E.g: Capital Gains is assessed, in some places, only when capital
assets are sold, and in some places they may also get a lower rate (than regular Income Tax) if held for a length of time. Certain capital
assets may be completely exempt from tax. Tjos generally apply to individuals. And a great majority treat capital gains from sale of
company assets as ordinary incomes and charged at normal rates – ordinary profits and cap. Gains – business income.

Computation of Income

• Profit and Loss Statement Method: (Gross income less allowable deductions/exemptions). U.S. U.K, Canada, Mexico…

• Balance Sheet Method: Income = difference between net worth at beginning and end of accruing period.

Income Tax Rates

Individual Income Taxes:


Very few countries impose a flat rate: Bolivia, Grenada, Jamaica…..
11 impose no taxes at all; 97 – graduated scale (progressive – slab system).

Business Income Taxes: Majority, flat rates (+ different rates by sectors or by form of ownership or by origin of owners), but you will
also find graduated tax rates. Even in graduated tax rates for businesses, they tend to be lesser number of slabs – 2-3 as compared to
individ. scenarios.

Developing countries: special adjustments to meet macro-economic conditions – inflation indexes, accounting adjustments,
etc. Or they may also be pegged to performance or reported performance. The issue is: are the companies under-reporting or
actually suffering a loss? (Page 718 of Ray August).

WHAT IS DONE DEPENDS ON TWO CONTRASTING FACTORS: (1)High rates, inflexible structures etc., would lead to
higher tax revenues (assuming that tax collection machinery exists and functions properly). BUT this may also lead to shrinking or
non-growing tax base – because of dampening of economic activities. (2) Lowering of tax rates – may energise the investment and
entrepreneurial activities. How the balance is to be struck is difficult to say.

COMPANY AND PERSONAL INCOME TAXES

A welter of rules, and legal systems obtain here. The essential issue here is how the country treats Company and Shareholders in terms
of incidence of taxation – on both, some amalgam? Only one? Most jurisdictions it is both, but some countries may elect to use taxes
as a tool to encourage or discourage particular forms of business organizations (and whatever the conceived social purposes).

1. Classical System (followed in most countries): Tax on company earnings and then tax (on individual shareholders) when
dividends are distributed. Dividends are not deductible. Undistributed dividends/profits are subject only to ordinary
company taxes.

Other Systems:

2. Shareholder Imputation System: Similar to classical system: ordinary business income tax on all profits and then
shareholders pay taxes on distributed dividends. Shareholders are given a credit for taxes paid by company, which is
used to offset (by a certain percentage) their personal income tax obligations. (Followed in Austria, Canada, France,
Korea, New Zealand and 17 other countries).3
3. Company Deduction System (Estonia, Iceland, Norway) – converse of Shareholder Imputation System – Companies are
allowed to deduct dividends (as certain percentages) as operating expenses – and shareholders pay the full ordinary tax
rates on all of their income including dividends received.

4. Company two rate system: (Germany, Japan, Panama): 2 rates – higher rate for undistributed dividends, and a lower rate
for distributed dividends.

5. Shareholder two rate system: (used in 14 countries): lower tax rates on income from dividends.

6. shareholder exempt system: (13 countries). No taxes on dividends.

FULL INTEGRATION SYSTEMS

Company does not pay any taxes, whether profits are distributed or not – shareholders are deemed to be earning that
income (even undistributed dividends) and they have to pay. Not fully followed in most countries, except for smaller
companies (S-Corporations in United States – only one class of stock, no more than 100 shareholders, only natural
persons and citizens or residents…. Limited use for entry into US by foreign companies).

Foreign Shareholders (2 general ways):

(1) nationality or residency of shareholders;


(2) shareholders personality (juristic or natural person).

And they may be subject to higher or lower taxes on dividends; some countries provide tax breaks for shareholders that are
juridical persons (companies).

OTHER TAXABLE TRANSACTIONS

Merger: One company merges INTO another, one survives and the other disappears into the surviving company. Surviving
company IS COMMONLY TAXED ON THE INCREASE IN BOOK VALUE OF THE TRANSFERRED ASSETS.
Shareholders are usually taxed only when sale of stock/shares they receive from surviving company.

Consolidations: Two companies merge to form a new entity/company. – generally tax exempt transactions – but shareholders
are taxed on sale of stock/shares. New company no tax obligation – as along as assets are carried over at their book value.
Liquidation: Liquidating company taxed of profits made and no further liabilities. Shareholders are taxed of distributed
assets/residual worth. Some may not impose any liability on shareholders.

F. DOUBLE TAXATION

Taxpayers Earning income in two or more countries – face this problem (or are subject to worldwide tax regimes of their home countries) – they
are often taxed in one country + a second time.

SYSTEMS FOR RELIEF FROM DOUBLE TAXATION

Most countries now provide relief from double taxation to some extent or the other with respect to at least some of the persons
potentially subject such double taxation – done UNILATERALLY (by themselves), Bilaterally (treaty with another nation – so affects
only persons from that other nation) or multilaterally (where more than one nation is party to the treaty). These treaties are generally
executed to increase the volume of trade and investments between the countries and also a political tool for building ties.

EXEMPTION, CREDIT OR A DEDUCTION

EXEMPTION: if subject to tax in one country, then that income is exempted from tax in the other country. (either in
the host state – state that is the source of income) or in the home state (where the taxpayer resides). Normally – host
state (where income is generated) taxes and the home state exempts from further taxation.

CREDIT: Tax paid in state is used as a credit against a tax payer’s liability in the other state. Direct credit for an overseas
branch or in the form of an indirect credit for a foreign subsidiary.

Example (Direct Credit):

IBC – resident of B, with a branch in O.


IBC Income in B = $1 Million
Branch income in O = $100,000
B has IT rate of 50% on worldwide income of companies resident there.
O = IT rate 30% on foreign branch income and gets $30,000 (as IT) from the branch of IBC.
IBC then uses this as a tax credit in B
Total Income = $1 Million + $100,000 = $1.1M
50% IT rate in B means tax liability of $550,000.00
But actual required to be paid is $550,000 - $30,000 = $520,000. In any event the max tax liability is what IBC would
have paid in B (i.e., $550,000 or 50%, i.e., the highest tax rate between the two countries); but less than $550,000 +
$30,000 = $580,000 if IBC had not been given the credit.

Example (Indirect Credit - Subsidiary):

MSC – resident/national of G (IT rate is 50%)


MSC’s subsidiary in L
Subsidiary earns $100,000 and is subject to IT of 30% in L
What would be the tax by G on $70,000 repatriated to MSC?

A Four Step Grossing Up is used:

L Tax X Divdends Paid/ After Tax Earnings =


Total Deemed Taxes.

$30K X $70K/$70K = $30K

Now the dividends are grossed up:

Dividend + Taxes Deemed Paid = Taxable Income


$70 K + $30K = $100K

Taxable Income X Tax Rate in L = $100K x 50%

Grossed Up tax = $50K

Fourth and finally, credit the taxes deemed paid:


$50K - $30K = $20K on the dividends ($70K)
The Total paid is again $50K, the higher amount payable.

DEDUCTION METHOD:

Deduct the taxes paid in one country from the profit liable to be taxed in the home country.
GCC – resident/entity in T, with a branch in K.

Branch earns $100K in profits, K subjects it to 40% tax i.e. $40K.

Now T allows the income (earned in K) after taxes to be repatriated (or counts it as taxable income) – and imposes 50%
tax – so GCC now pays 50% of $60K = $30K

Total tax liability is $70K.

Comparison: Exemption – Best; Credit – Internediate; Deduction – Worst. This is from taxpayers perspective. From
the countries perspective, the inverse would hold – so why do countries do it?

Host countries: Enticement of foreign businesses;


Home countries: encourage repatriation of earned incomes.

CONSEQUENTLY = Most widely adopted is CREDIT SYSTEM, FOLLOWED BY EXEMPTION AND THEN
BY DEDUCTION.

But what happens when there is a dispute with tax authorities? If the dispute is with tax authorities in home
state, the courts tend to interpret the treaty in a manner to raise the tax revenue; if the dispute is with tax
authorities of host state, then courts may tend to interpret in favour of tax-payer, as host state is trying to
encourage foreign investment. (THIS IS AN OVERBROAD GENERALISATION BY RAY AUGUST – It
depends on many factors, including how specifically the treaty has been written, the inclinations of judges etc.)

G. TAX TREATIES

Earning income (by individuals) and profist by businesses across countries raise the following issues:

1.Double Taxation;
2. Tax Incentives;
3. Tax avoidance; and
4. Tax Evasion.
While some commentators believe that unilateral method is the best, others have advocated bilateral or even multilateral treaties. The
former favour flexibility for each country, the latter favour greater harmonization. The first attempt to draft broad guidelines to tackle
these issues in 1920’s (League of Nations) – European centric, and for developed nations. Later on Organisation for Economic
Cooperation and Development (OECD – Paris, France – originally with 30 and odd countries now 61) – took that model and further
tuned it to produce: MODEL CONVENTION FOR AVOIDANCE OF DOUBLE TAXATION. (OECD MODEL TREATY).

But the above was developed country centric. So UN drafted another one “Model Double Taxation Convention between Developed
and Developing Countries” (UN MODEL TREATY). UN experts believed that bilateral are better and not multilateral. But there
are some multi-lateral treaties – Double Taxation Agreement, 1966 (some African nations and Malagasy Common Organisations),
1966 Avoidance of Double Taxation by ANDEAN Common Market (Chile, Peru, Ecuador and Bolivia) etc.

Principal Topics Addressed by most treaties:

(a) the persons and taxes covered by treaty;


(b) basis (nationality or residency or source);
(c) provisions for avoiding double taxation;
(d) provisions against tax avoidance and evasion.

(a) COVERAGE: Broadly mirror the OECD and UN Model treaties - so taxes covered are income taxes, capital gains taxes,
and taxes on net wealth. Persons covered are both natural persons and companies.

(b) Basis for Taxation:

OECD and UN Model tax treaties – residency with contracting parties. MOST STATES TODAY DO NOT INSIST
ON TAXING THEIR NON-RESIDENTS (EXCEPT U.S.). U.S. claims it means to ensure that its citizens always value
their citizenship, but most commentators believe that economic factors are at play here – the US knows that its citizenship
is valued, so it acts as a disincentive for US citizens from moving out and taking up residency elsewhere – what’s the
point?:

RESIDENCY THE KEY FACTOR: HOW IS IT ESTABLISHED?

OECD and UN Model Rules:

(1) Normally a resident in which he/she has a “permanent home available.”


(2) If an individual does not have a home available in both countries – residence is the country “with which
his personal and economic relations are closest”
(3) If neither of above works (i.e., center of Vital Interest cannot be found), residence is in the country of
“habitual abode”
(4) If habitual abode in neither of the contracting nations (or any of the nations in a multilateral treaty) –
then citizenship/nationality is taken;
(5) If nothing works – then competent authorities of both states work out a mutual agreement as to how to
treat that person.

(c) DOUBLE TAXATION PROVISIONS:

Again OECD/UN Model Rules. Depends on three factors:

(1) residency;
(2) personality; and
(3) type of income.

General rule is that residency should hold – i.e., person should be taxed only by the country he/she is resident of;

Exceptions: Tax Payers Personality and types of income involved:

Tax Payers Personality Exceptions:

(a) persons providing independent and professional services; (independent scientific, literary, artistic
works… self employed physicians, lawyers, engineers, architects….). May be TAXED BY A
CONTRACTING STATE IF THEY ARE NON-RESIDENT BUT HAVE A FIXED BASE –
however, only the income attributable to that fixed base is taxable.

(b) Employed Persons;

Nonresident employed persons may be taxed by a contracting country in which he/she is a


nonresident to the extent that they receive taxes from that country – but not if (1) present less
than 183 days, (b) paid by a non-resident employer, and (c) nonresident employer does not have a
fixed base or permanent establishment. (all three conditions have to be met for this exception to the
exception to work).

(c) Companies; and


Non-resident companies may be taxed by contracting state – PERMANENT ESTABLISHMENT
– BUT ONLY INCOME ATTRIBUTABLE TO PERM. ESTABLISHMENT ia taxable.

Double Taxation Issues are imp’t in Company context: Perm. Establishment is defined with
some degree of detail: Includes but not limited to:

(i) Branch offices, factories, workshops;


(ii) Mines, oil and gas wells, quarries and other places for extraction of natural resources;
(iii) Building sites, construction projects, assembly projects that last for more than 12 months.

BUT PERM ESTAB DOES NOT INCLUDE THE FOLLOWING (6 groups), most important of
which are:

Facilities for storage display or deliver goods, maintenance of stocks of good/merchandise for
display, delivery or processing by another;

Building sites, construction project or assembly project less than 12 months.

FORCE OF ATTRACTION RULE: OECD more liberal in favouring main residency country, but UN follows this rule. Company from Country A,
has a Perm. Establishment in Country B. – Country B may tax not only profits generated by the company through Perm. Establishment, but also any
profits that come to company from any other activities in Country B not related to Perm. Establishment (say independent activities by parent
company in country B).

(d) Special persons.

Estates of deceased persons, personal trusts etc. Though juridical entities, they are not business entities –
manage estate of the deceased, beneficiary etc.) – UN AND OECD MODEL RULES look to residency
of the individual (deceased, beneficiary or trust). – for tax residency issues.

Other Exception to General Rule that States May Tax only Their Residents:

Special rules relating to property – immovable property, dividends, royalties and capital gains.
TAXATION OF COMPANY DIVIDENDS? ANY EXCEPTIONS TO RESIDENCY RULE?

It varies:
Older Tax Treaties followed the source path (where capital was invested.

OECD Model Treaty: 25% of subsidiary is owned by parent company in Country A, then country B where the company is
located may impose no more than 15% withholding tax on dividends remitted; and Country A may tax the dividends received
by the parent.

UN MODEL TREATY: Similar to OECD, but leaves open for negotiation between contracting parties – reg. percentage of
ownership, and percentage of withholding tax. (BIG DEAL – these in any case are only model rules),

Other differences (between OECD and UN model treaties) with respect to interest, royalties etc. (See page 732 of Ray August)

CAPITAL GAINS:

Both are similar: Art. 13 of OECD:

(1) Gains derived from alienation of immovable property – resident of Country A gains, where property is located in
Country B, B can tax it;

(2) Gains from alienation alienation of movable property forming properly a part of business property of a Permanent
Estab (or a fixed base) in Country B, and company resident in Country A, - may be taxed in Country B.

(3) Gains from alienation of ships or aircraft operated in international traffic, boats….. etc…. taxable only in
Contracting States which is the place of effective management.

(4) Other than 1, 2 and 3, gains from alienation of property can be taxed only in Country of residence of company.

H. TAX INCENTIVES

To understand the issues created by Tax Incentives, first let us look at the concept of TAX SPARING: the essential theme here is that
the tax incentive given by host state is actually equivalent to tax paid even though no tax or lesser tax is paid – the idea is that risk
is being taken by company in locating business in a foreign land – and that is being compensated for by tax incentives (general
and broad understanding). So, unless home country recognizes the tax incentive as actually tax being paid, the effect of tax
incentive by host country would dramatically reduce and home countries get a tax windfall (having charged on the entire profits
by residency requirements).

If tax sparing clauses are effectively drafted, then the impact of tax incentives given by host country can be given maximal impact.

Under OECD/UN Model Rules – the idea is that host state concentrate on encouragement of trade through tax incentives and
home state concentrate on avoidance of double taxation. Many forms of tax incentives – (see page 732 of Ray August) – some
important ones:

1. Tax Holidays;
2. Wide array of exemptions;
3. carrying forward of allowances for income tax deductions;
4. Import incentives
5. Export incentives
6. Tax exemption for expatriate employees.

Tax incentives are meant to assist new start companies set up by foreign entities in their first few years when they are struggling – but
this can go too far – and many MNC’s exploit this and the benefits go to the strong rather than the weak being allowed to grow big
and compete.

Interaction of TAX SYSTEMS:

Business managers planning overseas development of their companies should recognize that their strategy should be based on
a thorough understanding of double taxation, double taxation relief, tax incentives and tax sparing concepts. And whether
national tax legistions (i.e., the actual tax schemes put in place) give effect to the intent of the treaty fully or partially.

I. Tax AVOIDANCE AND EVASION:

Avoidance: Using a loophole to avoid paying taxes by exploiting the doubt as to what a particular clause or word means.
Narrow v. strict construction. In US at tax times – blaring headlines/billboards – avoidance is legal evasion is illegal and
criminal!!! In India, the attitude of courts has been more towards ensuring the state gets the benefit of the doubt; the attitudes
in US generally have been towards favouring the individual, relative to India. But the norm has been towards protecting the
state interest.
Evasion is a matter of enforcement, surveillance, checks and prosecution – Tax Voidance is more intractable in terms of
visualizing a straightforward way of countering it. Apart from usual problems that one could expect when expert tax lawyers are
retained by companies wishing to exploit tax loopholes (and some large accounting firms have been prone to encourage rather than
discourage tax avoidance schemes) – international business raises special issues: limitations in terms of sharing of data between two
tax jurisdictions and secrecy/privacy laws in many countries.

OECD has generally tried to counter the tax avoidance schemes/ruses, especially the most tax costly ones:

1. Tax Havens, 2. Transfer Pricing,


3. Treaty Shopping & 4. Thin Capitalization

1. Tax Havens:

Definition: Countries that provide refuge from taxes for (1) tax payers themselves; (2) taxpayers income; or (3) taxpayers
capital and other assets.

Impose few taxes and also have secrecy laws that forbid foreign governments from obtaining information assets, + rules
that allow for complete and full transfer and exchange of currencies.

Tax havens are not new – ancient practices. In modern times this has gathered in intensity and breadth. Some countries
have attempted to compile lists and curtail them (through diplomatic pressure, boycotts etc). BUT THE PROBLEM IS
WITH HOW ONE DEFINES A TAX HAVEN – by the fact that tax rates in the said tax havens are judged to be very low –
but how low is low? Many countries that were sought to branded as tax havens resist the pejorative use. Different
jurisdictions have attempted to do different things – and they are constantly evolving.

The other problem may be that location of business in a tax haven may also be for other legitimate reasons – to serve that
nation, to keep ones developmental activities secret from competitors etc.

US Sub-Part F style: Controlled Foreign Corporations – 50% of all its voting stock, on any given day in a year is owned or
controlled by US shareholders (citizens, residents, corporations, estates, trusts etc.). US shareholders are those vwho own
more than 10% of voting stock (singly). Such US shareholders are subjected to a tax on deemed income of CFC whether or
not it has been distributed. (For details of Deemed Income, see page 737 of Ray August).

2. TRANSFER PRICING
Example:

X and Y are associated businesses – but residents in A and B – two countries.

Assoc. Businesses = loosely linked affiliates, close knit elements of a multinational enterprise. But really under common
ownership.

Transfer Goods or merchandise back and forth between themselves. The price set is arbitrary. If some single taxpaying
authority were taxing, the price would irrelevant – because profits made by overall enterprise would always be the same and so
would the taxes.

However – two different regimes of tax rates. Say one enterprise is located in a low tax rate country and the other in a high tax
rate country –

A low tax rate country where X is resident; and B is High Tax Rate Country where Y is resident.

So X sells goods/merchandise, to Y in B for a very high and arbitrary price (say normal price is $q, and they sell it for 5$q
price) – so what happens – Y can show low or non-existent profits – and pay very low amount of taxes in B. To be sure X will
have higher profits – but because of low tax rate – the overall tax burden of the enterprise is much lower than what would have
been if normal arms length prices had been charged.

So countries depend on two factors : (1) arms length principle; and (2) unitary business rule.

ARMS LENGTH PRINCIPLE

(1) arms length principle: a very well established principle in most countries and also by OECD and UN Model rule;
(2) basically looks first at what the actual would have been if the dealings were with a third party (i.e., B, the high rate
country would start the exercise with respect to Y).
(3) first principle is to try and determine what the arms length prices could have been;
(4) 3 different methods have evolved:

(i) Comparable uncontrolled market price determination – in some instances may be possible
Difficult to ascertain w/certitude – factors impeding it – price fluctuations, differential pricing in
different areas, disentangling shipping costs, quantity and quality influence on prices etc. Unique
products are even more difficult, because by definition no one else would be producing them

(ii) Cost Plus method

The idea is to ascertain the actual cost of production – costs of goods, services and the like and arrive at a
cost and then use a mark up profit on top.

(iii) Resale minus method – deduct appropriate mark up profits and costs.

(5) Lot of countries use all three methods to triangulate and arrive at a reasonably certain procedure.

(6) Apart from inhenernt difficulties in each of above three methods – from a tax enforcement perspective – costly – lot
of manpower required to do a lot of spade work, securing data from foreign country etc. So at best may be usable
on a random or flagged target basis.

UNITARY BUSINESS METHOD (ORIGINATED IN California):

1. Basic principle is to derive local earned income from worldwide income and tax a certain percentage of it;

2. Very formulaic:

Taxpayers prop in state/Taxpayers and affiliates property worldwide = a

Payroll of Taxpayer in state/ taxpayers and affiliates worldwide payroll = b

Sales of taxpayer in state/ Taxpayers and affiliates sales worldwide = c

(a + b + c)/3 = T.
T X consolidated worldwide taxable income of taxpayer and affiliates = INCOME DEEMED TO BE TAXABLE BY
STATE.

3. Advantage – ease of use – especially in US because worldwide incomes are expected to be reported. Wide systemic
response, costs less, because reporting burden now shifts on to the taxpayer.

4. Could be problematic – of imposing a heavy burden, and riving businesses out;

5. Disliked by most other countries as being unfair;

6. 1985 – US govt considered legislation to ban Unitary Business Method – but no legislation was ever passed – and
this freedom has been used by states and affirmed by US Supreme Court (Barclays Bank, Plc v. Franchise Tax
Board of California, 1994) (page 739).

3.Treaty Shopping

- tax payer shops for countries with beneficial tax treaty provisions, and sets up subsidiary enterprises in those countries – to
take advantage of those treaties;

_ involves two situations:


(1) Direct Conduit Companies;
(2) Stepping Stone Conduit companies.

(1) Direct Conduit Companies:

Comp. X in State A has a subsidiary, Comp. Y in Country B.

Normal scenario: Dividends, interest or royalties back to A, B would impose withholding taxes. To avoid these taxes, Y shops
around for a Country C, that has a beneficial tax treat with State A and State B and where withholding taxes are reduced or
eliminated when dividends etc., remitted to State A. Now what they do is incorporate company T in Country C and make it the
parent company of Y in country B – so now we have elimination of withholding taxes in Country B, which is what should have
been possible. T acts as the direct conduit company.

(2) Stepping Stone Conduit Company:


A second intermediate Country D and company Q is used to move profits out without allowing for withholding of taxes by B.
Depending on where the linkage is missing – that country is looked for and placed to close the loop.

It can of course get more complex – in terms of technology fees, royalties, (transfer pricing scenario) to reduce tax burden in C
and then repatriate the whole thing to A etc.

ABUSE:

o generally considered improper;


o proper benefits of tax treaties do not go to residents of treaty countries etc.

COUNTER MEASURES:

o Specific anti-abuse treaty provisions;


o Anti abuse national legislation: (Switzerland and US are the only two countries). Swiss rule: treaty rights are
suspended for that company if found abusive. Various ways of abuse have been defined (see page 746) – primarily
by identifying who the beneficiaries are – whether in treaty country or not, if substantial shares of Swiss shares are
held by non-residents etc.
o Where anti abuse legislations are not there, common law method used – principles of equity – substance over form
approach – attempt to determine if movements of income based on legitimate commercial reasons or merely a sham.

Tax Treaty Provisions:

o Look through approach – treaty benefits granted if and if shares of parent company are owned mostly by residents
of that company;
o Exclusion Approach – low tax holdings etc., are excluded from treaties;
o Subject of tax approach – treaty says that taxation must be in either of the states, but not avoided in both;
o Channel Approach - primarily for stepping stone arrangement – treaty benefits are not given if certain percentage
of income is used to pay for charges made by indiv. or companies who are not residents of treaty states;
o Bona fide approach:

Affiliated companies – not allowed treaty benefits unless they can demonstrate sound commercial reasons for their
structure and transactions.
o ABSTINENCE APPROACH – because of abuse – some states have abstained from entering into such treaties.

THIN CAPITALISATION:

- purposely financed by loans by parent company and not by capital/equity investments


- High debt to equity ratio
- Tax treatment of interest is different from treatment of dividends – interest is almost always deductible as an expense
from income taxes – whereas dividends are generally not.

Most commonly countered by national legislation, rather than tax treties. Usual mechanism is to disallow deductions
for interest payments made to parent/affiliated companies. Some allow the showing that debt/equity ratio is an arms
length ratio or commercially reasonable.

Evasion: Manifestly illegal – non filing of returns, filing of deliberate/false returns and consequent deliberate non payment of taxes.

Significant problems of combating this – helping a foreign state collect taxes is always politically and also legally problematic
– data has to come from multiple countries; Sovereignty issues, and helping a foreign tax authority may also run afoul of
human rights regulations/laws. Enforcement of foreign tax judgments puts pressure on local authorities – lack of knowledge,
the highly intricate nature of tax laws etc. So reassurance that foreign taxes are equitable, conscionable etc. Generally Forum
Non Conveniens is quickly used – when asked to interpret foreign tax laws. Occasionally successful. (Kalo v. Commissioner
of Internal Revenue – United States Sixth Court of Appeals 1998).

International Cooperation

* A key to combating tax evasion;


* Becoming more common place –

1972 Nordic (Finland, Iceland, Norway Sweden. Greenland etc.) Convention Regarding Mutual Assistance in
Matters relating to Tax – most important – exchange of information automatically, presence of tax officials of one
jurisdiction in other jurisdictions; one country carries out the tax investigation of the other in its own jurisdiction.
EU adopted a tax collaboration directive in 1975 similar but much more restrictive in terms of sharing of information –
privacy issues.

Bilateral cooperation agreements.

National Schemes for Combating Tax Evasion: