Principles of International Taxation
Angharad Miller & Lynne Oats
Part 1 - Introduction to Tax
Chapter 1 - Introduction to Taxation
Governments levy taxes to provide public goods, distribute resources, and stabilise their economy.
Every tax has three essential elements: a base, a rate, and a taxpayer.
Types of taxes: consumption taxes, wealth taxes, personal income tax, capital gains tax, and corporation tax.
Compliance and administrative costs of taxation.
Part 2 - Introduction to International Tax
Chapter 2 - Introduction to International Taxation
Mills, Erikson and Maydew (1998) estimate that large corporations save on average $4 for every $1 spent on tax planning activities.
Planning technique include the use of tax havens, the use of specially targeted tax regimes by countries which are not obviously tax havens, and the manipulation of international transfer prices to transfer profits into low tax jurisdictions away from higher tax ones.
Chapter 3 - The Right to Tax Individuals
OECD Model Convention on Double Taxation 'tie breaker' guidelines:
- 'vital interests': permanent home then personal and economic relations
- habitual abode
- mutual agreement
Approaches to determining the tax residence of individuals:
- according to time spent in a particular country
- according to a person's connections with a particular country
- according to residence rules adopted for other civil law purposes
Chapter 4 - The Right to Tax Companies
Approaches to determining tax residence for companies:
- under the legal approach, tax residence is determined according to the country of incorporation/registry in the commercial register.
- under the economic, or commercial connection, approach, tax residence is determined according to one or more of these factors: place of management, principal business location, or tax residence of shareholders (not widely used).
The international standard most commonly used is the 'place of effective management' or 'central management and control':
- where the governing body meets
- where the decision to carry out operations emanates from
- where strategic control is exercised
- where the fundamental policies are conceived and adopted as opposed to the place where they are carried out
- possibly where shareholders' general meetings are held
- possibly where the books and records are held
Chapter 5 - The Double Tax Problem
There are two types of double taxation: economic and juridical.
Economic double taxation is a broad term that covers any situation where an amount of income is taxed twice.
Juridical double taxation occurs where more than one country attempts to tax the same income.
There are three main methods by which countries of residence may give relief for double taxation:
- deduction method (foreign taxes are treated as an expense of doing business)
- exemption method (foreign income is not taxed at all (exempt)
- credit method (foreign taxes generates credits to be used against residence taces)
More precise description:
- The deduction method still means double taxation, even though alleviated.
- Credit method is more profitable when the foreign tax rate is higher, while the exemption method is more profitable when the foreign tax rate is lower
- 'Exemption with progression' is the exemption method, but when all profits, including foreign ones, are taken into account to determine the domestic tax rate
- 'Exemption with participation' is the exemption method only applicable where shareholding stays below a certain limit (as an indication of participation in management)
- 'Ordinary credit', by opposition to 'full credit' described above, implies credits are capped at the tax rate the company would pay if its foreign profits were earned domestically
For the domestic regulator, choosing between methods of double tax relief is a tradeoff between capital export neutrality and domestic tax base protection.
Types of foreign tax which may qualify for double tax relief ('creditable taxes'):
In connection with foreign dividends:
- direct taxes on the foreign shareholder: withholding taxes
- indirect taxes on income suffered by the foreign shareholder / head office: usually the foreign corporation tax
Turnover taxes such as sales taxes or indirect taxes generally do not entitle to double tax relief. But the General Agreement on Tariffs and Trade (GATT) permits the indirect taxes on exports to be rebated where these can be ascertained with accuracy (e.g. VAT with EU to non-EU)
'Portfolio investment' vs. 'foreign direct investment':
- portfolio investment is when a shareholder owns only a very small percentage of the total shares in a company
- foreign direct investment is when a shareholder controls a significant share of a foreign company (typically 10%+)
Where there is foreign direct investment, most countries will allow the foreign corporation taxes ('underlying tax') suffered on the foreign profits out of which the dividend has been paid to be set against the domestic tax liability in addition to any withholding tax.
Chapter 6 - Variations on the Credit Method
Pooling allowed of foreign income in the home country tax computation ('onshore pooling').
Pooling allowed of foreign income within a foreign intermediate company ('offshore pooling').
Tier limitations on indirect credits from foreign subsidiaries.
Potential limitations on pooling: tax havens and credit capping.
Chapter 7 - Double Tax Treaties
Treaties cannot, of themselves, impose tax liabilities where none exist under domestic law. They can only reduce or eliminate domestic tax liabilities.
Double tax treaties are instruments of international law, and most are governed by the Vienna Convention on the Law of Treaties whilst their text is usually based on the Model Convention provided by the OECD. The provisions of treaties normally override any conflicting provisions in a country's domestic law.
The OECD Model Convention awards priority in taxing rights to the country of source.
There is a general principle that countries will not enforce the tax claims of other countries. E.g. 'English courts have no jurisdiction to entertain an action [...] for the enforcement, either directly or indirectly, of a penal, revenue or other public law of a foreign State.' (Dicey and Morris, The Conflict of Laws).
Interpretation of Tax Treaties: States may not use any material prepared unilaterally to aid interpretation, but only the materials which were agreed upon by both parties at the time the treaty was concluded. All interpretative materials must be contemporaneous with the signing of the treaty unless concluded with the other contracting state subsequently by mutual agreement.
The OECD Commentary and reports of the OECD Committee on Fiscal Affairs may be used to help interpret treaties, and are sometimes expressly referred to within tax treaties.
Bilateral treaties remain the norm compared to multilateral treaties.
Part 3 - International Tax Planning
Chapter 8 - Permanent Establishments
The term 'permanent establishment' (PE) most commonly refers to a foreign branch. A PE is part and parcel of the same corporate entity as the head office.
The State where the PE is located may tax the profits of the entity which are attributable to the PE using the source principle; those profits must be arrived at by employing the fiction that it is a separate legal entity.
Requirement of a 'fixed place of business'. OECD commentary: fixed means established at a distinct place with a certain degree of permanence. Mechanical equipment does not have to be fixed to the soil. At least six month is usually necessary for permanence to arise.
The override to the 'fixed place of business' requirement: concluding contracts in the other State.
The exception for activities which are 'preparatory or auxiliary': stock used for storage, display, or delivery; purchasing goods or gathering information; always for the company's own benefit only.
The use of agents: independent agents do not count; dependant ones do. Dependence exists if and only if the agent can bind the enterprise in contract in the State concerned; employment status is irrelevant. There also has to be frequency and customer-facing.
Independence of an agent will be demonstrated by a combination of the following factors:
- bearing a commercial degree of entrepreneurial risk
- being both legally and commercially independent of the enterprise
- not being required to comply with detailed instructions from the enterprise
- not being subject to comprehensive control by the enterprise
- having skills and knowledge on which the enterprise relies
- working for a number of different clients
Some difficulties with the agency rules: the concept of agency is understood differently in different countries, depending on whether the country has a common law or civil law system.
The attribution of profits to a PE.
The 'working hypothesis': 'the profits to be attributed to a PE are the profits that the PE would have earned at arm's length as if it were a separate enterprise performing the same functions under the same or similar conditions'.
PE - An outdated concept?
There is an ever-increasing non-correlation between the location of tangible assets and that of intangible assets.
Chapter 9 - Companies Expanding Abroad
A commonly adopted strategy is to commence with a foreign branch so as to utilise any foreign losses in the early years, but then convert the branch to a subsidiary, so that only profits remitted to the UK are taxed in the UK.
Chapter 10 - Individuals Working Abroad
Tax position of UK residents working abroad.
Tax position of individuals coming to the UK to work.
Tax treatment of employees resident but not ordinarily resident in the UK.
Tax treatment of employees who have a foreign domicile and work for a non-resident employer.
National insurance contributions for employees going to work abroad.
The taxation of share options for internationally mobile employees.
Tax equalisation arrangements.
Personal tax planning for employees posted abroad.
Chapter 11 - Tax Aspects of Financing for Multinational Groups
Debt financing is usually more tax efficient than equity financing because interest is tax deductible whereas dividends are not.
The effect of withholding taxes.
International treasury management within multinational groups of companies.
Maximising the value of the tax deduction for interest: basic strategies.
Financing investment in countries with high inflation.
Cross-border tax arbitrage:
- hybrid financial instruments (e.g. convertible bonds)
- the double dip lease (lessor/lessee)
- 'Entity classification' ('check the box' rules)
- losses of dual resident companies
- cross-border 'repos'
Part 4 - International Tax Avoidance
Chapter 12 - Introduction to Tax Havens
Offshore financial centers are jurisdictions in which transactions with non-residents far outweigh transactions related to the domestic economy.
The types of tax havens (Kudrle (2003)):
- Production havens (e.g. Ireland)
- Base havens, also sham or secrecy havens (e.g. Caribbean and Pacific islands)
- Treaty havens (e.g. Netherlands)
- Concession havens, also 'head-quarters' havens (e.g. Belgium)
The growth of the offshore financial sector.
The Eurobond Market: Eurobonds are negotiable, fixed term and bearer.
Chapter 13 - Anti-Haven Legislation
Chapter 14 - Transfer Pricing
Transaction -based methods of determing ‘arm’s length’ price.
The OECD recommends the use of three methods:
- comparable uncontrolled price (CUP)
- resale price minus
The US insists on a statistical approach, whereby only values within the inter-quartile range (excluding the lowest 25% and the highest 25% of results) are considered acceptable. The IRS also favours the median point as the most appropriate point in the range for a comparable.
Transactional-profit-based methods of determining ‘arm’s-length’ price.
These are identified by the OECD as methods of last resort but are increasingly being used, particularly in the US:
- transactional net margin
- comparable profits method (CUP)
- profits split
Cost sharing arrangements: the current regulations merely require that the actual percentage of expected benefit should not deviate from the percentage used to determine cost sharing payments by more than 20%.
Chapter 15 - Treaty Shopping
Part 5 - International Tax Policy
Chapter 16 - E-Commerce
Chapter 17 - Tax Competition
Chapter 18 - European Corporation Tax Issues
Chapter 19 - VAT and Customs Duties