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International Tax

Written by: Saurabh Kumar - Recently completed my masters in Law from University of London.
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International Tax is a field where the taxing jurisdiction of two countries is involved. Tax is a sovereign issue and every state has its right to tax its residents but when there is taxing of the same property or person by two different states then the conflicts arise. The problem comes when there is an “imposition of comparable taxes in two or more states on the same taxpayer in respect of the same subject matter and for identical periods “(OECD Committee on Fiscal Affairs). Therefore International double taxation occurs where the tax authorities of two or more countries concurrently impose taxes having the same bases and incidence in such a way that a person incurs a heavier tax burden than what he suppose too. A country will usually reserve a right to tax its residents on their worldwide income and also the tax authority usually wish to tax all income and gains no matter the person is resident or no and this is done on source basis. Under the source principle a country reserves the right to tax not only the worldwide income and gains of its tax residents but also the income and gains of non-residents arising within its border.

One of the key issues on international tax is the question of jurisdiction which arises through residence and source. The way in which these concept interact causes potential problems and there is more debate about which is more important in terms of the allocation of taxing rights between nation states. Principle guiding the development of international tax policy includes capital export neutrality and capital import neutrality. Much of the focus of current international tax policy development stems from the need to control the tax planning activities of multinational group of companies who have considerable choice available to them as to where to locate their activities so as to potentially achieve tax savings.

There are two kinds of double taxation

1) Juridical double taxation

International double (or multiple) taxation occurs where the tax authorities of two or more countries concurrently impose taxes having the same bases and incidence in such a way that a person incurs a heavier tax burden than if he were subject to one tax jurisdiction only.

2) Economic double taxation

Economic double taxation takes place when two different persons are taxable in respect of the same income and capital.

To avoid this double taxation, countries enter into double taxation treaties with other countries based on the OECD model. The Organization for Economic Co-operation and Development is an international body which plays a very important role and its model on avoiding double taxation is very well adopted by most of the developed economies follows its own US model and most of the developing nations including India follow the UN model which is mostly based on the OECD model with one of the major differentiating factors being the definition of permanent establishment.

Tax treaties avoid double taxation through a tie breaker clause. There are times when individuals and corporations are resident for tax purposes in more than one jurisdiction and in such a case the tax treaty between nations decide the taxing right.

The OECD model recognises the right of the source country to tax profits arising from the presence of the PE with the resident state giving tax relief for the tax paid in the source state.

The two most common ways by which the resident state relieves double taxation are:
1) Exemption method – Article 23 A
2) Credit method- Article 23 B

Article 23 A and 23B of the OECD model describe two methods; either of the methods can be used to avoid double taxation. However, Article 23 A and 23 B do not require that the state of residence eliminate double taxation in all cases where the state of source has imposed its tax by applying to an item of income a provision of the convention that is different from that which the state of residence considers to be applicable.

With globalisation and free movement of capital and labour, there has been a major shift in the policies and objectives of the OECD as far as double tax treaties are concerned. The focus has shifted from avoiding double taxation to avoiding double non-double taxation.

Since OECD consists of the 30 most wealthy and developed nations in the world, they have seen their tax base being eroded in recent times because of mushrooming of tax havens and with their domestic companies establishing and expanding overseas.

The developed nations have tried to protect their tax base by enacting various anti-avoidance provisions. The three most common anti – avoidance measures adopted by the taxing authorities of these countries is Controlled Foreign Companies regime, transfer pricing and thin capitalisation. OECD has recognised these measures and has adopted them in the model stating that they do not contravene the basic International Tax principles.

1) Transfer Pricing
Today the role of multinational enterprises in the world trade has increased over last 20 years and this growth presents complex taxation issues for both tax administration and the MNEs themselves since separate country rules for the taxation of MNEs cannot be viewed in isolation but must be addressed in a broad international context. The need to comply with laws and administrative requirements that may differ from country to country creates additional problems.
Transfer prices are the prices at which an enterprise transfers physical good and intangible property or provides services to associated enterprises. Article 9 of OECD deals with associated enterprises and it deals with transfer pricing at arm length’s principle. There are various methods given to use transfer pricing and the concerned state is ready to use any of them.

2) Thin Capitalisation
Financing an overseas investment is complex as it can be financed by equity, intra group debt or external debt when a group guarantee may be required by the lender. This is important as interest is deductible and dividends are not. Thin capitalisation rules really relate to excessive loans to help tax authorities to protect their tax base in relation to inbound investment by regulating the proportion of debt on which interest is deductible. Thin capitalisation is a mechanism wherein funds are infused into a company in the form of loan rather than equity to avail tax benefits to ensure that the capital of the company is very small or thin. A higher debt component in the capital structure reflects by an extraordinary high debt-equity ratio enables companies to save on taxes since interest on loans is normally deductible for calculating taxable profits. This is in contrast to dividens which are not deductible. If the company’s debt or equity ratios exceeds a certain norm then some or all of the interest is to be disallowed as an expense or depending on the terms of the relevant country’s domestic legislation more generally treated as dividends. The most obvious thin capitalisation arises in the context of associated enterprises, Article 9 of OECD Model which allows the profits of associated enterprises to be adjusted to the arm’s length profit should be considered first.

3) Controlled Foreign Company (CFC)

The general rule of international tax is that the profits of a subsidiary are not taxed in the country of the parent unless and until distributed by dividends to the parent. Controlled Foreign Company rules help tax authorities to protect their tax base in relation to outbound investment by providing an alternative means of taxation at the level of parent company. CFC rules operates in an environment where all group transaction take place at arm’s length.

The general feature of CFC

1) Bring forward the time of taxation at the level of parent
2) Tax system which might otherwise not be taxed
3) Focus on investment income
4) Can focus on and therefore tax business profits

India and International Taxation

Under Section 90 of Indian Income Tax Act, the Central Government is authorised to enter into Double Tax Avoidance Treaties (DTAA). The object of such agreements is to evolve an equitable basis for the allocation of the right to tax different types of income between ‘source’ and ‘residence’ states ensuring in that process tax neutrality in transactions between residents and non- residents. India had DTAA with most of the countries.

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