The two basic principles of international taxation, residence and source, are explained in this month’s article. The concepts form the basis of one of the first books that I wrote in 1978, ‘The Principles of International Tax Planning’, which was reproduced in 1980, and then again in 2005 with the addition of a case study approach. I have now decided to create a new version based, of course, on the same principles, and I am delighted that my son Nick has joined the firm and will be responsible for producing the next version. Nick and Dmitry Zapol will work in close collaboration on the new book, and I anticipate publishing this in September.
The two issues of residence and source feature significantly in the advice that we give to our Clients. Many of our Asian, Eastern and some Western European individuals are keen to compare the consequences of being resident in their countries with lifestyle changes in places like the US, Canada, Switzerland, Spain and the UK.
As regards source, issues such as permanent establishments are important concepts for our corporate Clients to understand, particularly in today’s digital environment where the OECD, in its BEPS, project is attempting to widen the scope of the digital permanent establishment.
This topic was the main issue discussed at the recent IBSA conference at the Mandarin Oriental Hotel in London, where the head of the OECD BEPS project, Raffaele Russo, spoke of the various issues in which they were engaged. Professional advisors, such as Omleen Ajimal from Squire Patton Boggs, and industry tax directors such as Keith Brockman from Mars Ltd, Jose Villoldo from Omnicom Europe, Harm Oortwijn from Paramount Pictures and Gary Howlett from Kaspersky Lab expressed believable scepticism that the OECD ideas could be adopted universally.
The next IBSA event is on July 29th – for IBSA members only – entitled ‘Intellectual Property as a Value Proposition’ and I hope to see many of you at this discussion group hosted by Farrer & Co. And a save-the-date note that the next annual IBSA conference will be held at the Mandarin Oriental Hyde Park hotel again in London on November 27th.
Overseas branches of the IBSA are getting underway. Following the opening of branches in Singapore, Hong Kong, Cyprus and Israel to date, we are planning to open branches in Switzerland, Italy and Malta in September, in October in the US and Russia and at the end of January 2015 in Mauritius. If you are interested in helping develop any of these local branch committee, please let me know.
I hope you are enjoying the summer of sport. Disappointments are, of course, inevitable, but with our wide network of colleagues around the world, there will always be those who are happy with the results! At the time of writing, our Serbian friends will be delighted with Sunday’s incredible Wimbledon final, and we won’t know until next Sunday which of our colleagues in Argentina, Brazil, Germany or the Netherlands will be delighted with the World Cup result. All we do know is that those of us living in the UK have had to keep our notorious upper lip very stiff during the month of June!
I hope you enjoy the rest of the summer.
With my best regards
SOURCE VS RESIDENCE
The two basic concepts of international taxation are residence and source. Where these exist in different jurisdictions, there is the potential for double taxation which is precluded either through unilateral legislation or double tax treaty arrangements. At the same time, we need to consider the anti-avoidance legislation that exists universally to deny tax benefits which were not intended by governments. The focus of an international tax specialist has also to extend to VAT and similar indirect taxes which can in some cases create far greater international tax problems than direct taxation. These four issues — source, residence, tax avoidance and indirect taxes — are the four sections of the newly arranged ‘Principles of International Tax Planning’ that will be published by IFS in September 2014.
Taxation as a result of Source
Taxation based on source will relate to the form of income or capital gains with specific rules in varying jurisdictions. It is useful to look at the format of the OECD Model Double Tax Treaty and consider the relevant articles as they relate to the source of income or gains. The OECD Model Commentary is helpful in understanding the policy that various countries follow in creating their domestic laws dealing with cross-border transactions.
For example, starting with trading income, one needs to understand the definition of a trade which is generally based on products or services being sold. Since one of the functions of double tax treaties is to facilitate international trade without creating impediments (such as imposing tax obligations on activities with little or no connection with a particular country), the permanent establishment exemptions may override the normal source rules of where a trade is taking place.
Real estate income and generally capital gains relating to real estate would normally have a source where the real estate is situated, and this is generally maintained despite double tax treaty arrangements in place. This is because most countries would not wish to cede their rights to tax income and gains from local real estate (as opposed to allowing certain trading activities such as a purchasing office or a warehouse to be exempt from local source taxation).
Personal income such as employment income would generally only have a local source if the individual is employed by a local entity, or is employed by a foreign entity but is resident in the relevant country for more than 183 days in a fiscal year. However, this is not the case for entertainers and sportsmen for whom specific legislation exists in most countries, imposing a local source on their income even if they are present in the territory for a very limited time period.
The local source rules only apply to performance income — for example, on the pitch or on the stage — so that, for example, payments to an entertainer for endorsing a product of a local company, or appearing on a television commercial advertising a product, would not generally be regarded as performance-related, and would therefore fall under the normal income tax rules relating to other individuals. However, where an ‘image rights’ payment is received for wearing a product on the football field, for example, this can hardly be regarded as non-performance related, and it is in this area where tax investigations are currently being focused.
Passive income such as dividends would have a local source, being where the payer company is located; interest is sourced generally where the debtor resides; and royalties are generally sourced where the intellectual property is utilised or exploited. However, it would be difficult for tax authorities to raise assessments against foreign corporate or individual tax payers who are liable to tax on such passive income as a consequence of source, and therefore countries impose a withholding tax on account of their tax liability. In order to encourage foreign investment, double tax treaties would normally limit the amount of withholding tax that can be imposed upon such foreign taxpayers, and often may provide full exemption from withholding tax to maximise foreign investment (again one of the functions of a double tax treaty). It should be realised that withholding taxes are only on account of an income tax or capital gains tax liability which may be imposed as a result of the source rules.
Taxation as a result of Residence
Although this may appear to be easier to determine on the surface, compared with source rules, there may be issues which override the normal considerations of where a legal or other entity or individual may be taxed according to the residence concept. For example, US citizens are taxed on their worldwide income wherever they are resident; UK non-domiciled but tax resident individuals may elect to be taxed on a remittance basis only so that their foreign income and capital gains which are not brought in the UK may be exempt from UK taxation. Companies may be incorporated in a particular territory but may be managed and controlled elsewhere, in which case they may be tax resident in more than one jurisdiction. If a double tax treaty exists between these two jurisdictions, then the treaty should determine the place of residence according to the place of effective management of the company, but this may be difficult to determine.
On this topic, it is clear that substance is a vital ingredient in determining where a company is considered resident in international tax matters. Whereas in the past offshore companies were prodigiously used in cross-border tax structures, nowadays they may be disregarded if they don’t have the degree of substance required to justify their existence. This may include occupation of their own premises and employment of adequate (in terms of numbers and experience) personnel for the functions required by the offshore company.
The beneficial ownership concept has been expanded through case law such as Indofoods and Prévost to enable tax authorities to disregard entities used as conduit companies purely for tax mitigation purposes. The cases illustrate the issues determining beneficial ownership as regards who is able to benefit from double tax treaty protection in respect of income and gains which have a local source. Thus, the limitation on benefits provisions in US double tax treaties and similar anti-avoidance provisions in other treaties, attempt to penetrate structures designed to minimise local taxation if it is considered that beneficial ownership does not reside with that particular entity receiving the income.
For individuals, the connection with a particular country may create tax residence irrespective of their exceeding the normal 183-day limit in a tax year. Thus, before the statutory residence test was introduced in the UK in April 2013, exceeding 90 days per annum on average over 4 years would create UK tax residence in each of these years. Ireland, Norway and many other countries have similar rules to determine residence over a period of years, as does the US through its cumulative presence calculation over three years.
But it is not only the number of days in a particular country that may determine tax residence; having what is known as your centre of vital interests in a country may create tax residence irrespective of the number days spent there. The centre of vital interests test is normally divided into social and economic interests, the latter being, for example, employment with a local company, and the former being a home, family or other connection to the particular country. Generally, the centre of personal/social interests is more important so that if the individual is employed in another country but has his spouse and children living locally, this may create local tax residence. And it is not only spouses that are taken into account nowadays, but partners if there is a degree of permanence to the relationship, particularly if a child is involved.
It is relatively easy nowadays for individuals to move their country of residence from one place to another, although there is frequently an exit tax associated with such departure. Such a tax requires their assets to be deemed to have been realised on the day of departure and the relevant capital gains calculated, on which local tax will be levied as if the assets had indeed been realised. This could be a significant deterrent to individuals moving from one country to another, and such exit taxes may also be relevant for companies wishing to re-domicile into another territory. Where there is an overriding multi-lateral arrangement, such as exists within the European Union that delays the moment of imposition of the exit tax liability, such taxes may be prohibited, but otherwise the cost of transferring residence may be considerable.
If any individual, corporate or other entity is considered to be tax resident in a particular jurisdiction, the consequences of such residence determination extend far beyond the domestic jurisdiction. Controlled foreign company (CFC) legislation may exist to impose domestic tax on profits earned by foreign subsidiaries, whilst similar legislation may exist for individuals imposing tax on profits earned by foreign entities to which they have transferred their rights to receive income or capital gains. This anti-avoidance legislation is particularly relevant to foreign trusts and foundations which have been increasingly targeted, not only in the US and the UK, but also in countries such as France, Italy, Israel and Russia where hitherto trusts may have been used to shield foreign income and gains from local taxation.
In the current environment advocating transparency in all areas of international business, as well as the disclosure of all transactions designed to create tax benefits for individuals or corporations, it is becoming easier for tax administrations to investigate the affairs of resident taxpayers. Where transactions create double taxation as a result of residence and source, unilateral law or double tax treaties may resolve the problem. Where taxation is entirely avoided, transparency will allow tax administrations to consider whether such avoidance is justifiable. The OECD BEPS provisions recommend the disallowance of structures involving, for example, hybrid entities designed to avoid taxation in two or more jurisdictions.
The standard anti-avoidance provisions of transfer pricing adjustments, including thin capitalisation issues, have been bolstered in recent years by the adoption of general anti-avoidance rules (GAAR), which have been part of Australian tax legislation for many years and have been recently introduced into the UK. The concept of adhering to substance over form has been relevant in continental European countries for many decades, and adopted in the UK through court decisions in the eighties. However, it is now being universally adopted both in terms of the transactions themselves and also the corporate entities involved. One may well query the use of offshore jurisdictions in the future within international business structures, and clearly such centres have realised this by concentrating their efforts on developing collective investment vehicles such as funds.
Although so much focus has been levelled at corporate taxation and the avoidance of tax by certain multi-national household names, corporate tax generally accounts for no more than 5% of a country’s tax revenue. Indirect taxes such as VAT, on the other hand, may well account for five times the revenue of corporate taxation.
As regards source taxation, VAT legislation as well as other indirect tax legislation, such as customs duties, has clarified the nexus (source) rules for VAT and particularly developed them over the last few years. It is now the position within the EU that VAT is no longer regulated by where the supplier is based, but rather where the customer is located. This has been an important development following the significant increase in e-commerce trade, where previously companies could be located in offshore jurisdictions without VAT legislation so as to be able to offer goods without such incremental cost for the customer. Tax Administrations realised the loss of tax revenue through the use of such offshore companies, and imposed VAT liability on ‘Product’ where the customers received such products, with certain de minimis rules applying below a certain value for each product. In fact, these de minimis rules are likely to be abolished so that all products are subject to VAT where the customers are based.
For services, such as the downloading of music or other services, this has proved a more difficult issue to address, but with effect from 1 January 2015, all services will also have their VAT nexus or source where the customer is based. The tax will need to be collected and accounted for either through the ‘MOSS’ mechanism (‘mini one stop shop’ or effectively the payment gateways) or through direct registration in the relevant countries where sales of services are effected. Therefore, for VAT and other indirect taxes, the question of residence and source is less of an issue.
Is it worth it?
The final chapter of the new book will ask the same question I asked back in 1978: ‘Is it worth it?’ For genuine business transactions, tax mitigation is an essential ingredient to limit costs and maximise return to investors. Without such tax mitigation, investors will be reluctant to invest in the particular project, and of course the economic consequences of losing investment opportunities are fully understood. However, where structures are developed purely for tax avoidance motives, one has to question whether the savings that may be achieved are worth it in relation to the reputational risks to both companies and individuals from entering into such arrangements. It has been well publicised that the household names referred to above have found that reputational risk has a far more serious effect on their bottom line after-tax profits than achieving what ultimately are only going to be temporary tax savings.
Article written by Roy Saunders
8th July 2014
Roy Saunders, Chairman, IFS and IBSA. IBSA is the network for international business advisors and their clients, bringing together specialist advisors to enable businesses to optimise the structure of their international operation by enhancing resilience in tax planning, mitigating regulatory and market risk and enabling sustainable multi-jurisdiction growth.