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Two Basic Rules of Taxation1. The Residence Rule.
2. The Source Rule
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The Residence Rule Residence rule applies to the person and holds that
income of a person is taxable in the country in whichhe resides.
Playing in South Africa.
Income is taxable in India.
Residence Rule is applicable.
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The Source Rule The source rule on the other hand applies to the
income and stipulates that an income is taxable in thecountry in which it originates
Playing in India.
Income is taxable in India.
Source Rule is applicable.
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The Problem: Double Taxation
If both the above rules are applied simultaneouslyin a case,
it is possible that same income gets taxedtwice in 2 countries viz. in the country of
residence of the person as well as in thecountry of source of income.
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Double Taxation
Double Taxation makes international tradeunviable.
Everybody would prefer to deal domestically
rather then going international.
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The Remedy: Tax Treaties (DTAAs) To avoid the above problem of double taxation,
governments of different countries enter into
agreements with each other for avoidance of doubletaxation. These agreements are called Tax Treatiesor Double Taxation Avoidance Agreement(DTAAs)
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Terminology Country where income is actually
earned.Source Country
Country where the personresides.
ResidenceCountry/Home
Country
Tax recovered by Source countryon the income of Non Residents.
Withholding Tax
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Tax Treaties (DTAAs)Tax treaties basically allocate jurisdiction between the source andresidence country.
Different sections of agreement cover different income andprovide which country shall be levying tax on that income andunder what situations.
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Tax Treaty ModelOrganisation of
Economic Co-operation
and Development(OECD)Model.
United Nations ModelDouble Taxation
Convention between
Developed andDeveloping Countries.
United States ModelIncome Tax Convention
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Allocation of Taxation Rights -
Generally
Salary
Taxable in the country of residenceunless employee is in other country
beyond a prescribed period.
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Allocation of Taxation Rights -
Generally
Capital Gain
Taxable in the countryof residence.
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Country ofResidenceNo PE
SourceCountryPE
Allocation of Taxation Rights
Business Income
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Other Income like Interest, Dividend, Royalty andFees for Technical Services.
GenerallyCountry ofResidence
Limited to ratesprescribed in theagreement.
SourceCountry
Allocation of Taxation Rights -
Generally
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Methods of Elimination
Credit Method In this method, credit for tax paid in the source
country is given by the residence country against
its domestic tax as if the foreign tax were paid tothe country of residence itself.
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Methods of Elimination
Exemption Method
In this method, each country providesfull exemption to the income of itsresidents which according to the treaty is
to be taxed in another country.
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Treatment of Income covered
under Treaty by a countryResidential Status Country in which
Income is TaxableTreatment
Resident
Residence Taxable as per thedomestic law
SourceEither full exemption is
granted to income orcredit for tax paid insource country is given.
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Treatment of Income covered
under Treaty by a country
Cont....
Residential Status Country in whichIncome is Taxable
Treatment
Non
Resident
Residence Ignored
Source Taxable as per thedomestic law subject tolimitation if any by treaty
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Treaty ShoppingIs a situation where resident of a third
country takes benefit of tax treatybetween 2 different countries.
This is normally achieved by creatinglayers of ownership structures betweenorigin country and target country.
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Countries with which no
agreement exists.Country of Residence provides a unilateral tax credit.
Non Residents are taxed fully.
Relief is provided to Residents.
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General Criterion for PEAs per the principal generally followed in DTAAs,
Business Income of a non resident is taxable in sourcecountry only if it is related to a permanent
establishment or a fixed place of business in thesource country.
Accordingly business income of a non resident shall betaxable in India only if that non resident has apermanentestablishmentor a fixedplace of businessin India and income is related thereto.
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General Criterion for PE The term permanent establishment (PE) is normally explained by Article 5 of the
DTAAs. According to Article 5(2), various instances of PE include
1. a place of management,
2. a branch,
3. an office,4. a factory,
5. a workshop,
6. a sales outlet,
7. a warehouse,8. a mine, an oil or gas well, a quarry or other place of
extraction of natural resources
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Treaty Shopping- Prevention Countries generally include in its tax treaties specific
rules that limit the benefits under the treaty in certaincircumstances. These rules are typically called
limitationon benefitsor LOBprovisions.
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Terminology
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Tax HeavensCountries with very low or nil rates of taxation. Bermuda Isle of Man Cyprus Jersey Mauritius Cayman BVI
"What identifies an area as a tax haven is the existence of a composite tax structureestablished deliberately to take advantage of, and exploit, a worldwide demand foropportunities to engage in tax avoidance.
..The Economist
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Tax Shelters : Offshore Companies Creating Bulk of profits in Tax Heavens.
Example:
If US Import Co. buys $1 of goods from India and sells for $3, ImportCo. will pay tax on $2 of taxable income.
However, tax benefits can be exploited if Import Co. is to set up anoffshore subsidiary in the British Virgin Islands to buy the same goodsfor $1, sell the goods to Import Co. for $3 and sell it again in thedomestic market for $3.
This allows Import Co. to report taxable income of $0 in USA (because
it was purchased for $3 and sold for $3), thus paying no tax. While the subsidiary will have to pay tax on $2, the tax is payable to the
tax authority of British Virgin Islands. Since the British Virgin Islandshas a corporate tax rate of 0%, no taxes are payable.
