Taxes have been the main source of income for kingdoms, kingdoms and states since time immemorial. Some of the oldest texts in the history of government speak of taxation in some form or another. At that time taxation was limited to income earned in the domain of the ruler; today we call it Domestic Tax. However, after the Industrial Revolution, cross-border trade increased significantly. Various economic theories about international trade point to countries specializing in producing goods and products in which they have a competitive advantage. Countries that do not have a competitive advantage in certain goods, obviously imported from countries that have these advantages. And everyone stands to gain.
However, international trade raises various tax problems. These mainly come from the Source Rules or the Tax Residence Rules. These rules seem to have been inherited from ancient times as well.
According to the Sourcing Rule, if a business derives income from sources in a country, that country has the sovereign right to tax that income. The rulers of old made sure that caravans that entered their territory from outside, to sell their wares, paid taxes before they returned. This may be the origin of sourcing rules and possibly customs as well.
Under the Residence Rule, all income of a tax resident of a country will be taxed in that country. In ancient times, anyone who grew crops in the territory of the ruler, paid taxes on the produce. Somewhere along the way the definition of “all income” expanded to global income and that is what stands today.
Currently, tax laws in most countries, except for a few, follow a combination of Source Rules and Residence Rules.
First Conflict
As international trade increased in the world, the first conflicts in taxation arose. This is a clear conflict between the Source Rules and the Residence Rules. This is explained with the help of the following examples:
Assume Company A is a US taxpayer and must pay US tax on its global income under US tax law. Company A transfers some technology to Company India for use in India. Under Indian tax laws, Company A is taxed in India under the rules of sourcing its revenue from technology transfers. And herein lies the conflict. Company A is taxed in India on technology transfer under the sourcing rule and taxed on the same income in the US under the residency rule, resulting in double taxation.
Obviously no wise business would want to engage in cross-border trade in such a scenario. Countries will lose important tax revenues as a result of this double taxation. It is imperative for countries to enter into a Double Taxation Avoidance Agreement to resolve this double taxation problem.
Double taxation avoidance agreement (DTAA)
Therefore, countries involved in international trade began negotiating the Double Taxation Avoidance Treaty or DTAA’s as they are often called. Negotiations are mainly bilateral because the economic and trade relations between the two countries are specific to those countries. However, to aid negotiations and to standardize treaty formats, the DTAA Model and Convention were developed.
The United Nations developed the United Nations Model Convention with the aim of assisting developing countries in their negotiations with developed countries. The Organization for Economic Cooperation and Development (OECD), developed its own Model Convention to help developed countries. The US, as the main trading partner for most countries, establishes its position as the US Model. Each Model has its own commentary explaining the Model’s terms. While all Models contain similar provisions, there are certain important differences. We will discuss this in the next article. The models do not carry legal force but act as a guide for the government and in the interpretation of the DTAA.
Using this Model as a starting point in bilateral negotiations countries seek to avoid double taxation issues by:
- Establish taxation rights for various types of income. In the interest of advancing economic development, investment and international trade, some countries have agreed to waive their right to tax income thereby avoiding double taxation.
- Compares taxes paid in one country with taxes owed in another. This offset or “tax credit” means that the business is only burdened to the extent of the higher taxes in both countries.
DTAAs help in overcoming major stumbling blocks for successful international trade.
But the Government still loses revenue
Bilateral DTAA, although in principle following the various Models, deviates from it in the language and terms used. This is obviously specific to the negotiations at hand. The end result is a large number of similar DTAA but with significant deviations in some cases. Large Multinational Corporations seek to capitalize on this deviation and engage teams to maximize the benefits of the “network of agreements”. The International Tax Specialist Profession was born. The role of the International tax specialist is to find legal ways to avoid taxes in higher tax areas. They do this among other things, by placing holding companies in low-tax jurisdictions with a network of lucrative agreements that result in base erosion and profit shifting, commonly referred to as BEPS by tax authorities.
Governments around the world are aware of this technique, also known as “deal shopping” and are trying to prevent it through various anti-avoidance measures. US tax law has enacted anti-avoidance measures such as transfer pricing, controlled foreign company rules, thin capitalization rules, and limit benefit clauses in its DTAA. But the loss of income continues.
Overtime the way business is conducted has also changed. The digitization of business processes and e-commerce has resulted in technology companies being able to take advantage of loopholes in the country’s domestic tax provisions, and in the languages of various DTAAs. It is important to note that the tax provisions and DTAA are intended to address the tax issues associated with traditional brick and mortar businesses rather than newer digital commerce. It will take some time for tax authorities to examine the leaks they are facing as a result of digital trading.
Global Initiative to check tax leakage
To minimize the negative impact of BEPS, the OECD Fiscal Affairs Committee developed 15 Action Plans and in November 2015 these were endorsed by the OECD Council and the leaders of the G20 Countries.
Briefly, this action plan is as follows:
1. The Tax Challenges of Digitization
The action plan seeks to address the challenges and difficulties posed by the digital economy in the application of existing international tax rules.
2. Neutralize the hybrid mismatch setting effect
Strive to develop model treaty provisions and general recommendations for domestic rules relating to entity transparency, dual domicile and the application of methods to eliminate double taxation.
3. Controlled Foreign Company Rules
General recommendations to strengthen regulations relating to taxation of controlled foreign companies.
4. Interest cutting restrictions
A general approach based on best practices to prevent bottom erosion through higher interest payments in intra-group company financing.
5. Dangerous tax practices
Mandatory rules to avoid harmful tax practices to increase transparency
6. Prevention of abuse of agreement
Mandatory provisions and recommendations to prevent abuse of the agreement. Including the Principles objective test, Benefit Limitation rules, Dividend transfer transactions, capital gains tax liability, anti-abuse rules for permanent establishments located in third jurisdictions.
7. Status of Permanent Establishment
Recommend changes to the definition of a permanent establishment to avoid its formation through a Board of Commissioners structure, exemption from certain activities or separation of contracts.
8. Revision of existing transfer price standards (covered in Action Plans 8 to 10)
Guidance for ensuring that transfer pricing results are in line with value creation in terms of intangibles, risk and capital, and other high-risk transactions.
9. Transfer Price
Same as in Action Plan 8
10. Transfer Price
Same as in Action Plan 8
11. BEPS data analysis
Methodology for collecting and analyzing data on BEPS and actions to address issues as they arise.
12. Mandatory Disclosure Rules
Design of mandatory disclosure rules for aggressive tax planning.
13. Country-by-Country Reporting
Revised guidance on country-by-country reporting to increase transparency on Multinational Enterprises.
14. Collective Agreement Procedure
Develop solutions to overcome barriers to dispute resolution between tax authorities based on the Collective Agreement Procedure, and incorporate arbitration as a dispute resolution option.
15. Multilateral Instruments
Provide analysis of legal issues related to the development of multilateral instruments to enable streamlining the implementation of BEPS issues.
Most Action Plans can be implemented through changes made in a country’s domestic tax laws. However, Action Plans 2 (Neutralizing the effects of hybrid incompatibility arrangements), 6 (Prevention of Abuse of Covenants), 7 (Status of Permanent Establishment), and 14 (Mutual Agreement Procedures) require multilateral agreements for their implementation. This resulted in the creation of the Multilateral Instrument officially known as the “Multilateral Convention for implementing tax treaty related measures to prevent Base Erosion and Shifting of Profits”.
Disclaimer: This article is for informational purposes only and readers are advised to seek professional advice before acting on the information provided here