Part III International taxation issues

• Individuals and companies may be engaged in cross

border activities
• sales between companies in different countries;
• individuals travel from one country to the other for
business or any other purpose;
• generation of income in one country as a result of
investments made by individuals or corporations of
another country; or
• services rendered by residents of one country to
persons in another country etc.
• International taxation deals with the taxation of
cross border activities by individuals or companies
(income originated in different countries);
• Countries involved in international taxation are
source and residence countries;
• The State where the income is generated is the
source country (State);
• The state where the taxpayer resides is the residence
country (State);
• Residence rules;
• Individuals’ residence – number of days /months
supplemented by other requirements;

• France 180 days; Germany 6 months; Ethiopia 183

days (and other requirements like has a domicile
within Ethiopia; etc
• Companies residency rules usually consider:
– where the headquarter is,
– where the ownership is,
– Where the effective (central) management is etc.

• Countries have specific rules pertaining to the

determination of the resident of a company;
• For example UK company residency rules:
• if it is incorporated in the UK or, if not incorporated
in the UK, if its central management and control is
exercised in the UK.
• Ethiopia company residency rules:
• Has principal office in Ethiopia;
• Effective management in Ethiopia;
• Registered in the trade register of the concerned
government office;
• who should tax foreign source income? Residence or
source country?
• both countries have sovereign right to impose tax;
• every country has the right to tax income accruing,
arising or received in it, on account of the activity
carried on in its territory.
• Residence and source based taxation
• Residence based taxation
• All incomes (both foreign and domestic source
incomes) are taxable in the country of residence
only;
• No tax on foreign source income in source countries;
• foreign source income is exempted in the country of
source;
• likely to give advantage to developed countries at
the cost of developing countries;
• Source based taxation
• Foreign source income is taxed in the country of
origin and exempted in the country of residence;
• No taxation on foreign source income in the country
of residence;
• Likely to cause distortions – excessive capital export
• Specifically, excessive capital outflow to countries
where the tax rate is low;
• Global and territorial systems of taxing residents

• Global system (worldwide) - the total amount of tax

payable should be roughly independent of whether
the income is earned at home or abroad;
• It taxes residents of a country on their worldwide
income no matter in which country it is earned;
• Examples of countries using WWI method:
• A resident in the UK or US is liable to tax on
worldwide income;
• A resident of Ethiopia is also subject to tax on
worldwide income;
• Territorial system – an individual (a company)
earning income abroad needs to pay tax only to the
host government;
• Territorial taxation – taxes income in the country it is
earned; does not tax foreign source income;

• any business income earned in a territory is subject

to income tax in that territory, regardless of whether
the business is owned by foreigners.
• any foreign source income earned by residents are
exempted.
• Example: Mr ABC a resident in the US earned income
of $10,000 from work performed in the UK (in the
year 2021). He also earned $120,000 in the US (same
year).
• Home country (country of residence)= USA
• Host country = UK
• Income generated in the home country = $120,000
• Foreign source income = $10,000
• Taxation in the UK (host country)-non-resident
taxation
• Mr ABC is liable for income tax on $10,000;
• Taxation in the US (home country) resident taxation
(WWI)
• Residents are taxed based on their worldwide
income;
• Worldwide income in the example
• Income in home country + income in host country
• =$120,000 + $10,000 = $130,000;
• The foreign source income =$10000 is taxed twice
(double taxation of the same base);
• One of the problems in taxation of foreign source
income is the existence of double taxation;
• Double taxation has effects on the cost of operations
and effectively may act as a hindrance to cross
border activities (investments);

• International taxation regime deals with how to tax

international activities and avoid unfair treatment of
taxpayers (double taxation);

• In international taxation regime, the source State

(country) is granted prior right to tax all income and
the residence State (country) has the primary
obligation to prevent double taxation;
• Avoiding double taxation
• The principle underlying avoidance of double
taxation is to share the revenues between the
countries involved;
• Double taxation is usually avoided through a Double
Taxation Avoidance Agreement (DTAA) entered into
by two countries for the avoidance of double
taxation on the same income.
• The DTAA eliminates or mitigates the incidence of
double taxation by sharing revenues arising out of
international operations by the two contracting
states to the agreement.
• objectives of a tax treaty include:
• prevent double taxation;
• facilitate cross boarder activities (investment etc) by
removing tax impediments;
• eliminate tax avoidance;
• exchange of information; and
• determine dispute resolution mechanisms.
• Methods for preventing double taxation
• three methods of providing relief from double
taxation –
• exemption, credit and deduction methods
• Exemption method- the residence country exempts
income that has arisen in the source country;
• Foreign source income is taxed only in the country of
origin (source);
• Example Netherlands
• credit method -residence country grants credit for
taxes paid by its resident in the source country;
• The tax paid in the source country is credited against
the total tax liability in the resident country;
• Countries using this include the US, Ethiopia etc
• Deduction method – resident countries allow
residents to deduct tax paid to a foreign country in
respect of foreign income;

• Mostly the credit method is adopted in the DTAA for

providing relief from double taxation;
• Multinational enterprises (companies);
• MNE is an entity that conducts business in more than
one jurisdiction;
• Worldwide tax saving- profit maximization
• Multinational corporations are subject to tax in their
home country depending on the specific
multinational taxation system adopted by the home
country.
• Taxation and MNE
• Strategies used by MNE in reducing tax burdens:
– Affiliates – subsidiaries
– Tax havens
– Payments to and from foreign affiliates (transfer price)
etc
• Branch and subsidiary income
• An overseas affiliate of MNE can be organized as a
branch or a subsidiary;
• A foreign branch is not an independently
incorporated firm separate from the parent;
• Branch income becomes part of parent’s income;
• A foreign subsidiary is an affiliate organization of the
MNE that is independently incorporated;

• In the case of the US for example, a foreign

subsidiary is a company owned by a US corporation
but incorporated abroad and hence a separate
corporation from a legal point of view;

• Taxation of income from a foreign enterprise can be

deferred if the operation is a subsidiary;

• Profits earned by a subsidiary are included only if

returned (repatriated) to the parent company;
• Thus, for as long as the subsidiary exists, earnings
retained abroad can be kept out of reach of the
resident country’s tax system;

• Controlled foreign corporations (CFC) rules

• In the US, CFC is a foreign subsidiary that has over
half of its voting stock held by US shareholders;
• The undistributed income of minority foreign
subsidiary of a US MNC is tax deferred until it is
remitted via a dividend;
• This is not the case with a CFC- the tax treatment is
much less favourable;
• Tax Havens
• A tax haven is a jurisdiction which serves as a means
by which firms and individuals resident in other
jurisdictions reduce the taxes that they would
otherwise be obliged to pay there;
• tax havens may be identified by reference to the
following factors:
– no or only nominal taxes (generally or in special
circumstances);
– laws or administrative practices which prevent the
effective exchange of relevant information with other
governments on taxpayers benefiting from the low or no
tax jurisdiction;
– Lack of transparency;
• Tax competition – governments compete for taxes;

• Tax competition occurs when countries adapt their

tax policies strategically to make themselves
attractive to new enterprises or to keep themselves
attractive for existing ones;
• Perhaps the best known case of a successful country
in tax competition is Ireland;

• Low taxes in Ireland attracted considerable foreign

investment and thus contributed to the rapid
economic modernization of the country and the long
1990s boom (Genschel 2002);
• the new East European accession countries tried to
copy this success and thus attracted resentment
from old EU member states;

• Germany and France were particularly critical of the

East European low tax strategy;

• large EU member states’ complaints are

understandable because the low tax strategy of the
small countries is openly aimed at capturing their
capital and productive businesses.
• Small countries – large countries winners and losers
in tax competition
• Small countries benefit from reducing tax because
the resulting tax deficit on ‘home’ capital can be
over-compensated by the attraction of foreign
capital;
• From the perspective of small countries, reducing
the tax rate leads to the inflow of foreign capital,
especially from large countries and leads to an
income and welfare gain for them;

• In a situation of tax competition, the welfare of small

states rises while that of large states falls.
• Overall, the welfare loss of large countries is greater
than the gain experienced by small countries
(Bucovetsky 1991; Wilson 1991; Dehejia/Genschel
1999);
• In general, a very popular public opinion is that if a
state has a higher corporate tax rate than others,
then for tax reasons large companies will move their
production and jobs to low taxation countries;

• Relocation takes a number of factors into account –

access to market, factors of production etc;
• A company does not relocate solely because of tax
burdens (EC 2001);
• However, the above point does not apply to all
industries;
• Surveys show that companies choosing a location for
a financial services centre clearly focus their
attention on tax factors (Ruding Report 1992);

• An important reason for the stiff competitive

pressure in corporate taxation is that multinationally
integrated companies can perform ‘tax arbitrage’;

• They can avoid taxes by transferring ‘profits’ from

high to low tax jurisdictions;
• through this they can benefit from the good
infrastructure and other locational advantages in
high tax countries and the tax advantages offered in
low tax countries or tax havens;

• ‘profit shifting’ happens through various techniques

such as the (legal) manipulation of internal transfer
pricing for products or the skillful choice of financial
structures, especially debt rather than equity
financing;
• In this way multinational companies can book the
profits in low tax countries and their losses in high
taxation countries, without changing their location of
real production;

• Many empirical studies have investigated whether

and how strongly tax differences between countries
influence decisions on where companies transfer
their ‘profits’;

• Despite different approaches, all the studies come to

the same conclusion: the transfer of taxable profits is
very sensitive to taxation;
• Payments to and from foreign affiliates for the
purpose of shifting profit;
• Having foreign affiliates offers transfer price tax
arbitrage strategies (for shifting the profit);

• Transfer pricing
• The transfer price is the accounting value assigned to
a good or service as it is transferred from one
affiliate to another;
• Transfer pricing refers to the prices that related
parties charge one another for goods and services
passing between them;
• For example, if company ‘X’ manufactures goods and
sells them to its sister company ‘Y’ in another
country, the price at which the sell takes place is
known as the transfer price;
• These prices can be used to shift profits to
preferential tax regimes or tax havens
;
• If, a subsidiary in a high-tax jurisdiction charges a
price below the “true” price (i.e. it transfers at a
price below the actual price), some of the group's
economic profit is shifted to the low-tax subsidiary;
• Consequently, the assessee is able to escape tax or
mitigate it but at the same time the tax base of high-
tax jurisdiction is eroded;
• Hence, unless prevented from doing so, corporations
or other related persons engaged in cross border
transactions can escape from paying tax by
manipulating the transfer prices;
• If one country has high taxes, do not recognize
income there- have those affiliates pay high transfer
prices;
• If one country has low taxes, recognize income there
– have those affiliates pay high transfer price to the
co. located in low tax jurisdiction;
• Most countries have transfer pricing rules which
regulate the prices charged by related cos.
• Most tax systems, including the U.S. transfer pricing
rules, follow the arm’s length principle;
• Under the arm’s length principle – transfer price
should be the price that would have been set if the
parties (to the transaction) were unrelated
enterprises acting independently;
• the underlying principle is that the prices charged by
related parties (mostly units of an MNC) to one
another should be consistent with the price that
would have been charged if both parties were
unrelated and negotiated at arm's length;
• Methods of determining the arm’s length price;
– Comparable Uncontrolled Price Method,
– Resale Price Method,
– Profit Split Method,
– Comparable Profits Method ,
– Cost Plus Method.