At one time international tax issues were the problem of only a handful of tax specialists who were advising large multinational corporations. Over the last 30-40 years there have been significant technological breakthroughs that have led to increases in international trade. The improvements in telecommunications and transportation have caused the exports of goods and services originating in the United States to increase from $26B in 1960 to $930B in 1997. With the increase in economic integration and the growth of international trade among small to mid-sized companies, more and more tax advisors are faced with the complicated tax issues related to foreign investment. During this course we will analyze some of the major issues that countries must face when designing international tax rules and in coordinating those rules with the tax systems of its trading partners.
Many of you who are enrolled in this program probably have some background in domestic taxation. For those of you consulting with clients that reside in high-tax jurisdictions, it could be that these clients are handing over a significant portion of their income to the government, even though it is an accepted and legal principle of taxation to arrange business and personal affairs in such a way as to attract the lowest possible tax burden. Whether or not you are “legally” qualified to provide advice to clients regarding foreign tax law, it is certainly beneficial that you have as much knowledge as possible related to foreign tax systems.
From a domestic tax perspective, you may be aware of strategies for creating tax base deductions such as office expenses or depreciation. Or you may be able to generate cash flow that does not constitute taxable income, e.g. a bank loan on property. You may also be able to reallocate highly taxed income into income taxed at a lower rate, such as capital gains. Many of these techniques can also be used in global tax planning. But there is are some significant differences between domestic and international tax planning.
International tax or taxation refers to the international aspects of laws in individual countries. There are no actual international tax laws stemming from legislation of individual countries or from international organizations such as the United Nations or the Organization for Economic Cooperation and Development (OECD). The nearest we come to an “international tax law” is found in the system of tax treaties. These agreements have been entered into by most developed nations, as well as many developing nations, to facilitate trade. To date, there are over 2,000 bilateral tax treaties in existence. These treaties limit the powers of the taxing authorities that are party to the treaties and provide significant tax relief to taxpayers when the treaty is incorporated into a jurisdiction’s tax law through domestic statutes. Virtually all current income tax treaties are based in a large part on the OECD Model Treaty.
The primary operational goals of tax treaties are to reduce the risk of double taxation to taxpayers engaged in cross-border transactions and to decrease the risks of under taxing taxpayers, by promoting cooperation between responsible governments. These goals are advanced by standards that promote agreement related to international tax rules in adopting income tax treaties that follow the same general pattern. Additionally, tax treaties aid in preventing discrimination against nonresidents and foreign nationals, encourage exchange of information, and advocate mutual cooperation in the resolution of disputes. Treaties will be discussed in more detail later in this course.
Reasons for double taxation:
Any time there is an overlap of fiscal sovereignty or powers at domestic or international level a situation of double taxation may arise. This could be a result of multiple powers that exist within a country between federal and State governments or international double taxation could arise as a result of conflict of tax claims actually made by two or more judicial taxing powers. Double taxation may be economic or juridical:
(a) Economic double taxation applies to the same tax object and legally different, but economically similar or connected subject ("economic identity of subject"). Economic double taxation may result in double or multiple tax on different persons on the same income (Examples: husband and wife, partnership and partners, company and shareholder, parent and subsidiary).
(b) Juridical double tax relates to the same tax object and the same tax subject ("legal identity of subject"). Juridical double taxation issues arise due to overlapping claims of fiscal jurisdiction. The OECD Committee on Fiscal Affairs defines international juridical double taxation as "the imposition of comparable taxes in two or more States on the same taxpayer in respect of the same subject matter and for identical periods".
The cause of international double tax is the "overlapping of tax jurisdictions in the international sphere" (Knechtle 1976) due to: (a) tax jurisdiction or taxing power to demand taxes; (b) the legal relationship between the tax authority and the taxpayer to impose tax based on fiscal facts and; (c) the tax obligations between taxpayer and taxing power arising from fiscal attachment, based on (a) personal attachment or tax residence, or (b) economic attachment or source or situs.
Three main types of conflicts may arise due to these overlapping tax jurisdictions, which would result in juridical double taxation. They are:
Source - Source conflicts: Two or more countries claim the same income of a taxpayer as sourced in their country under their tax laws.
Residence - Residence conflicts: Two or more countries regard the same taxpayer as tax resident in their country under their tax laws ("dual residence").
Residence - Source conflicts: Same income is taxed twice, both by the source country, where it is derived under its "source rules", and in the country to taxpayer's residence under its "residence rules".
Residence-source taxation is the most common form of conflict seen in international taxation. In this instance the taxpayer satisfies a single relationship in two jurisdictions simultaneously. The country of residence or citizenship taxes on a worldwide, unlimited basis, due to the "residence rule", while the country of source reserves its right to tax all incomes arising from economic activities within its territory ("source or situs rules"). Relief from double taxation may be addressed under domestic law and/or tax treaties.
Dual source issues may arise as a result of definitions that vary from tax jurisdiction to tax jurisdiction or if certain jurisdictions impose taxes on a deemed source basis. These situations would require specific treaty provisions on source rules or use of mutual agreement procedures provided for by tax treaties. Dual residence problems are generally resolved through the tie breaker clause in tax treaties or under domestic law through specific legislation or practice.
Because each country follows its own specific tax practices and applies the interpretation under its own legal system, many tax issues come about due to inconsistency in tax rules and practices. Some of the more common reasons for juridical double or multiple taxation might include:
Varying definitions of tax terms and classification of transactions by different countries. For example, commonly used terms in domestic law and treaties such as income tax, total income, residence, domicile, immovable property, permanent establishment, may vary considerably according to the context.
Differences in "connecting factors" and tax computation rules applied in different jurisdictions. Foreign credit calculations made under domestic tax rules to relieve double taxation may not coincide with the basis applied in the source country. More than one country may claim earnings or gains as arising from within its jurisdiction.
The legal nature of the taxpayer, e.g. individuals, companies, trusts, partnerships, may affect the tax rate and the tax computations. Different jurisdictions may characterize them differently under their domestic law.
While tax treaties assist in resolution of juridical double taxation, economic double taxation is usually relieved through domestic tax legislation.
International Tax Conflict Rules
Although each country may apply distinct definitions of tax terms and taxable entities, use diverse bases for computing taxes, or may have separate tax accounting rules under their domestic laws, a connecting factor between the taxpayer, or business activity, and the tax jurisdiction must be established before cross-border transactions can be taxed. A tax liability can only arise through connecting factors
What is considered a connecting factor:
The fundamental components or "identity criteria" include:
The identity of the taxpayer, or the relationship to the taxed object that creates a tax liability (or "tax subject").
The identity of the subject matter, or the facts that give rise to the tax liability (or "tax object").
The two fundamental "connecting factors" to a tax jurisdiction that would lead to a tax liability are (i) the tax subject or fiscal domicile or residence, and (ii) the tax object or source or situs or place of action or work. A "tax object" may, therefore, be (i) taxed by the State of residence only, (ii) taxed by the State of source only, or (iii) taxed by both States, subject to specific limits.
Tax conflicts can arise due to the connection with a tax jurisdiction or authority of either the tax subject or tax object. Tax subjects are liable to full unlimited tax liability due to personal attachment on residents. Tax objects are subjected to tax in a fiscal jurisdiction due to economic attachment on source or situs.
The primary aim of tax treaties is the allocation of tax objects through conflict rules between the contracting states and to eliminate double or multiple taxation, in cases of juridical double taxation. Tax treaties allow for distribution of tax revenues through "distributive rules" under allocation or attribution principles. Most tax treaties give prior taxing rights to the source country with reduced or no taxation on some incomes. The country of residence is obligated to provide tax relief to avoid double taxation.
Allocation rules
The conflict rules on tax objects allocate exclusive or limited taxing right to one or other country. These conflict rules include:
The primary right to tax is with country of residence of the subject.
The source country reserves the right to limited taxation of the object.
The source country does not have exclusive taxing rights.
The residence may require to give credit or exemption.
Allocation principles provide for:
Full or unlimited (worldwide) taxation from personal attachment of persons due to fiscal sovereignty ("totality principle") on the total worldwide economic interests of the taxpayer, regardless of source, based on tax residence rules under domestic laws.
Limited taxation from economic attachment of persons of assets (including situs) or income arising from sources within the fiscal jurisdiction ("source" or "origin principle").
Attribution rules
Conflict rules also provide for attribution of source to specific tax jurisdictions. The general attribution rules include:
immovable property : situs
industrial/business profits : permanent establishment
shipping and air transport, directors' fees : residence
employment, professional services : working place
government salaries and pensions : sovereignty
others: residence, but source may have simultaneous right
Relief From Double Taxation Rules
Conflict laws also add rules under domestic law or treaties in order to eliminate or relieve double taxation. They include:
Exemption method: Full exemption or exemption with progression.
Credit method: Full credit, or ordinary credit at progressive rate or sole income rate.
Tax deduction: Tax costs as production costs or expenses, based on cash on accrued basis.
Loss deduction: Deduction of losses in case of permanent establishment (wholly or partial)
The subject and scope of international tax is not limited income tax. It may also include estate taxes, gift taxes, inheritance taxes, general wealth taxes, sales taxes, customs duties, and any number of special levies. Wealth transfer taxes have important international implications when a resident receives a bequest or gift from a nonresident or non-domiciled individual or when a person owns property in a foreign country.
There are several different issues that fall under the scope of international tax that present potential tax implications involving the laws of two or more countries. These issues may include international trade of goods and services; manufacturing by a multinational entity; international investments by individuals or investment funds; and taxation of individuals who work outside of their resident country. Tax issues may be highly complicated, as in the case of multinational corporations with subsidiaries in several countries or extremely simple involving individuals working in a foreign country.
The international tax law of a country has two broad dimensions:
The taxation of resident individuals and corporations on income arising in foreign countries, and;
The taxation of nonresidents on income arising domestically.
Obviously when two jurisdictions want to participate in trade, both governments are interested in collecting taxes on the transactions. Both parties may claim that they have the right to tax based on residency of the parties. When tax claims between jurisdictions overlap we run into a problem known as juridical double taxation. The problem usually arises due to one country claiming taxing authority based on residence and the basing their claim on where the income was generated. In some cases, both jurisdictions may claim residency of a taxpayer under their specific residency guidelines. In order to avoid double taxation a significant number of countries have entered into bilateral tax treaties with other jurisdictions and/or have implemented domestic legislation to address the issue.
You can see that it is essential that the jurisdictions coordinate their taxing efforts. If for example, if a business in France is assessed a 50% tax fee on any gains that had occurred in France while the US assesses the business as a resident with 50% on any gains anywhere in the world, the combined tax rate would be 100%. This policy would certainly deter businesses from involvement in non-profitable transactions or trades and it would result in loss not only the businesses, but the individual jurisdictions as well.
Ideally, each country or jurisdiction should have established tax legislation that is neutral; that is, it does not encourage or discourage particular trade activities or the outflow of capital. Individuals and entities should make their investments based on reasons other than taxation. If a taxpayer’s decision to invest in their resident jurisdiction or elsewhere is not is not dependent on taxation, this is referred to as capital-export neutrality. Capital inflows are considered desirable and are encouraged through tax and other economic policies by almost every jurisdiction in the world, whereas capital outflows are generally thought to diminish national wealth. Many countries adopt measures designed to discourage capital outflows, although they may also have provisions of their tax laws that have the unintended effect of encouraging outflows. Effective policymakers exercise caution in discouraging outflows because limitations on capital outflows may discourage capital inflows. For example, if a country imposes high withholding taxes on dividends, interest and royalties paid to nonresidents, investment by nonresidents is likely to be discouraged.
Let me illustrate how the capital-export neutrality policy works. A resident jurisdiction taxes a resident company at a rate of 35% on worldwide income. The jurisdiction where the branch is located taxes at a rate of 30%. With the system of capital export neutrality, the resident jurisdiction would then credit the foreign tax against the resident tax and then tax the foreign profits at 5%. So, if the investment is located abroad, the foreign jurisdiction would collect the 30% and the resident jurisdiction would collect 5%. If the investment were located in the resident jurisdiction the resident tax authority would collect. This neutrality system works well to deter taxation based investment decisions.
To summarize, a country’s principle of capital-export neutrality should avoid international tax rules that might cause its multinational companies to bear a higher effective tax burden in foreign markets than the multinational companies of other countries. To implement this principle fully, residence countries would need to exempt all foreign-source income from domestic tax.
Another system of taxation neutrality is known as capital-import neutrality, or sometimes, foreign or competitive neutrality. In this system all companies competing in a particular market are taxed equally. That is they are exempted tax on income from foreign investment. The problem here of course is that businesses will choose jurisdictions with lower tax rates – thus violating the above system of capital-export neutrality.
National neutrality is another system. In this system the total returns on investment shared by the taxing authority and investor are the same regardless of where the investment was made. The rate is not altered and the taxes paid to the foreign jurisdiction would be deductible but not creditable as a business expense against domestic income tax liability, making taxes higher to the investor since the reduction will not be dollar for dollar.
Most countries have adopted international tax rules that contain some features that are consistent with capital-export neutrality. Other features are consistent with capital-import neutrality. For example, most countries do not tax foreign-source income earned by foreign corporations controlled by residents except in special circumstances. There is no consensus among tax analysts as to the proper balance between these principles in the design of international tax rules.
The fairness and efficiency of income taxation ultimately depends not on the income tax laws of any one country but on the combined effects of the income tax laws of all countries. Countries typically have little to lose and much to gain by coordinating their income tax systems with the tax systems of their trading partners. Tax treaties are the primary vehicles for achieving such coordination.
Currently the U.S. tax system incorporates all of the above methods. As you will see in subsequent weeks, the U.S. does offer tax reductions to taxpayers with foreign operations to offset certain (not all) taxes paid abroad (capital-export neutrality). In allowing U.S. taxpayers to deduct foreign taxes that are not creditable, we see an illustration of national neutrality. By taxing foreign businesses at the same rate as domestic taxpayers and by exempting U.S. earnings of foreign subsidiaries of U.S. corporations from taxation to encourage competition, the U.S. tax authorities are exhibiting capital-import neutrality.
When designing international tax rules, each country should attempt to achieve certain primary goals. In part these goals can be achieved through unilateral action. But to successful achieve all of the goals, a country needs to cooperate with any major trading partners.
The first major goal of international tax rules would be to provide each country of the world with an equitable share of the tax revenues on income generated through transnational activities of both domestic and foreign taxpayers. In order to achieve this goal a country must protect its own domestic tax base through the development of sound domestic tax rules, and to avoid entering into tax treaties that significantly limit its right to tax its domestic-source income.
Fairness of tax law should be achieved by imposing equal tax burdens on taxpayers with equal income, without regard to the source of the income. Additionally, the tax burdens should be proportionate to the taxpayer’s ability to pay. As this relates to businesses, related corporations should be imposed with the same burdened that would be imposed on a single corporation engaging in comparable activities.
In order to achieve fairness for domestic taxpayers operating abroad, the full taxation of both domestic and foreign-source income is required. Additionally, foreign-source income must be taxed whether the income is earned directly or through some foreign entity. Though no one can tax the nonresident income that arises outside its borders, the country can promote fairness standards, by imposing tax burdens that are consistent with international tax standards and by cooperating with foreign countries in the assessment and collection of tax on their residents and nationals.
Although countries must be concerned about the welfare of nonresidents, their primary obligation is to advance the economic interests of its own citizens and residents. Each country should avoid tax measures that undermine competitive positioning in the global economy. To do this it is wise to remove any provisions of the tax law that are inclined to draw capital and jobs out of the country or that deter import of capital and jobs. It is not in the best interest of a country's competitiveness to offer tax incentives and or other policies that encourage vengeful responses by foreign jurisdictions.
The goals presented above do not rely on the so-called principles of capital-export neutrality or capital import neutrality. They do, however, incorporate the aspects of capital-export neutrality and capital-import neutrality that have received wide acceptance among tax analysts.
International Tax Systems
Nearly every jurisdiction has developed basic tax guidelines related to foreign taxpayers and residents doing business abroad. The guidelines generally are in the form of domestic tax legislation or result from bilateral tax treaties. Each country or jurisdiction has its own unique set of guidelines, but there are also similarities and clear agreements from one jurisdiction to the next.
Jurisdiction is determined by one of two things – territory or nationality. For tax purposes, tax jurisdiction can be claimed on citizens of a country, or, because of their legal ties, businesses that are incorporated in a country. Citizens and companies incorporated in the U.S. may be taxed on their worldwide income by U.S. taxing authorities. Income includes salary, investment returns, profit from sale of goods, etc.
The most common determination for tax jurisdiction is territory. If one lives within the borders of a particular jurisdiction, that person or entity is expected to contribute to the support that country through the payment of taxes. Taxing authority can be claimed if a person is a citizen or a resident as defined by that country’s rules. A business may be considered subject to tax in a particular jurisdiction if they are incorporated there and have sufficient connections to the jurisdiction – incorporation alone is sufficient for some countries. For individuals, their connection to the country is what determines territorial jurisdiction. This connection may be citizenship or residence.
In cases where an individual is neither a citizen nor a resident of a country, the country still may claim territorial tax jurisdiction on the income derived within that jurisdiction. This is referred to as “source jurisdiction.” A non-resident for example, may have taxes imposed by the jurisdiction in which profits are earned. Other income that may be considered taxable is investment income, such as dividends, royalties, interest, and rent. However, most countries will not tax income of a foreign company’s operations outside of their own jurisdiction.
Because U.S. citizens living abroad are still subject to U.S. taxes because as U.S. citizens they are still protected by the U.S. government and because they have the option of relocating to the U.S. at anytime. Just as individual citizens abroad are protected by U.S. law, such is the case with U.S. corporations operating in foreign jurisdictions – they too benefit under U.S. corporate laws regardless of where they are situated.
As mentioned earlier, the issue of double taxation may arise when two (or more) jurisdictions claim the right to tax a person or entity. This could occur for example, if one country claims jurisdictional rights based on residency or nationality while another country claims taxing authority on the basis of income earned within its territory. The U.S. has a general policy of allowing the country with territorial jurisdiction to be the primary taxing authority, while the country claiming nationality or residence jurisdiction is the secondary taxing authority. The U.S. in most cases will credit the taxes paid in another jurisdiction by a U.S. citizen or resident against income taxes due in the U.S. and this is only the surplus of U.S. income tax on foreign income beyond foreign tax collected is paid to the IRS.
A number of other countries use the territorial approach in determining taxing jurisdiction, not including certain income earned in foreign countries in the tax base and crediting foreign taxes paid. When claiming taxing authority based on territory, a jurisdiction will tax a non-resident in the same manner as a resident, with the jurisdiction claiming all business profits earned within that jurisdiction. Expenses associated with the business profits are typically deductible. Non-business investment income, e.g. interest, dividends, royalties, and rent, may be subject to limited jurisdiction, this generally occurs in jurisdictions where gross salary is taxed with no deductions allowed. This is tricky since low tax rates on gross income may result in high tax rates on net income, depending on the expenses involved in producing a product or service.
FUNDAMENTAL U.S. JURISDICTIONAL TAX PRINCIPLES
International transactions fall into one of two major categories. The export of capital or other resources from a country is often referred to as an "outward-bound" or "outbound" transaction. Transactions that involve the import of capital or other resources from a foreign country are commonly referred to as "inbound” transactions. We will refer to the "taxation of foreign income" and to the "taxation of nonresidents." The taxation of foreign income for one country or the residence country, will be the taxation of nonresidents for another country or the source country.
Outward Bound Transactions
A transaction that a country considers to be outward-bound typically involves its domestic rules for taxing the foreign income of resident taxpayers. This is the export of capital or other resources to another jurisdiction. The taxation rule for U.S. outbound transactions is relatively simple. It involves taxing U.S. residents and citizens, regardless of where they reside, on their worldwide income under specified I.R.C. rules. Domestic corporations created or organized in the U.S. are taxed on worldwide income as well, again, under specified I.R.C. rules. If U.S. individuals or corporations are partnered in either U.S. or foreign partnerships, they are also taxed on worldwide income. In some circumstances, a single transaction may have consequences under both sets of rules. An example would be the liquidation of a foreign associate into a domestic parent corporation.
There are a number of consequential rules related to U.S. taxation of foreign activities that we will discuss in detail later in this course. From a domestic standpoint, income from a corporate subsidiary within the U.S. will not generally be assessed to the parent until a dividend is paid by the subsidiary. However, in the case of foreign subsidiaries with parent within the U.S. it is not uncommon for the foreign subsidiary’s earnings to be taxed prior distribution. This method of taxation is to dissuade U.S. corporations from diverting income outside U.S. in an effort to avoid immediate tax consequences. From the domestic perspective, U.S. taxpayers are assessed taxes on all income, with some exclusions for foreign income.
As we discussed earlier on, U.S. citizens and residents, that may include U.S. corporations, may be able to take advantage of international tax provisions relating to foreign tax credits. Should a U.S. taxpayer earn income in a foreign jurisdiction that is taxable by that jurisdiction, the U.S. will allow the taxpayer to offset taxes due in the U.S. by the amount paid in the foreign jurisdiction. However, this may not be as simple as it sounds. For example, if the foreign jurisdiction chooses to tax income that the U.S. considers source income, there may not be any credit of foreign taxes paid. If the foreign tax is higher than the U.S. tax on income, the entire foreign tax may not be credited. The foreign tax cannot be used to offset U.S. tax on U.S. It can only be utilized to offset U.S. taxes on foreign income. In this manner the U.S. is not relinquishing their right to collect taxes on U.S. income to a foreign country.
Inbound Transactions
Inbound transactions refers to transactions involving the import of capital or other resources from another jurisdiction. In contrast to outward-bound transactions, inbound transactions typically invoke a country's rules for taxing non-residents on domestic income. Under U.S. taxation laws, nonresident aliens and foreign corporations are not subject to taxation on their worldwide income. In some instances, however, both inbound and outward bound rules may apply. An example would be the liquidation of a foreign subsidiary into a domestic parent corporation.
Let’s take a look at how the taxation rules apply to certain non-resident taxpayers.
Individuals
The basic tax provisions for non-resident taxpayers can be found in I.R.C. § 871(b). This code provides that non resident alien individuals who are engaged in trade or business in the United States will be taxed in same manner as a U.S. taxpayer is taxed on income connected with the performance of business or trade under I.R.C. § 1. In essence, a nonresident alien will be taxed very much like a U.S. resident on the majority of business earnings. For our purposes now, probably the two most significant terms in I.R.C. § 871(b) are “engaged in trade or business” (also known as ETB) and income that is “effectively connected” (also known as EC). These terms are defined in I.R.C. § 864(b) and 864(c) respectively. Taxes on certain types of recurring investment earnings may also be assessed to nonresident aliens. “Fixed or determinable annual or periodical gain, profits, and income” (FDAP) that is sourced in the U.S. may be taxed at a flat 30% rate under I.R.C. § 871(a). Most significantly, interest, dividends, rents, and royalties are generally subject to a 30% tax on the gross amount of the distribution, unless these distributions can be effectively connected to performance of U.S. business or trade. In the case of the later, the income will be taxed on the net amount. For the most part all income from services in the U.S. is considered effectively connected and thus taxable under I.R.C. § 871(b) or 88s. Reg. §§ 1.864-4(c)(6)(ii).
Though nonresident aliens are not usually taxed on capital gains since they are not the recurring type addressed above, there are a few exceptions. They are:
Capital gains generated by the sale real property located in the U.S. or sale of stock from certain U.S. real property holding corporations. These are regarded as effectively connected income and subject to taxation in the same manner as other business income.
Capital gains transactions that are effectively connected with the performance of business or trade that will be deemed taxable as business earnings under I.R.C. § 871(b).
Capital gains for nonresident aliens who have lived in the U.S. for 183 days or more in a taxable year. U.S. residency for tax purposes is defined as any foreign individual who is present in the U.S. for 183 days or more during a given tax year. Without a treaty provision allowing otherwise, the individual would be liable for tax on worldwide income, which would include all capital gains. Should a treaty be in place, the taxes on capital gains may be precluded.
Corporations
Tax treatment for foreign companies – those incorporated in other jurisdictions – is very similar to the treatment of nonresident aliens. Foreign corporations are taxed on taxable income that is effectively connected with the performance of U.S. business or trade under the provisions of I.R.C. § 11. Just as domestic corporations, foreign corporations are taxed on business profits from the performance of business or trade in the U.S. Again, as with nonresident individuals, corporations are subject to a flat 30% tax on a gross basis for fixed or determinable annual or periodical gains, profits, and income such as investment earnings (I.R.C. § 881) if the income is not effectively connect with the conduct of a U.S. business or trade.
Branch profits tax is one more area that must be addressed. This becomes a little more complicated. Take for example a nonresident alien individual who conducts business in the U.S. through a U.S. corporation. The corporation will be taxed on its earnings under I.R.C. § 11 while the shareholder will be liable for a 30% tax on dividends paid under provisions of I.R.C. § 871 resulting in a double tax. Should the alien individual run a U.S. business through a foreign corporation the effectively connected business income would still be taxable, but in the past, the dividends distributed to foreign shareholders easily escaped the 30% taxation. To ensure the equalization of tax on distributed corporate earnings, U.S. Congress enacted a profits tax I.R.C. § 884. Now a foreign corporation must pay a 30% branch profits tax that provides for repatriation from the U.S. branch of earnings from the U.S. to the corporation’s home jurisdiction. Branch profit tax is assessed in addition to the tax under I.R.C. § 882 and no further tax is levied where branch profits tax applies if a foreign company makes a dividend distribution to its foreign shareholders.
Partnerships
Nonresident alien individuals or nonresident corporations that are part of U.S. or foreign partnerships are most commonly taxed as though the partner had directly earned the income. Partnerships are not generally considered taxable entities for U.S. tax purposes.
DEFINING RESIDENCE
To exercise residence jurisdiction, a country must provide rules that classify individuals and legal entities either as residents or as nonresidents. The rules for determining the residence of individuals and legal entities are discussed below.
1. Residence of Individuals
In many countries, residence is determined under a very sweeping facts-and-circumstances test. The government must determine from objective evidence if an individual has established their loyalty to the country by joining its economic and social life. The most significant evidence of loyalty is in the maintenance of a dwelling or an abode in a given jurisdiction that is available for the taxpayer's use. Of additional importance might be the place where the individual works, the location of the individual’s family, social ties to the country, if they have a visa and immigration status, and lastly actual physical presence in the jurisdiction. A common rule under the facts-and-circumstances test is that an individual who has established residence in a country is unable to leave that residence until another residence is established elsewhere.
Some countries use an arbitrary test, often tied to the rule or presumption that an individual present in a country or at least 183 days of the taxable year is a resident for that year. The 183-day test is may be most enforceable in countries that exercise tight control over their borders. However, this test is extremely difficult for the tax authorities of a country to enforce when a large number of individuals frequently enter and leaving the country without border checks. In most countries, the test probably cannot operate effectively unless the burden of proof is put on the individual to prove that he or she is not present for the 183-day period. Many individuals with substantial economic ties to a country can plan around the 183-day test. Because of this, a country using the 183-day test is likely to catch only unsophisticated and unadvised individuals, who may not have very substantial ties to that country. The facts-and-circumstances test is unsatisfactory because it is often extremely difficult to apply. A good test of residence is one that the large majority of individuals can apply to obtain a consistent and clear results Though a simple and certain test for residence may be desired, an arbitrary test for determining residence is may result in many individuals who engage in cross-border activities ending up being considered as residents of more than one country.
The facts-and-circumstances test using certain objective tests to establish premises may offer a good balance between certainty and fairness. It may be appropriate for such a test to apply more rigorously in circumstances where a taxpayer is attempting to give up residence in a country as opposed to a taxpayer attempting to acquire residence in the country. The following presumptions might be used, separately or in combination, to establish a prima facie case for residence:
Individuals present in a country for l83 days or more in a taxable year are considered residents for that year unless it is established that they do not have a dwelling in the country nor are not citizens of the country. Individuals having a dwelling in the country are residents unless they also have a dwelling in another country.
Citizens of a country are residents unless they have established a dwelling abroad and are regularly outside the country for more than 183 days per year.
Individuals who have established residence in a country cannot relinquish residence status until they have established residence status in another country.
Individuals who have either resident or nonresident status for visa or immigration purposes might be presumed to have the same status for income tax purposes.
Residence of Legal Entities or Corporations
The residence of a corporation is in most cases determined by reference to its place of incorporation or its place of management. The place-of-incorporation test provides simplicity and certainty to the government and the taxpayer. It is not easy for a corporation to change its place of incorporation without provoking a tax on the accrued gains from the property. As a result, the place-of-incorporation test places some limits on the capacity of corporations to move their country of residence to avoid taxes. Many countries use the place-of incorporation test.
The place-of-management test is less reliable in its application, at least in theory. The majority of countries using this test use practical tests, such as the company's head office or the place where the board of directors meet, to determine the place of management. A place-of management test is easily capitalized on for tax avoidance reasons because a change in the place of management generally can be accomplished without provoking taxes. The place-of-management test is used by the United Kingdom and many of its former colonies. Some countries use both the place-of-incorporation test and the place of management test.
For legal entities other than corporations, residence is generally determined either under a place-of-organization test or a place-of-management test. Determining the residence of a partnership is sometimes difficult because of the informality with which a partnership can be established. Difficult problems also can arise under the laws of some countries in determining the residence of trusts. These problems are especially difficult when the country of organization, the country of management, the country where the Grantor or Settlor is located, and the country where the beneficiaries are located are all different.
Treaty Issues Relating To Residence For Individuals
Under Article 4 of the OECD Model Treaty, a "resident" of a country for the purpose of the treaty is a person taxable in that country "by reason of his domicile, residence, place of management or any other criterion of a similar nature." To avoid situations where a person is considered resident in both countries, Article 4(2) offers a series of tie-breaker rules to give residence jurisdiction to one country. The first tie-breaker is the place where the individual maintains a permanent home. The second tie-breaker is the country in which the center of the individual’s vital interests is located. The third is the place of the individual's habitual dwelling. The fourth is the country of citizenship. If these tie-breakers are ineffective in making the individual a resident of only one country for treaty purposes, certain tax officials of the two countries (the `competent authorities") are mandated to determine residence through mutual agreement. Most modern tax treaties follow the OECD Model Treaty rather closely on these tie-breaker rules.
For legal entities that are resident in two countries, Article 4(3) of the OECD Model Treaty makes the entity a resident of the country where its effective management is located. This provision of the model treaty will probably not be acceptable to countries that use place of incorporation as the singular test of residence for corporations. Many treaties attempt to resolve conflicts over the residence of entities by referring the issue to the competent authorities. Some treaties use place of incorporation as the tie-breaker if the company is incorporated in one of the treaty countries. Other treaties provide that a dual-resident company is not considered a resident of either country for most treaty purposes.
The United States demands the inclusion in its tax treaties of what is commonly referred to as a "saving clause". The typical saving clause provides, with some exceptions, that the United States reserves the right to tax its residents and its citizens as if the treaty had not come into effect. For example, a US citizen resident in the treaty country is not entitled to the reduced rate of withholding provided in the treaty on dividends received from the United States.
The U.S. is unique in that it taxes its citizens on their worldwide income regardless of residence. This has been justified in court based on the theory that benefits of citizenship extend beyond territorial boundaries. As mentioned earlier, the U.S. protects citizens anywhere in the world and they have the right to return to the U.S. at anytime. Taxes are considered the cost of maintaining those benefits.
All persons born or naturalized in the U.S. and subject to its jurisdiction is considered a citizen. Those persons who are noncitizens, but have filed a declaration of intention of being a citizen though not yet granted are considered aliens.
Although determining citizenship is relatively easy, determining residency is another matter. In order to determine whether an individual is to be taxed on worldwide income or on business and investment income under various I.R.C. rules, is contingent on the determination of residency.
The three tests for determination of residency in the United States are:
Lawful admission into the U.S. (Green Card test)
Substantial presence, or;
A first year election by the alien to be treated as a resident
Once an individual becomes a legal resident in accordance with the immigration laws, they remain a resident until that status is revoked or relinquished.
The “substantial presence test” is met if the individual is present in the U.S. for 31 days in the present year and at least 183 days in the prior three-year period, ending on the last day of the present year, using a weighted average. The weighted average is as follows: days present in the present year multiplied by one, days in the last preceding year multiplied by 1/3, days in the next preceding year multiplied by 1/6. So, if an individual is in the U.S. for 120 days in the current year and as well as each of the two preceding years, the weighted average is 180 days - they will do meet the requirements of the substantial presence test. If you add two days to each year the average would be 183 and they would be considered a U.S. resident. Presence in the U.S. is constituted by any day they are “physically” present, discounting commutes to Canada or Mexico. Should the individual not be able to leave due to illness, teaching position, student status, professional athlete status, or a position as a foreign government employee, the days do not count.
An alien is not a resident if they have been in the U.S. fewer than 183 days and has a home with closer connections that within the U.S., even if they satisfy the substantial presence test. I.R.C. § 7701(b)(3)(B). In this instance, the tax residence is considered to be at the taxpayers regular abode or principal place of business.
On some occasions a newly arrived person in the U.S. may want to be considered a resident even though they cannot satisfy the substantial presence test. This may be due to the fact that the person is earning an income in the U.S. and the tax burden will be less than his homeland as a result of substantial personal deductions. A first-year election of residency is available for aliens in the U.S. for 31 consecutive days with 75% of those days in the current tax year. The alien must first, however, meet the substantial presence test for the succeeding year.
Corporations
For corporations, the residency is very similar to the test for individuals. Just as with individuals, U.S. corporations, if incorporated within the U.S. are taxable on their worldwide income. Foreign corporations not organized or created in the U.S. are taxable on income effectively connected with the performance of business or trade in the U.S. or on certain investment income under I.R.C. §§ 881.
Though residence of a U.S. corporation is fairly easy to ascertain, whether or not the entity is a corporation is not so easy to determine. The U.S. treasury department has provided us with a list of regulations and rules that make this determination easier.
A business entity incorporated under U.S. federal or state law is a corporation for U.S. tax purposes.
A business entity formed or created under foreign law is a corruption for U.S. tax purposes if that type of entity is clearly listed in the Corporation Regulations.
A business entity that is not treated as a corporation under the first two items ca chose its classification as transparent partnership or non-transparent corporation for tax purposes. If only one owner is part of an entity and that entity chooses not to be a corporation, it will be considered a sole propiertorship with income considered to be directly that of the owner.
This list is for U.S. tax purposes only and other jurisdictions may use their own domestic rules to determine treatment of an entity.
Expatriates
There are certain cases when a U.S. citizen chooses to renounce their citizenship. Should the person be a nonresident, income from foreign sources will usually not be subject to U.S. taxes. If it is determined that the citizen relinquished citizenship in an effort to avoid taxes, the taxpayer will be taxed like a U.S. citizen or resident on income from U.S. sources for a period of 10 years if the tax exceeds the tax that would apply to the nonresident under I.R.C. § 871. By applying this rule, U.S. tax authorities have ensured that any gains received by the expatriate will be taxed as income from U.S. sources. This rule also applies to long-term residents who chose to end residency in the U.S. Long term is classified as anyone who has been a lawful permanent resident in the U.S. for 8 of the 15 years preceding termination of residency.
In order to terminate residency or renounce citizenship in the U.S. without presumption of tax avoidance an individual needs to meet certain net income or net worth tests. Should the individual’s average annual net income over a five-year period prior to expatriation exceed $100K, or if the individual’s net work is equal to or exceeds $500K, tax avoidance is presumed.
In future weeks we will discuss how these residency rules influence tax treaty provisions.
