International Tax: Residence Jurisdiction

ITP

Residence Jurisdiction

Residence jurisdictions impose tax on the basis of a nexus between the jurisdictions and the persons. This establishes a worldwide taxation on residents, which may promote potential overlapping taxing right between resident jurisdictions and source jurisdictions. Some obvious risks are double taxation, discouraging international commerce and investment, and unfair taxation.

In practice, most countries tax residents on worldwide income. Exemptions apply for active business income earned by residents through foreign branches/permanent establishments and income earned by foreign subsidiaries owned by residents. Furthermore, they tax nonresidents only on income derived from a source in their country.

Defining Residence

With respect to individuals, residence may be determined under some tests. Firstly, facts-and-circumstances test. The following factors are considered: the location of income-producing activities, the location of family, the social ties to the country (bank accounts, club membership, driver’s license), visa and immigration status, actual physical presence.

Secondly, objective test. An individual may be determined as a resident if:

  • presents in a country for 183 days or more per year (unless they are not citizens and do not have a dwelling and are in the country);
  • have a dwelling in a country (unless they also have a dwelling in another country);
  • are citizens in a country (unless they have established a dwelling abroad and are regularly abroad for > 183 days per year);
  • domicile in a country (domicile means an individual’s permanent connection with a country, such as the country where he/she is born or his/her parents are domiciled); or
  • have resident status for visa or immigration purposes;
  • however, they are still residents if:
    • they are temporarily absent from a country but intend to return and resume residence in the country; or
    • they have not established residence status in another country

Thirdly, special rules. Diplomats, military personnel, and other government employees are deemed to be residents of the country that employs them (despite the fact that they have spent most of their time outside the country)

With respect to corporations, residence is usually determined under place of incorporation test, place of management test, and residence of the shareholder test. With respect to other legal entities, residence is determined under place of organization test or place of management test. Some issues arise when we need to determine residence status of partnerships and trusts. Partnerships can be established informally, so that it is difficult to determine their status of residence. Therefore, they are usually treated as transparent for tax purposes. As for trusts, difficulties arise where the country of trusts organization, the country of the trustees, the country of the grantors/settlors, and the country of the beneficiaries are different.

Tax Treaties on Residence

Relevant Articles in tax treaties are Article 4 and Article 1(3). Article 4 regulates the definition of resident and tie-breaker rules. Article 1(3) is a saving clause.

  • Art 4 (Resident)
    1. Art 4(1): the definition of resident
      • The OECD Model Treaty: domicile, residence, place of management or any other criterion of a similar nature
        • For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof as well as a recognised pension fund of that State. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

      • The UN Model Treaty: as above plus place of incorporation
    2. Art 4(2): tie-breaker rules for individuals
      • The OECD and UN Model Treaties: permanent home, the center of vital interests, habitual dwelling, citizenship (plus the competent authorities’ determination under Art 25)
      • The OECD Model Treaty:

        • Where by reason of the provisions of paragraph 1 an individual is a resident of both Contracting States, then his status shall be determined as follows:

          • a) he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

          • b) if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

          • c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national;

          • d) if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

    3. Art 4(3): tie-breaker rules for legal entities
      • Until 2017: place of effective management
        • Problem: many countries tend to treat dual-resident entity as not being resident in either country
      • In 2017: amendment of the OECD and UN Model Treaties -> the competent authorities should endeavor to establish the residence of a dual-resident entity, considering place of effective management, place of incorporation/creation, other relevant factors.
        • Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavour to determine by mutual agreement the Contracting State of which such person shall be deemed to be a resident for the purposes of the Convention, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by this Convention except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting States.

    4. Art 1(3): saving clause
      • “This Convention shall not affect the taxation, by a Contracting State, of its residents”
      • History:
        • was initially enacted in the US treaties: the US reserves the right to tax its residents and citizens in a treaty country as if the treaty had not come into effect
        • Example: If a US citizen in Country B receives a dividend from the US, then the citizen is not entitled to the treaty benefits.
      • Art 1 of the OECD Model Tax Treaty (Persons Covered)
        1. This Convention shall apply to persons who are residents of one or both of the Contracting States.

        2. For the purposes of this Convention, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State shall be considered to be income of a resident of a Contracting State but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State.

        3. This Convention shall not affect the taxation, by a Contracting State, of its residents except with respect to the benefits granted under paragraph 3 of Article 7, paragraph 2 of Article 9 and Articles 19, 20, 23 [A] [B], 24, 25 and 28.

Worldwide Basis

Worldwide basis taxation is an immediate effect of establishing a nexus between the jurisdictions and the persons. In this section, discussions will be narrowed into policy considerations of worldwide basis and how exceptions and limitations are applied to minimise potential overlapping taxing rights.

Two main policy considerations of worldwide basis taxation are equity and neutrality. Under the equity perspective, tax burden on equal amounts of income should be the same regardless of whether the income is derived from domestic source or abroad, because all residents get benefits from public goods and services. Under the neutrality perspective, with respect to individuals, taxation should not give incentive for its residents to work abroad. With respect to legal entities, worldwide taxation promotes capital-export neutrality: tax burden on capital owned by residents of a country should be the same regardless of whether the capital is invested at home or abroad. However, if the other country adopts territorial basis with relatively lower tax rates, taxing on a worldwide basis would impede its residents carrying on business in the other country to compete with local investors and other foreign investors from countries that adopt territorial basis. To prevent such condition, under international norm, active business income is taxed on territorial basis. Therefore, worldwide taxation should provide exemption for foreign source income or provide tax credits against residence country tax.

While active business income earned by a branch or permanent establishment is exempt or subject to foreign tax credits, how do we treat expenses or losses incurred by the branch/PE? Foreign source losses are usually limited to the amounts of foreign source income. Howerver, deductions may be recouped if the business is sold/transferred to a foreign subsidiary.

Some exceptions apply with respect to worldwide taxation. First, foreign subsidiaries. Residents’ foreign subsidiaries are out of the scope of worldwide taxation (in contrast with foreign branches or PEs). As the result, if a business is located in a lower-tax country, establishing a foreign subsidiary and defer the foreign profits may reduce tax burdens more than establishing a foreign branch. Second, temporary residents. They are residents in a country only for short terms (e.g. < 5 years) and still retain substantial economic interests in their home country. They are excepted from the application of worldwide taxation to avoid double taxation. For example, pension plan of a temporary resident. An executive is resident in country A. He then takes a temporary posting in country B. He plans to retire in country A.

  • Country

    A

    B

    Contributions Deductible if paid by employees; Not taxable if paid by employers Not deductible if paid by employees; Taxable if paid by employers
    Accumulated income Not taxable N/A
    Distributions Taxable Taxable only to the extent that they exceed the contributions to the plan
  • Outcome: double taxation on the contributions made when he lived in Country B

Another example is a trust established by a temporary resident. A is resident in country A. He establishes a trust under the laws of country A for the benefit of his children. A moves to country B to take a temporary position. These are the rules of trust in both countries:

  • Country

    A

    B

    Accumulated income Taxable, at the tax rate applicable to the children Taxable, even though the trust income is taxable in country A
  • Outcome: double taxation on accumulated income derived when he lived in country B

Special Issues on Residence

This section covers three special issues on residence: exit/departure taxes, trailing taxes, and part-time resident.

Exit/departure taxes will be illustrated by an example. Taxpayer A (resident in country A) acquires shares in B Co (resident in country B) and then earns unrealized capital gains. Tax treaty between Country A and Country B provides that, where gains are realized, the residence country is entitled to tax such gains. An opportunity is available in tax treaty between Country B and another country, which is Country C. Under the treaty, the residence country is entitled to tax realized gains but with a lower tax rate. In this case, if Taxpayer A changes his residence to Country C, then the application of tax treaty between Country B and Country C tax would result in a lower tax on realized capital gains. This practice can be prevented by Country A by applying exit/departure taxes, deeming departing residents to have disposed of their shares. In this case, Country A will impose tax on the unrealized gains/income (that are, unrealized gains and unaccrued interests) at the date of residence cessation. However, the application of exit/departure taxes raises liquidity problems and potential double taxation (Country C will also impose tax on the portion of the unrealized gains).

The next issue is trailing taxes. These are taxes on all/certain items of income (commonly: capital gains) of a resident even after the taxpayer ceases to be resident under the country’s ordinary rules. There are some variations around the world.  In Germany, the threshold is that the taxpayer moves to a designated tax haven. In the US, the threshold is that the taxpayer moves to designated tax havens and such taxes are limited to 10 years. In the UK, the threshold is that the taxpayer resumes his residence within five years (which is a short period). However, trailing taxes are not allowed under Art 13 of the OECD and UN Model Treaties (Capital Gains).

The last issue is part-time residents. Part-time residents cease their residence in a country (Country 1) and starts to be a resident in another country (Country 2) for part of the year. They are different from deemed residents. Deemed residents present in the other country (Country 2) for more than 183 days and therefore are treated as residents in the other country for the entire year (they may still maintain the residence in the Country 1). Some possible rules for part-time residents are:

  • Country 1 may still tax the taxpayer on worldwide income for the entire year. However, if Country 2 also imposes tax on worldwide income for the entire year, the result is double taxation.
  • Alternatively, Country 1 may tax the taxpayer on worldwide income for only the portion of the year during which the taxpayer is actually resident (deductions, allowances and credits are prorated). However, there may be some difficulties in determining cutted-off income, expenses etc, and Country 2 should provide the taxpayer with personal allowances for the rest of the year.

Source:

  1. Brian J. Arnold, International Tax Primer (4th ed. 2019)
  2. OECD Model Tax Convention

 

1. Foto_AGUS DWI PUTRA

Hi, this article is summarised from Brian J. Arnold’s “International Tax Primer”. If you wish to read the book, please click FREE PREVIEW from Amazon.

One comment

  1. […] In practice, most countries tax nonresidents only on income derived from a source in their country. Tax treaties generally provide source countries with the first right to tax income sourced there. However, the taxing right is limited (in terms of tax rates) on certain categories of investment income and is precluded on certain categories of income. Moreover, with respect to residents, most countries tax them on worldwide income (income from foreign branches/PE are exempt or entitled to tax credits; income earned foreign subsidiaries owned by residents are exempt; see International Tax: Residence Jurisdiction). […]

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