International Tax: Source Jurisdiction

ITP

Source Jurisdiction

Source jurisdictions impose tax on the basis of a nexus between the jurisdictions and the income or activities generating the income. In other words, the income is generated or the activities are carried on in the jurisdictions.

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).

A person may be taxed simultaneously by a source jurisdiction (under the application of source rules) and by a residence jurisdictions (under the application of worldwide taxation). Therefore, there may be potential overlapping taxing right between resident jurisdictions and source jurisdictions. Some obvious risks are double taxation, discouraging international commerce and investment, and unfair taxation. Good source rules are needed to prevent such risks. Some characteristics of good source rules are:

  • Broadly acceptable to many countries to effectively eliminate double taxation and prevent double nontaxation
  • Reasonably allocate income and tax
  • Allocate income to a country where the income has a substantial economic connection (that is, where the value is added/created)
  • Should not allocate income to countries that do not impose tax
  • Applicable on a reciprocal basis
  • Clear and simple for taxpayers and tax officials to apply
  • Cannot be subject to manipulation by taxpayers

We will discuss how source rules are applied on employment and personal service income, business income, and investment income.

Employment and Personal Service Income

Under this category are income derived by employees, professionals and other independent contractors. In most countries, source is based on the location of service performance or the location of service consumption (even if the service is performed in another country; applied by South American and Latin American countries). In the US, for example, nonresident aliens’ income from employment and from personal services (categorised under business income) has its source in the location of service performance.

Model Treaties

With respect to income derived by employees, the OECD and UN Model Treaties (Art 15: Income from Employment) provide source countries with taxing right if the employment is exercised in source countries and at least 1 of 3 requirements is satisfied (otherwise, the residence country of employees has exclusive taxing right). The 3 requirements: the employee

  1. is present in the source country for 183 days or more;
  2. is paid by or on behalf of an employer resident in the source country;
  3. the employee’s remuneration is deductible in computing the profits attributable to a PE in the source country of a nonresident employer

With respect to income derived by professionals and other independent contractors, the UN Model Treaty and the OECD Model Treaty have slightly different treatments since 2000. Under the UN Model Treaty, such activities are categorised as independent personal services and therefore Art 14 (Independent Personal Services) applies. Under Art 14, a source country has taxing right if the service provider has a fixed place* or spends at least 183 days in the country (otherwise, the residence country has exclusive taxing right). By contrast, under the OECD Model Treaty, such activities are categorised as business activity and therefore Art 7 (Business Profits) applies.** Under Art 7, such income is sourced in the location of a PE.

*) It needs to be mentioned that the UN Model Treaty recognises a deemed service PE where a taxpayer furnishes services in a source country through employees or other personnel for a period of more than 183 days in any 12 month period beginning or ending in the year (Art 5(3)(b)).

**) Before 2000, Art 14 of the OECD Model Treaty (Independent Personal Services) applied for such income. However, in 2000 the Article was eliminated to clarify that the exceptions to PE status in Art 5(4) (that are, preparatory and auxiliary exceptions) and the agency PE rules in Art 5(5) and (6) are equally applicable to income from professional and independent services, just like other business activities.

In addition under this category, fees for technical services are treated in the UN Model Treaty to be sourced in the location where the fees are paid (either by a resident or by a nonresident with a PE). Included in the definition of fees for technical services are consulting, technical, and management fees. Some exceptions are amounts paid to employees, amounts paid for personal services, and amounts paid for teaching in/by educational institutions.

Business Income

Business income is taxable in source countries if the taxpayer carries on business through a PE in the countries and generates income attributable to that PE. Attributable income of a PE is determined by assuming that the PE is a separate legal entity and that it deals at arm’s length with other parts of the enterprise.

The OECD and the UN Model Treaties: Art 7.

In the US, income of nonresident aliens from the sale of purchased or produced inventory has its source in the location where the inventory is sold or produced, respectively. 

Investment Income

Dividends, Interest, Royalties

Some discussions arise on whether source taxation is better than residence taxation in terms of taxing dividends, interest and royalties. On the one hand, some argue that source taxation is not very good because of excise tax effect. Withholding tax on such income may become excise rather than income tax. For example, a lender requires that the payments be made net of tax (additional cost borne by the borrower). They prefer residence taxation because it promotes business efficiency (because there is no tax consequences in inter-company transfers) and is simple in terms of administration. However, some other argue that residence taxation may promote tax avoidance scheme through treaty shopping (by changing residence?).

In general, dividends, interest and royalties are taxed by source countries through withholding tax on a gross amount at a flat rate (some limitation on the rate applies to prevent excessive taxes). The following paragraphs will discuss source rules of such income in detail.

With respect to dividends and interest, the OECD and the UN Model Treaties provide that such income has its source in the payer’s residence country (Art 10 and 11). As for interest, if it is borne by a PE, then source is deemed to be in the country where a PE (as a payer) is located (regardless of whether the person having that PE is resident of the country or not) (Art 11(5)). Under the US source rules, nonresident aliens’ income has its source in the residence of payer (in respect of interest), in the US (in respect of dividends received from domestic corporations, or in the foreign country (in respect of dividends received from foreign corporations).

With respect to royalties, the OECD and the UN Model Treaties have different treatments. Under the OECD Model Treaty, residence countries have exclusive taxing right (Art 12). By contrast, under the UN Model Treaty, the source is in the country where royalties arise (i.e., where the property is used and legal protection is provided). Moreover, if royalties are borne by a PE/fixed base, then the source is deemed in country where a PE/fixed base (as a payer) is located (regardless of whether the person having that PE/fixed base is resident of the country or not) (Art 12(5)). Under the US source rules, nonresident aliens’ royalty income has its source in the location of property (in respect of natural resources) or the location where the property is used (in respect of patents, copyrights, etc).

Other types of investment income

1) Rental income

  • from business operation -> treated as business income
  • of immovable property -> Source = the property location
  • of movable property -> Source = the country in which the property is used
    • The OECD (Art 7) and UN (Art 12) Model Treaties: treated as business income
  • US source rules:
    • Rents: Source = location of property

2) Gains from disposal

  • of immovable property -> Source = the property location
    • The OECD and UN Model Treaties: Art 13(1)
  • of assets used in carrying on a business -> Source = the country in which the business is carried on
    • The OECD and UN Model Treaties: Art 13(2)
  • of shares -> Source = N/A (i.e. exclusive taxing right for the residence country), with the following exceptions:
    • The UN Model Treaty:
      • Art 13(4): if the value of the shares is derived principally from immovable property located in another country, then source = that other country
      • Art 13(5): if the taxpayer (who disposes of shares in an entity) holds substantial shares in the entity, then source = the country in which the entity is resident
    • The OECD Model Treaty
      • Art 13(4): if the value of the shares is derived principally from immovable property located in another country, then source = that other country

Source:

  1. Brian J. Arnold, International Tax Primer (4th ed. 2019)
  2. U.S Internal Revenue Service, Pub. 519 (2018)

 

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.

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