International Tax: Taxation of Residents (3 Methods of Relief)

ITP

International Double Taxation

The term of double taxation has legal-concept definition and economic-concept definition. Under legal concept, it means the imposition of income taxes by 2 or more sovereign countries on the same item of income (including capital gains) of the same taxable person for the same period. Under economic concept, it means multiple taxation of the same item of economic income.

There are some types of international double taxation. First, source-source claims. Second, residence-residence claims. These constitute cases of dual-resident taxpayers. Third, residence-source claims. This type is the most likely to occur, needing attempts of the international tax community to eliminate them. Fourth, double taxation resulting from different application in terms of the definition of income, timing and tax accounting rules, arm’s length prices. Fifth, double taxation resulting from anti-avoidance rules. For example, country A denies the deduction of interest pursuant to thin capitalization rules and treats it as a dividend, while country B imposes tax on the interest.

Tax treaties play significant roles in eliminating international double taxation. This is achieved by providing relief from types 1-3 above. With respect to type 1 (source-source claims), potential double taxation is eliminated by explicit rules for the source of income. For example, under Art 11(5) of the OECD and UN Model Treaties, interest is deemed to arise (=have its source) in the country in which the payer is resident. With respect to type 2 (residence-residence claims), potential double taxation is eliminated by tie-breaker rules. With respect to type 3, potential double taxation is eliminated by reliefs granted by residence countries, which will be discussed below in detail.

Relief Methods

There are three methods of relief: deduction method, exemption method, and credit method.

Simple illustrations

First, deduction method. A taxpayer is allowed to claim deductions referring to its foreign source tax. Example 1: A (resident in country A; tax rate 50%) earns 100 of income from country B (tax rate 40%) on which she has paid tax of 40 in country B. Under the deduction method, for the purpose of country A’s taxation, her taxable income  = 100-40 = 60 and tax payable in country A = 30.

Second, exemption method. A taxpayer is allowed to exclude its foreign source income. Example 2: see example 1 above. Under the exemption method, for the purpose of country A’s taxation, her taxable income = 0 (because the foreign income is exempt) and tax payable in country A = 0.

Third, credit method. A taxpayer is allowed to claim credits for foreign taxes. Example 3: see example 1 above. Under the credit method, for the purpose of country A’s taxation, her taxable income = 100, tax in country A = 50, tax credit = 40 and therefore tax payable in country A = 50-40 = 10. In practice, residence countries do not refund foreign taxes paid by their residents on foreign source income in excess of the domestic tax on that income. Moreover, many countries allow uncreditable foreign tax to be carried forward to certain future years.

Outcomes of different tax rates

Now we will compare outcomes of the relief methods. The outcomes depend on relative difference between foreign tax rate and domestic tax rate. If foreign tax rate is lower than domestic tax rate (as illustrated in example 1-3), then the outcomes are:

  • Method

    Tax payable Outcome
    In Country A

    (50%)

    In Country B

    (40%)

    Total

    Deduction 30 40 70 The highest
    Exemption 0 40 40 The lowest
    Credit 10 40 50 Medium

If foreign tax rate equals with domestic tax rate (from example 1-3 but the tax rate of country A = 40%), then the outcomes are:

  • Method

    Tax payable Outcome
    In Country A

    (40%)

    In Country B

    (40%)

    Total

    Deduction 24 40 64 The highest
    Exemption 0 40 40 The lowest
    Credit 0 40 40 The lowest

If foreign tax rate is higher than domestic tax rate (from example 1-3 but tax rate of country A = 30%), then the outcomes are:

  • Method

    Tax payable Outcome
    In Country A

    (30%)

    In Country B

    (40%)

    Total

    Deduction 18 40 58 The highest
    Exemption 0 40 40 The lowest
    Credit -10 (=0) 40 40 The lowest

The results above bring into three conclusions. First, in all cases the deduction method results in the highest effective rate than the other methods. This means that the adoption of deduction method creates a bias in favor of domestic investment over foreign investment. However, such bias may be justified under the perspective of national self-interest in two aspects. Firstly, the outcome encourages domestic investments. Secondly, residents with equal net worldwide income (worldwide income less total foreign taxes) pay the same amount of domestic tax. Second, if the effective foreign tax rate is lower than the domestic effective tax rate, then the outcome of the exemption method is lower than that of credit method. Third, if the effective foreign tax rate equals with or is higher than the domestic effective tax rate, then the outcome of the exemption method equals with that of credit methods.

Further discussions

In this section, we will further discuss each method under policy and practical perspectives.

Deduction method. The method is not authorised by the OECD and UN Model Treaties. However, some countries still use it for some possible reasons. First, those countries retain the deduction method as an optional relief, despite having adopted the credit method. Second, those countries (essentially) use the deduction method when taxing a particular income (i.e. dividend income derived from foreign portfolio investments). For example, A (residents in country A) owns 25% shares in FCo. FCo (foreign corporation) earns 100 of foreign income, pays foreign income tax of 20, and distributes the remaining profits of 80. Then, A’s dividend of 20 is taxable by Country A. This outcome (i.e., the taxable income of 20) is the same with the application of deduction method to A’s portion in FCo: A earns foreign income of 25 (i.e., A’s share in FCo’s profits), A pays foreign income tax of 5 (i.e., A’s portion in FCo’s dividend), and A’s net foreign income is 20 -> taxable by Country A.*

*) Country A’s treatment is unequal between indirect foreign income (as illustrated above, A’s taxable income in Country A is 20) and direct foreign income (from the illustration above, if another taxpayer, A2, carries on business in the foreign country and earns direct foreign income of 20, then A2’s taxable income in Country A would be 25). To treat equally, Country A could apply gross-up method: A’s taxable income = A’s dividend of 20 + A’s portion of FCo’s foreign tax of 5 = 25.

Exemption method. This method is authorised by the OECD and UN Model Treaties (Art 23A). Commentary on Art 23 A and 23 B of the OECD Model Tax Convention: Under the principle of exemption, the State of residence R does not tax the income which according to the Convention may be taxed in State E or S (nor, of course, also income which shall be taxable only in State E or S). Two main methods are recognised: full exemption (= territorial basis) and exemption with progression.**

**) The exemption with progression method is applied by Belgium, Finland, Germany, Netherlands. Example: Country A’s tax rates: tax rate of 20% for income under or of 10,000; tax rate of 40% for income above 10,000. A’s income consists of domestic source income of 10,000 and exempt foreign income of 10,000. Under regular exemption method: the applicable rate is 20%; taxable income is 10,000; tax = 2,000. Under the exemption with progression method:

  • without exemption: taxable income = 20,000; the applicable rates are 20% for income of 10,000 and 40% for the remaining income; tax = 6,000
    • then, the average applied rate = 6,000/20,000 = 30%
  • with exemption: taxable income = 10,000; the average rate = 30%; tax = 3,000

Among advantages of the exemption method are simplicity and neutrality. The method is simple for tax authorities to administer and effective in eliminating international double taxation. The method also promotes international competitiveness and capital import neutrality. Residents of country A earning income in country B are treated equally with residents of country B doing business in country B. However, the method brings some disadvantages. First, unfair. Where foreign taxes are lower than domestic taxes (see example 1), residents with exempt foreign source income are treated more favorably than other residents earning only domestic source income. Second, economic inefficiency. Based on the previous illustration, the method gives an incentive to shift domestic investments (e.g., loans) to low-tax countries. Third, adverse effect. The method may cause the shift of tax burdens from an income earner to the payer. For example, with respect to interest income:

  • ACo (resident in country A; tax rate 30%) loans funds of 100,000 to BCo (resident in country B; 20% WHT on interest); the interest is 10,000.
    • Assuming there is an opportunity for ACo to loan the funds to CCo (resident in country C; 0% WHT on interest), ACo can require BCo to pay the interest of 10,000 net of tax
      • BCo has to pay the interest of 10,000 and an additional cost of borrowing of 2,000.
      • The tax burden of ACo as the income earner shifts to BCo as the payer.
    • Outcome: ACo’s interest income is not subject to tax both in Country B (because of the shift of tax burden) and in Country A (because of exemption method)
    • In this case, credit method is better: ACo will not get any benefit from shifting the tax burden to BCo because ACo is still subject to tax in Country A (in addition, any paid foreign taxes can be credited).

Considering some disadvantages of the exemption method, the method should not be adopted fully. The method may be adopted limited to:

  • certain types of income (e.g., active business income earned by resident corporations through a foreign branch/PE, certain dividends received from foreign corporations in which resident corporations have a minimum ownership interest); or
  • foreign income in comparable countries (so as to be applied in the condition where foreign tax rate equals with domestic tax rate)

and adopted together with:

  • anti-avoidance rules (to prevent taxpayers from diverting  domestic source income to foreign source income)
  • accurate source rules and expense rules (to prevent taxpayers from deducting expenses incurred to earn exempt foreign source income against their domestic income).

Some countries (European countries, Australia, Japan, the UK, and the US) adopts participation exemption, which is an application of the exemption method on dividends. There are three key elements in the method. First, the level of share ownership necessary to qualify the exemption. Second, the nature of income earned by the foreign corporation out of which the dividends are paid.*** Third, the amount of foreign tax on the income of the foreign corporation.

Moreover, some countries extend participation exemption rules (i.e. exemption method on dividends) for capital gains on the disposition of shares in foreign affiliates. The reason is, in substantial participation, dividends are often a substitute for capital gains; if capital gains is not included in the participation exemption rules, ACo as a shareholder of BCo (resident in country B) has an incentive to divert capital gains into dividends (by asking BCo to pay dividends before the disposition of shares). Consequently, the share price (and gains) decreases (by the amount of the distributed dividend) and are converted into dividend (which is exempt).

***) The nature of income should be limited to active business income, not passive income.

  • Because passive income can be diverted easily to foreign subsidiaries in order to reduce residence country tax. For example (where passive income is allowed), A Co (resident in country A; 30% tax rate) has funds available for investment that could earn passive income of 1 million. If ACo invests in country A, then tax = 300,000; ACo’s net of tax return = 700,000. Alternatively, ACo can use the funds to acquire 100% shares in BCo (resident in country B; 10% tax rate). BCo would use the funds to earn passive income of 1 million, pays tax of 100,000 in country B, and distributes a dividend of 900,000 to ACo. Because Country A includes (or does not limits) passive income in its participation exemption rules, the dividend is exempt in Country A -> ACo’s tax = 0; ACo’s net of tax return = 900,000 (higher outcome).

However, applying limitation on active business income increases compliance cost from the requirement to keep track the type of income earned by BCo. Alternatively, a country can adopt CFC rules.

  • With CFC rules, a country immediately treats a CFC’s passive income as the controlling shareholder’s income to impose tax on that income. In the illustration above, if Country A does not apply the limitation on active business income but adopts CFC rules, then the dividend of 900,000 is fully exempt in Country A under the participation exemption rules. But BCo’s passive income of 1 million will be taxed by Country A under CFC rules.

In other words, by applying limitation on active business income, a country provides exemption on dividends originated from active business income of a foreign company; by adopting CFC rules, a country imposes tax on passive business income of the foreign company.

Credit method. This method is authorised by the OECD and UN Model Treaties (Art 23B). Commentary on Art 23 A and 23 B of the OECD Model Tax Convention: Under the principle of credit, the State of residence R calculates its tax on the basis of the taxpayer’s total income including the income from the other State E or S which, according to the Convention, may be taxed in that other State (but not including income which shall be taxable only in State S). It then allows a deduction from its own tax for the tax paid in the other State. Two main methods are recognised: full credit (= no limitation on credit) and Ordinary credit (= limitation on credit applies; see below: 4 Options on Credit Limitation).

The advantage of the credit method is neutrality. To the extent that foreign taxes do not exceed domestic taxes, resident taxpayers are treated equally from the perspective of the total domestic and foreign tax burden on their foreign source income and therefore neutral with respect to investment decision (whether domestic or abroad).

However, the method brings some disadvantages. First, complexity. The operation can be complex from the perspective of the government and taxpayers. What foreign taxes are creditable? How should the limitations on the credit be calculated (there are 4 options on credit limitation; see below)?

Second, triggers soak-up taxes. If Country A adopts credit method, country B (lower tax rate) can safely increase its tax rate to the level of Country A’s tax rate without the risk of losing capital import from residents in country A. In effect, tax revenue from such residents shifts from country A to country B. Some countries classify soak-up taxes as uncreditable foreign taxes.

Third, discouraging profits repatriation. This method discourages domestic corporations that have earned profits abroad through foreign affiliates from repatriating these profits as dividend distributions (an incentive to defer the tax so as to lower the present value when the tax is paid). For example, ACo (resident in country A, tax rate 35%) wholly owns BCo (resident in country B, tax rate 10%). BCo earns profits in country B of 100, pays tax to country B of 10. Under credit method, if ACo receives a dividend, the dividend will be included as its income (in contrast, exemption method does exempt the dividend). Therefore ACo has an incentive to defer BCo’s remaining profits of 90. To neutralize the bias in repatriation decision, Country A should tax ACo on an accrual basis (i.e., ACo is immediately taxed when BCo earns profits, regardless of whether the profits are repatriated). CFC rules apply limited ‘accrual basis’ (limited: only on certain income, only on abusive conditions).

Under the credit method, there are 4 Options on Credit Limitation:

  1. No limitation -> all foreign taxes are creditable.
    • Example 1:
      • ACo (resident in country A, tax rate 30%), domestic income of 200,000, foreign income of 180,000, foreign tax of 57,500
      • Tax before credit (TBC) = 30% x 380,000; Credit (C) = 57,500; Tax payable = TBC – C
  2. Overall/worldwide limitation
    • Example 2: just like example 1
      • Tax before credit (TBC) = 30% x 380,000; Credit (C) = the lesser of 57,500 and 30% x 180,000; Tax payable = TBC – C
    • Outcome: permits averaging of high foreign taxes paid to some countries with low foreign taxes paid to other countries
  3. Country-by-country limitation
    • Example 3: just like example 1, with additional facts:
      • Foreign income of 180,000 consists of foreign income from country X of 120,000, from country Y of 50,000 and from country Z of 10,000
      • Foreign tax of 57,500 consists of foreign tax paid to country X of 46,000, to country Y of 10,000, and to country Z of 1,500
      • Tax before credit (TBC) = 30% * 380,000; Credit (C) = Cx + Cy + Cz; tax payable = TBC – C
        • country X (Cx): the lesser of 46,000 and 30% * 120,000
        • country Y (Cy): the lesser of 10,000 and 30% x 50,000
        • country Z (Cz): the lesser of 1,500 and 30% x 10,000
    • does not permit averaging of high foreign taxes paid to some countries with low foreign taxes paid to other countries, but permits averaging of high and low rates of foreign taxes paid to a particular country on different types of income
  4. Item-by-item limitation
    • Example 4: just like example 1, with additional facts:
      • Foreign income of 180,000 consists of foreign income from country X of 120,000 (business income of 100,000 and dividends income of 20,000), from country Y of 50,000 (business income) and from country Z of 10,000 (interest income)
      • Foreign tax of 57,500 consists of foreign tax paid to country X of 46,000 (45,000 with respect to business income, 1,000 to dividends income), to country Y of 10,000 (with respect to business income), and to country Z of 1,500 (with respect to interest income)
      • Tax before credit (TBC) = 30% * 380,000; Credit (C) = Cx1 + Cx2 + Cy + Cz
        • country X – business income (Cx1): the lesser of 45,000 and 30% * 100,000
        • country X – dividends (Cx2): the lesser of 1,000 and 30% * 20,000
        • country Y (Cy): the lesser of 10,000 and 30% x 50,000
        • country Z (Cz): the lesser of 1,500 and 30% x 10,000

The credit method has a variation, which is indirect/underlying credit. Indirect/underlying credit denies the fact that ACo dan its foreign subsidiary are separate taxable entities (in other words, the method treats foreign subsidiarie as branches). This method usually requires that ACo has substantial interest (between 5-25%) in BCo’s share capital. For example, ACo (resident in country A) owns BCo (resident in country B). BCo earns profits and pays taxes in country B; the remaining profits are distributed as dividends to, among others, ACo. If Country A does not adopt indirect credit:

  • ACo’s income = the dividend
  • Tax before credit (TBC) = tax rate x ACo’s income
  • Credit (C) = 0
  • Tax payable = TBC – C = TBC

In contrast, if Country A adopts indirect credit:

  • ACo’s income = the dividend + BCo’s taxes (equals to the gross-up of BCo’s profits)
  • Tax before credit (TBC) = tax rate x ACo’s income
  • Credit (C) = BCo’s taxes
  • Tax payable = TBC – C

With respect to the credit method, some countries introduce tax sparing. This is a credit granted by the residence country for foreign taxes that, for some reason (e.g., tax incentives/holiday), which is not actually paid to the source country but would have been paid under the source country’s normal tax rules. In other words, tax sparing treats a tax incentive as a tax credit. The purpose is to prevent the shift of benefits from tax incentives/holiday provided by source countries (to attract investments) from the foreign investors to its home country (the residence country).

For example, this is the outcome where tax sparing applies:

tax sparing

(Without tax sparing credit, country B’s tax will increase from 100 to 400. In other words, tax holiday is not enjoyed by the taxpayer). Note: tax sparing is not needed if the residence country of potential investors uses exemption method (because foreign source income is exempt in their domestic tax system).

Tax sparing is a feature of tax treaties between developed countries (that grant tax sparing) and developing countries (that grant tax incentives). It is important for developing countries, to ensure that their tax incentives have positive impacts on investment decisions of potential foreign investors in terms of location. However, the US disagrees to give tax sparing credit because it is not consistent with efficiency and fairness goals of its foreign tax credit and encourages developing countries to engage in beggar-thy-neighbor bidding wars through their incentive programs. Consequently, the US does not want to enter into tax treaties with developing countries. (Now the US have been rapidly open to enter into tax treaties with developing countries)

Allocation of Expenses

Rules for allocating a proper portion of expenses (between those incurred in relation to foreign source income and those incurred in relation to domestic source income) are required. Some reasons are:

  • In exemption method, resident taxpayers are not allowed to deduct expenses related to exempt foreign source income (example: borrows fund to earn exempt foreign source income).
  • In credit method, resident taxpayers are allowed to deduct expenses related to foreign source income. However, the amounts of creditable foreign tax are the less of 1) foreign tax and 2) domestic tax rate x [net] foreign source income. Rules for allocating expenses will be used to determine [net] foreign source income

Expenses are allocated under two approaches: tracing approach and allocation/apportionment approach. The first approach is factual inquiry into the connection between the expenses and the foreign source income. The second approach allocates expenses by formula, on the basis of assets [foreign assets/total assets] or gross income [gross foreign income/total income].

Source:

  1. Brian J. Arnold, International Tax Primer (4th ed. 2019)
  2. Commentary on Art 23 A and 23 B of the 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.

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