🏏International Accounting Unit 5 – International Taxation

Key Concepts in International Taxation

• International taxation involves the application of tax laws and regulations to cross-border transactions, investments, and business activities
• Residence-based taxation taxes individuals and corporations based on their country of residence, regardless of where income is earned (United States)
• Source-based taxation taxes income based on the country where it is generated, regardless of the taxpayer's residence (Hong Kong)
• Permanent establishment is a fixed place of business through which a company operates in a foreign country, triggering tax obligations
• Controlled foreign corporations (CFCs) are foreign subsidiaries majority-owned by domestic shareholders, subject to special tax rules to prevent tax avoidance
• Arm's length principle requires related parties to conduct transactions at prices and terms comparable to those between unrelated parties
• Withholding taxes are levied on certain types of cross-border payments, such as dividends, interest, and royalties, at the source of income
• Tax treaties are bilateral agreements between countries to prevent double taxation and promote international trade and investment

Types of International Tax Systems

• Worldwide taxation system taxes residents on their global income, regardless of where it is earned (United States, Japan)
  • Allows foreign tax credits to prevent double taxation
  • May defer taxation of foreign subsidiaries' income until repatriated
• Territorial taxation system only taxes income earned within the country's borders, exempting foreign-sourced income (France, Netherlands)
  • Encourages repatriation of foreign profits
  • May apply controlled foreign corporation rules to prevent tax avoidance
• Hybrid systems combine elements of worldwide and territorial taxation, taxing certain types of foreign income while exempting others (United Kingdom, Germany)
• Value-added tax (VAT) is a consumption tax levied on the value added at each stage of production and distribution, common in many countries (European Union)
• Goods and services tax (GST) is a similar consumption tax applied to the sale of goods and services, used in some countries (Australia, Canada)

Double Taxation and Tax Treaties

• Double taxation occurs when the same income is taxed by two or more countries, often due to overlapping residence and source-based taxation
• Tax treaties are bilateral agreements between countries to prevent double taxation and promote international trade and investment
  • Allocate taxing rights between the residence and source countries
  • Reduce withholding tax rates on cross-border payments
  • Provide mechanisms for resolving tax disputes
• Model tax conventions, such as the OECD and UN models, serve as templates for negotiating tax treaties
• Mutual agreement procedure (MAP) allows taxpayers to request assistance from competent authorities to resolve treaty-related disputes
• Limitation on benefits (LOB) provisions in tax treaties prevent treaty shopping by ensuring only genuine residents of the contracting states benefit from the treaty
• Tax information exchange agreements (TIEAs) facilitate the exchange of tax-related information between countries to combat tax evasion and avoidance

Transfer Pricing and Multinational Corporations

• Transfer pricing refers to the prices charged for goods, services, and intangibles between related parties, such as subsidiaries of a multinational corporation
• Arm's length principle requires related parties to conduct transactions at prices and terms comparable to those between unrelated parties
  • Ensures proper allocation of profits and prevents tax avoidance
  • Supported by transfer pricing methods, such as comparable uncontrolled price (CUP), resale price, and cost plus methods
• Advance pricing agreements (APAs) are arrangements between taxpayers and tax authorities to determine the appropriate transfer pricing methodology for future transactions
• Country-by-country reporting requires large multinational corporations to disclose financial and tax information for each jurisdiction in which they operate
• Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax jurisdictions
  • OECD BEPS project aims to address these issues through a comprehensive action plan
  • Includes measures such as the principal purpose test (PPT) to prevent treaty abuse and the multilateral instrument (MLI) to modify existing tax treaties

Foreign Tax Credits and Deductions

• Foreign tax credits allow taxpayers to claim a credit for foreign taxes paid on foreign-sourced income, reducing their domestic tax liability
  • Prevents double taxation in worldwide taxation systems
  • Limited to the amount of domestic tax that would have been paid on the foreign income
• Foreign tax deductions allow taxpayers to deduct foreign taxes paid as an expense, reducing their taxable income
  • Less favorable than foreign tax credits, as they only provide a partial offset
  • May be the only option for taxpayers who do not meet the requirements for foreign tax credits
• Indirect foreign tax credits (also known as deemed-paid credits) allow domestic corporations to claim credits for foreign taxes paid by their foreign subsidiaries
  • Applies when the domestic corporation owns a certain percentage of the foreign subsidiary (e.g., 10% in the United States)
  • Encourages repatriation of foreign profits
• Foreign tax redetermination occurs when there is a change in the amount of foreign taxes paid or accrued, requiring an adjustment to the foreign tax credit claimed
• Carryforward and carryback provisions allow unused foreign tax credits to be applied to prior or future tax years, subject to certain limitations

Tax Havens and Anti-Avoidance Measures

• Tax havens are jurisdictions with low or no taxes, often used by individuals and corporations to minimize their tax liabilities
  • Characteristics include lack of transparency, minimal substance requirements, and limited exchange of tax information
  • Examples include Cayman Islands, Bermuda, and Panama
• Controlled foreign corporation (CFC) rules aim to prevent tax deferral by immediately taxing certain types of passive income earned by foreign subsidiaries
  • Applies when domestic shareholders own a certain percentage of the foreign corporation (e.g., more than 50% in the United States)
  • Subpart F income includes foreign base company income, such as dividends, interest, and royalties
• Thin capitalization rules limit the deductibility of interest expenses when a company is excessively financed by debt, particularly from related parties
• General anti-avoidance rules (GAARs) are broad provisions that allow tax authorities to challenge transactions or arrangements that lack economic substance and are primarily designed to avoid taxes
• Diverted profits tax (DPT) is a unilateral measure adopted by some countries (e.g., United Kingdom, Australia) to target large multinationals that artificially divert profits to low or no-tax jurisdictions
• Beneficial ownership requirements ensure that treaty benefits, such as reduced withholding tax rates, are only granted to the true owners of income, rather than conduit entities

Challenges in Global Tax Compliance

• Complexity of international tax laws and regulations, with frequent changes and variations across jurisdictions
• Increased scrutiny from tax authorities and the public, particularly in the wake of high-profile tax avoidance scandals (Panama Papers, LuxLeaks)
• Difficulty in determining the appropriate transfer prices for cross-border transactions, especially for intangibles and services
• Inconsistent application and interpretation of tax treaties and international tax principles by different countries
• Lack of a unified global tax system, leading to gaps, overlaps, and potential for double taxation or double non-taxation
• Challenges in obtaining and verifying tax-related information from foreign jurisdictions, particularly from non-cooperative or low-transparency countries
• Balancing the need for tax revenue with the desire to attract foreign investment and maintain competitiveness in a globalized economy
• Adapting to the digital economy, where traditional tax concepts such as permanent establishment and source of income may be less relevant

Recent Developments in International Tax Law

• OECD Base Erosion and Profit Shifting (BEPS) project, a comprehensive action plan to address tax avoidance by multinational corporations
  • Includes measures such as the principal purpose test (PPT) to prevent treaty abuse and the multilateral instrument (MLI) to modify existing tax treaties
  • Introduces new standards for transfer pricing documentation, including country-by-country reporting
• Global minimum tax proposal, aimed at ensuring large multinational corporations pay a minimum level of tax regardless of where they operate (Pillar Two of the OECD/G20 Inclusive Framework)
• Increased focus on the taxation of the digital economy, with proposals such as digital services taxes (DSTs) and the reallocation of taxing rights based on market presence (Pillar One of the OECD/G20 Inclusive Framework)
• Automatic exchange of financial account information between countries under the Common Reporting Standard (CRS) to combat tax evasion
• Unilateral measures adopted by countries to protect their tax base, such as the US Tax Cuts and Jobs Act (TCJA) of 2017, which introduced the global intangible low-taxed income (GILTI) and base erosion and anti-abuse tax (BEAT) provisions
• Growing importance of environmental, social, and governance (ESG) factors in international tax policy, with discussions on the use of tax incentives to promote sustainable development and the potential for a global carbon tax