International Taxation

General

Where a sole trader, partnership, or corporation has activities in more than one state, issues will arise regarding taxation in each state. States usually levy tax on the basis of the worldwide income of their residents and also tax income from activities conducted within their borders. This leads to the possibility of double taxation.

Most states levy taxes on individuals and entities in respect of trading activities and other revenues. Most states tax income progressively. Different rates are applied in bands to the taxable income. In the case of corporation tax, a single rate is more common.

Many states adopt a global tax model, which charges uniform rates of tax on all income. All income is aggregated, and taxable income is charged progressively at various rates on the net income. The type of income does not generally determine the rate of income under this model.

Corporations

A flat rate commonly applies to corporate taxation in many states. In other states, there may be progressive rates. The scheduler tax model applies tax at flat rates on different income sources. The rates may l vary depending on the type of income. This may incentivise or discourage activity within particular sectors.

States usually tax individuals and corporations. Corporations may be companies, joint-stock companies, corporations or limited liability partnerships. In some states, the type of corporate entity determines the tax rates.

When a state taxes the foreign income of its individuals and resident companies, it calculates the tax under its own rules. When the individual or corporate entity is paying tax in another state, that will be calculated under the laws of that latter state.

Mechanisms to do Business

The companies or entities may undertake business abroad through a number of different mechanisms. It may set up an office to promote its products abroad. The office may not (for example) undertake sales and orders or collect a debt but may provide assistance to local importers and distributors.

The agent is a separate entity or representative of the company in the other country. A branch is a unit of the parent company within the other country. It usually involves the establishment of plant, equipment and service offices.

A subsidiary is a local corporation established in the latter state and owned by a foreign parent. It is a separate legal entity. Most states allow 100% owned subsidiaries to be formed. Some require local participation.

A representative office in the above sense which does not undertake commercial activities within the host state is generally outside its taxation.

Branches

Branches or agencies are subject to tax in the host state. Branches are usually easier to establish in the host state than corporations. However, many states, including EU states, require branch registration and disclosure in the host state.

The parent company is taxed on its profit made within the host state. The parent company being the actual entity undertaking business, is fully liable for all the activities of the branch or agency.

Subsidiaries

Many states encourage foreign investors to establish subsidiaries. They may encourage joint ventures. Subsidiaries may enjoy lower tax rates, such as in Ireland. The establishment of a subsidiary limits the liability of the parent company. The parent is not subject to audit in the host state.

Local equity participation may be available through a development agency or otherwise. The establishment of a subsidiary may allow eligibility for grants, incentives, deductions, etc. on the same basis as local enterprises.

A subsidiary may have the disadvantage of extra costs and compliance obligations.   Audit requirements are generally more rigorous than in relation to branches. In some states, local subsidiaries may be subject to mandatory joint ventures or mandatory local holdings of shares by citizens.

Basis of Taxation

Most states tax residents’ persons and entities on their worldwide income. Some states, notably the United States, tax their nationals or citizens on a worldwide basis irrespective of their residence or where they are.

Residence is the most common basis of taxation. A residence is determined by a number of tests. The test may be based on the length of time spent within the state in the tax year. It may be based on the intention to make a place one’s permanent place of residence. It may be based on the person formally entering the state as a resident.

Commonly the test combines one or more elements of the above, particularly the first two elements. In the third case, admission to a country for example, by way of a visa, may make a person resident.

Many countries base residence on presence within the state for 183 days in a year. However, there will usually be a subsidiary test, which charges a person to residence based on the position over a number of years.

The residence of a company is determined by either the place where it is managed or controlled and/or the place where it is formed. In many states, the place in which it is formed is the state of residence. In some states, the sole test is central management and control. Many other states have a mixed test or an alternative test.

Income in Jurisdiction

States usually tax income from sources within their jurisdiction. The state in which the income is sourced usually has the primary right to tax it. This principle is reflected in double taxation agreements whereby the country of source generally has the primary right to tax the income concerned.

Questions may arise as to whether income is derived from a trade or profession carried on within the state. States usually provide rules to determine if a trade, business or profession is carried on within the country.

There is usually a number of factors, including the presence of a fixed place of business, assembly or manufacturing plants, the regular and continuous presence of employees and officers, regular and continuous after-sales support and active management situated locally. These are all factors in the determination of whether an activity is carried on within a state and thereby subject to its taxation law.

Diplomats

Foreign diplomats are exempted under the diplomatic conventions, in particular, the Vienna Convention on Diplomatic Relations. Foreign governments, diplomats, and international organisations usually enjoy immunity from taxation.

This immunity, however, is limited to non-commercial activities. Where states undertake commercial activity abroad, they will normally be taxed.

Capital & Income

States usually distinguish between income on a capital transaction and the income derived from trades and businesses.  are distinguished between income derived from capital transactions.

Capital gains are usually taxed at a lower rate with different rules and allowances. In many states, capital gains and ordinary profits on the part of a company are treated together and taxed at a single rate(s).

Adjusted Accounts

Employed individuals pay taxes on their wages or salaries. Individuals who are sole contractors, self-employed or companies calculate their income based on profits, less allowable deductions. This includes the United States, Ireland, the United Kingdom and Canada.

The ordinary accounts of the business are adjusted by adding back and deducting, respectively, accounting expenses not allowable as tax expenses and vice versa.

In many states, including continental Europe states, a balance sheet method is used. Income is calculated as the difference between the net worth at the end and beginning of the accounting period. Adjustments are made. Under most systems, there is a system of exemptions, deductions, credits, permittable expenses, and allowance for double taxation.

Flat Rate

A minority of states impose a flat-rate tax on personal income. Some states impose no personal income tax. Many use a graduated scale of rates.

Flat-rate income tax is more commonly imposed on companies. Some have different rates of corporation tax for companies engaged in particular industries.

Developing states with high inflation rates may use adjustment mechanisms, including inflation indexes and accounting adjustments. In some states, the tax reported may be adjusted unilaterally by the state authorities if it is determined that the level of law income returned is too low.

Corporate Tax

There may be two rates of company tax. A higher rate may apply to undistributed profits and a lower rate to distributed profits. The higher rate is to compensate for the non-taxation of the individual in respect of retained earnings.

States integrate corporate and personal taxation in different ways. A corporate taxpayer is taxed on its profits. This is not usually dependent on when dividends are paid. Dividends themselves are taxed in the hands of the individual shareholders.

Where there is a corporate shareholder, there may be a look-through so that receipts by the corporate shareholder are not taxed but are taxed on ultimate distribution to ultimate individual shareholders.

Tax on Shareholders & Company

Under the classical system of company taxation used in most countries, tax is imposed on the company’s earnings when received. Tax is imposed on dividends in the hands of shareholders when distributed.

The company pays to cooperate tax rates while individuals pay personal income tax rates. Distributions are not deductible in calculating tax. Generally, the recipients are not entitled to a credit for tax already paid by the company. There is, accordingly, an element of double taxation.

The shareholder imputation system is similar. However, the shareholders are given a credit for taxes paid by the company on dividends distributed. These may be offset against personal income tax. Accordingly, company tax is imputed to the shareholder.

The company deduction system is the other way around. Companies may be allowed to deduct distributed income as an expense before determining company income, thereby reducing corporate tax. Ordinary shareholders pay tax on dividends received in the normal way.

Shareholder Tax

The shareholder two-rate system applies a lower personal rate of income on dividends. Companies are taxed in the ordinary way.

The shareholder exempt system applies no tax on dividend income. The companies pay ordinary taxes. Most states use a combination or variation of the above.

Under the full integration system, no corporate tax is paid. All company taxes, whether distributed or not are deemed distributed to shareholders who pay their personal income tax accordingly. In the United States, certain types of companies, S Corporations, may elect for this treatment. Similar facilities are available under the laws of other states.

The taxability of shareholders depends on their residence. Foreign resident shareholders are not generally liable to tax on receipt. Foreign shareholders may in other cases be subject to higher or lower rate tax on dividends than nationals.

Where the shareholder is a corporation, payments to foreign parents may be exempt subject to or subject to special lower rates, depending on the degree of shareholding. Payments between domestic corporations may be wholly exempt.

Mergers & Reconstructions

Most states allow company mergers and consolidations to take place on a tax-neutral basis. Where companies merge, a person’s shareholding in one company is replaced by a shareholding in a merged entity. The share is not deemed disposed of for tax purposes.

Generally, mergers and consolidations are created on a tax-neutral basis. This reflects the economic reality that the shares in the original entity are merely replaced by shares in the new entity without any real disposal.