By Varun Chablani & Sumitha Krishnan
Taxation is a subject over which each State exercises its sovereign right. The basic charge of taxation can be traced to the domestic taxation law of a State. Each State, under its domestic law, exercises its right to tax a subject, based on a connection or link that the subject has with the State. In the absence of the link or connection, the State cannot exercise its taxing rights. In addition there must also be some link between the tax jurisdictions, the taxable person (“Tax Subject
”) and the taxable event (“Tax Object
”) [see end note 1] for exercising the right to tax an income.
Connecting factors for determination of the right to tax a transaction
The connecting factors for the States to exercise the right to tax are generally based on residence, nationality, citizenship or the domicile of the taxpayer (for the Tax Subject) and on the place of accrual over the income or gain (for the Tax Object). Other factors that can create a connecting factor for determination of a right to tax a transaction, include situs of the transaction or asset, the nature of the transaction or business operation or the character of the payment. We would, in this paper, analyse how this unilateral exercise of sovereign right by States have led to double taxation, which necessitated the development of International Tax Law to co-ordinate/integrate the tax laws between States.
Inter nation equity - a concept leading up to the states’ right to taxation
States strive to retain their sovereignty in the field of taxation as it is one of the most imperative factors in a State’s economic policy-making, whereby national governments may exercise their influence with a view to improve competitive edge of their economies.
The term “Inter-Nation Equity”, as described by Peggy Musgrave [see end note 2], is an “equitable division of the tax revenues between countries
”, “the problem of tax share in international business
”, and “equitable allocation of national gain and loss
”. Simply stated, the ‘Inter-Nation Equity’ school of thought believes that States have equitable rights inter-se to tax an income.
According to legal luminaries like Klaus Vogel [see end note 3], the term inter-nation equity is the “distribution among countries of the competence to tax
Further, Peggy Musgrave in her paper in 2006, regarded that the notion of “National Entitlement
” [see end note 4] is the basis for the concept of Inter-Nation Equity. National Entitlement means both the country of origin and the country of consumption are entitled to tax income.
Theoretical foundations of National Entitlements are ‘Ability to Pay principle
’, ‘Benefit Theory
’ [see end note 5] and ‘the Economic Allegiance Theory.
’ [see end note 6]These principles are discussed below:
Ability to Pay Principle:
At the international level the ability to pay to principle (which was first adopted in Canada) [see end note 7] has been invoked to support tax claims by both residence and source countries. Adam Smith [see end note 8] has been credited with the earliest rendering of this theory. The first of his four famous canons regarding taxes is, “[t]he subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities
”. The ability to pay is measured by net income.
The benefit theory is perhaps one of the most obvious arguments for exercising tax jurisdiction by a country (especially the source country). Under this theory, those who benefit from the public services provided by a country should be charged for such services[see end note 9]. Benefits may be provided to a tax payer by both the country of residence and the country of source. Therefore, the benefit theory supports taxation in the residence country and the source country.
Economic Allegiance Theory:
This doctrine was first proposed by Georg Von Schnaz [see end note 10] and is considered to be a modern thought on International Tax Theory and administration. The League of Nations’ economists considered economic allegiance to be the foundation of a States’ competence in taxation. The concept of economic allegiance was the basis of both residence taxation and source taxation [see end note 11].The following is an excerpt of the Report on Double Taxation Submitted to the Financial Committee (1923)
‘A part of the total sum paid according to the ability of a person ought to reach the competing authorities according to his economic interest under each authority. The ideal solution is that the individual’s whole faculty should be taxed, but that it should be taxed only once, and that liability should be divided among the tax districts according to his relative interests in each
Economic allegiance is based on factors aimed at measuring the existence and extent of the economic relationships between a particular state and the income or person to be taxed. The four factors comprising economic allegiance are
origin of wealth or income,
situs of wealth or income,
enforcement of the rights to wealth or income, and
place of residence or domicile of the person entitled to dispose of the wealth or income.
Therefore, under the economic allegiance doctrine also, both the country where income is originated and the country where the income is consumed have the jurisdiction to tax the income.
From the above theories it can be summarized that the connecting factors link the taxpayer to a particular tax jurisdiction based on:
personal links with the home state by virtue of residence, domicile or citizenship (for natural persons) and the place of incorporation or location of a registered office or management and control (for legal persons) (i.e. Country of Consumption or residence)
place of accrual or origin of income (i.e. Country of origination or source).
It should be noted that the above theories were developed during the time period where International business or income from overseas was rather nascent. Accordingly, the theories look into the aspect of the country’s right to taxation from domestic taxation point of view.
As a result, each country followed its own tax practices under its own legal system, and defined the connecting factors under its own laws. That is to say, different countries applied different definitions of taxable entities, taxable events etc. and used varying bases for computing the tax under their own tax accounting rules (for example, the terms such as income tax, total income, residence, domicile, immovable property, permanent establishment) and the characterization of transactions also varied from State to State.
Contribution of the inter nation equity concept to the development of international tax law
The above unilateral practices (as described in the previous chapter) of States contributed to the development of connecting factor conflicts such as:
Source-Source conflict: two or more countries may claim the same income of a taxpayer as sourced in their country.
Residence-Residence conflict: two or more countries regard the same taxpayer as tax resident in their country.
Residence-Source conflicts: the same income is taxed twice first by the country where it is derived under its “source rules” and then in the country where the taxpayer resides under its “residence rules” [see end note 12].
The connecting factor conflicts resulted in double taxation which affected the International trade between States and also led to the birth of the two below fundamental tenets of International Taxation Law:
Residence based Rule: Unlimited taxation rights are granted to the country of residence, due to the “personal attachment” of persons. The country of residence may impose its taxes on the worldwide income of individuals or corporations due to the protections it offers to the tax subject.
Source based Rule: Limited taxation rights are granted to the country of source due to the “economic attachment” of persons. The country of source reserves the right to tax the income that is derived from the economic activities within its territory [see end note 13].
Thus, the need for an instrument to allocate taxing rights between jurisdictions was felt, which led to the practice of States entering into Double Tax Avoidance Agreements (DTAA
). Nowadays, juridical double taxation conflicts are largely resolved through tax treaties negotiated under the principles of International tax law accepted by sovereign States. The OECD and UN Model Convention have framed guiding principles which strive to demarcate the rights between States to avoid double taxation.
In short, the Inter-Nation Equity concept has played a pivotal role in the development of international tax law as it stands today. It is interesting to note that, despite sea changes in the economy, society and technology over the years, the concept of Inter-Nation Equity is still prevalent in International Tax Law today [see end note 14].The development of international tax law as it stands today has contributed to the free flow of international trade and commerce between States and helped in States achieving newer heights in mutual economic cooperation and relationship.
[The authors are Associates, Direct Tax Practice, Lakshmikumaran & Sridharan, Chennai ]
Roy Rohatgi “Basic International Taxation” 2002 Kluwer Law International, ISBN 9041198520
Peggy B. Musgrave, “International Tax Base Division and the Multinational Corporation,” (1972) 27 Public Finance 39
Klaus Vogel, “World wide vs. Source Taxation of income–A Review and Re-evaluation of Arguments” in Influence of Tax Differentials on International Competitiveness Proceedings of the VIII Munich Symposium on International Taxation Deventer, Boston: Kluwer Law and Taxation Publishers 1991, at 160-61
Peggy Musgrave, The New Public Finance Responding to Global Challenges (Oxford University Press 2006), 167
Peggy B. Musgrave, “Interj-urisdictional Equity in Company Taxation: Principles and Applications to the European Union” in Cnossen, , at 46-78
First used by Georg Von Schanz as stated by Prof. Eric CCM Kemmeren in “Source of Income in globalized economies, overview of the issues and the plea for an Origin-Based approach”, November 2006, International Bulletin for fiscal documentation at p.430
Canada , Royal Commission on Taxation (Chair: K. Carter), Report, Vol. 4 (Ottawa: Queen’s Printer, 1966), at 483-84
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (Edwin Cannan, ed., Methuen & Co., 1925), at 310
Thomas S. Adams, “The Taxation of Business” Proceedings of the Eleventh Annual Conference on Taxation, National Tax Association, 1917 (New York: National Tax Association, 1918) 185, at 192
Prof. Eric CCM Kemmeren in “Source of Income in globalized economies, overview of the issues and the plea for an Origin-Based approach”, November 2006, International Bulletin for fiscal documentation at p.430
International Taxation of Permanent Establishments: Principles and Policy, Michael Kobetsky Cambridge University Press, 15-Sep-2011 - Law
Supra Note 1 Authors’ note – International Tax law, as it stands today, by and large, seeks to address the Residence – Source Conflict.
Supra Note 1
For example, where States adopt ‘Exemption with Progression Method’ or the ‘Credit Method’ in providing relief from double taxation.