1 of 37 Lecture 13 TAXATION Topics covered: Income Taxes Double Taxation Tax Treaties Tax Incentives Tax Avoidance and Evasion.

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Lecture 13

TAXATION

Topics covered: • Income Taxes • Double Taxation • Tax Treaties • Tax Incentives • Tax Avoidance and Evasion

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A. INCOME TAXES

1. Most Widely Used Basic Tax

2. Governments Use One of Two “Models” to Collect Income Taxes

a. Schedular model: Imposes taxes at flat rates on different sources of income.

b. Global model: Imposes uniform rates on all sources of income.

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A. INCOME TAXES

b. Global model (continued)1) Progressive rates are commonly

imposed. a) Defined: Rates that increase as income

increases.

2) Advantages of global model: a) Not regressive.b) Not anti-entrepreneurial.

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B. BASES OF INCOME TAXATION

1. Nationality Principle: States tax their citizens, nationals, and domestic companies on their worldwide income no matter where they may reside

JUDGE JUDY READY TO RULE--

Case: Cook v. Tait, US Collector of Internal Revenue for Dist. Maryland: +Court +Facts +Legal Significance +Parties +Rational+Issue +Result

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2. Residency Principle: States tax the worldwide income of persons legally residing within their territories

a. Determining residence1) Natural persons — determined by one or more of three

tests:a) Objective test: The length of time a person resides within a

state’s borders.

b) Subjective test: The intent of the individual to make a place his or her permanent domicile or household.

c) Declarative test: The individual meets the admission criteria for entering the country as a resident.

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a. Determining residence (continued)2) Companies — determined by two tests:

1) Where the company was incorporated.1) The rule common to common law countries.

2) b) Where the company is managed.1) The rule common to civil law countries.


Case: Crown Forest Industries v. Canada: +Court +Facts +Legal Significance +Parties +Rational+Issue +Result

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3. Source Principle: States tax a taxpayer’s income only from sources within their territorial jurisdiction a. Income accrued or derived from local sources

commonly includes:1) Income derived from property located within the

country.2) Income derived from any trade or profession

carried on through any agency or branch within the country.

3) Income derived from local employment.

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4. Interrelationship of Taxation Bases a. These three bases for imposing taxation may

be used in conjunction with each other.

b. Priority:1) Source principle is usually regarded as the

normal or default rule.

2) Nationality and residency are usually treated as supplemental and subordinate rules.

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1. Persons Immune from Taxation a. The following persons are commonly immune

from taxation:1) Foreign governments.

2) Foreign diplomats.

3) International organizations and their personnel.a) Depending on exemptions granted by the host

state.

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C. INCOME

1. Income Categoriesa. Personal or business income: The earnings or

profits made by individuals and businesses.

b. Capital gains income: The increases in value of the underlying capital owned or invested by individuals and businesses.

1) In most countries: All income (including capital gains) is taxed at the same rates.

2) Some countries: Capital gains are taxed at a different rate than personal or business income.

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C. INCOME

a. Capital gains income (continued)3) Other countries: Capital gains are

given allowed tax breaks depending on:

a) How long the assets are held, orb) To what purpose the proceeds are put.

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C. INCOME

2. Computation of Income a. Income of employed persons: Salaries and

wages.b. Income for self-employed persons and

companies.1) Calculated by one of two methods —

a) Profit and loss statement method: Gross business income is offset by allowable losses and deductions.

b) Balance sheet method: Income is calculated as the difference between net worth at the beginning and the end of the accounting period.

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C. INCOME

b. Income for self-employed persons and companies (continued)

1) Adjustments are made to reflect local definitions of income —

a) Personal exemptions.b) Deductions for expenses.c) Credits for double taxation.

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C. INCOME

1. Integration of Company and Personal Income Taxes

a. Problem: How to allocate (or integrate) the tax burden between companies and their dividend receiving shareholders.

b. Approaches:1) Classical system: Impose a tax on company

earnings and on company dividends when they are distributed.

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C. INCOME

3. Integration of Company and Personal Income Taxes (continued)

2) Shareholder imputation system: a) Impose a tax on company earnings and on

company dividends when they are distributed.

b) Give shareholders a credit for the taxes paid by the company on distributed dividends to offset their personal income tax obligation.

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C. INCOME


3) Company deduction system: a) Companies deduct distributed

dividends as an operating expense before determining their company income.

b) Shareholders pay ordinary income taxes on the dividends they receive.

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C. INCOME


4) Company two-rate system — applies two rates of company taxes:

a) Higher rate for undistributed profits.b) Lower rate for distributed profits.


Case: Johansson v. U.S.: +Court +Facts +Legal Significance +Parties +Rational+Issue +Result

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C. INCOME


4) Shareholder two-rate system: Imposes a lower personal tax rate for income received as dividends.

5) Shareholder exempt system: No taxes are imposed on dividend income received by shareholders.

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C. INCOME


7) Full-integration system: a) No company taxes are collected.

b) All company profits (whether they are distributed or not) are deemed to be distributed to shareholders.

c) Shareholders pay personal income taxes on distributed, and deemed to be distributed, dividends.


Case: Reiss & Company (Nigeria) v. Federal Bd. Of Inland Revenue: +Court +Facts +Legal Significance +Parties +Rational+Issue +Result

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D. DOUBLE TAXATION

1. Defined: Taxation of the same income in two countries

2. Systems for Relief from Double Taxation a. Exemption system:

1) Income is taxed in one state (commonly a host state).

2) Income is exempt from tax in a second state (commonly the home state).

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D. DOUBLE TAXATION

1. Systems for Relief from Double Taxation (continued)

b. Credit system: Tax paid in one state is used as a credit against a taxpayer’s liability in another state.

c. Deduction system: A taxpayer deducts the tax paid to one state from the profits liable to taxation in the second state.

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E. TAX TREATIES

1. Purpose: To ameliorate the problem of double taxation and other matters, including tax incentives, tax avoidance, and tax evasion

2. Model Treaties — these are widely useda. Organization for Economic Cooperation and

Development (OECD) Model Treaty.

b. United Nations (UN) Model Treaty.

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E. TAX TREATIES

3. Coverage of Tax Treaties a. Taxes covered by most treaties:

1) 1) Income taxes.

2) Capital gains taxes.

3) Taxes on net wealth.

b. Persons covered by most treaties:1) Natural persons.

2) Companies.

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E. TAX TREATIES

4. Double Taxation Provisions a. Significant factors: Residency, personality,

and source of income.

b. General rule: States may only tax residents.

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E. TAX TREATIES

1) Exceptions — relate to the taxpayer’s: a) Personality.

i. Non-resident person providing independent or professional services may be taxed by a tax treaty state if the person maintains a fixed base within that state.

ii. Non-resident employee may be taxed in a tax treaty state to the extent of the earnings the employee receives in that state.

iii. Non-resident companies may be taxed by a tax treaty state if they maintain a permanent establishment within that state.

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E. TAX TREATIES

1) Exceptions (continued) — b) Sources of income:

i. Immovable property is taxable only in the state where the property is located.

ii. Dividends remitted by a subsidiary are subject to limited withholding taxes by the host (or source) state.

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E. TAX TREATIES

1) Exceptions (continued) — b) Sources of income:

i. Dividends received by a parent company are subject to the ordinary income taxes of the home state.

ii. Capital gains relating to immovable and movable business property may be taxed in both states.

a] Other capital gains may only be taxed in the state of residency.

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F. TAX INCENTIVES

1. Purpose: A tax scheme used primarily by host states to encourage international trade

2. Examples of Tax Incentives a. Income tax holidays for foreign investors.b. Capital allowances (e.g., accelerated depreciation).c. Carrying forward of allowances for income tax

deductions.d. Waivers and deductions of import duties.e. Export subsidies.f. Deferment of corporation registration fees and duties.g. Tax exemptions for expatriate employees.

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G. TAX AVOIDANCE AND EVASION

1. Tax Avoidance a. Defined: Efforts by individuals and companies

to —1) Take advantage of loopholes in the tax laws, or

2) Where some doubt exists as to the interpretation of a tax law, to benefit from that doubt.

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1. Tax Avoidance (continued)b. Common examples:

1) Tax havens.

2) Transfer pricing.

3) Treaty shopping.

4) Thin capitalization.

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1) Tax havens. a) Defined: States that provide a refuge from taxes for —

i. Taxpayers themselves.

ii. The taxpayers’ income.

iii. The taxpayers’ capital and other assets.

b) Methods for countering:

i. Many states tax income earned in tax havens.

ii. Some states try to structure their own tax laws to limit the usefulness of tax havens to local residents.

iii. Other states impose special taxes on certain types of income and transactions that commonly involve the use of tax havens.

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2) Transfer pricing. a) Defined: The practice of charging arbitrary

prices for goods or services provided by one affiliate company to another affiliated company so as to lower the tax burden of the overall enterprise.i. Purpose: Allows small profits to be made on the

books of affiliates in countries with high taxes and large profits are assigned to affiliates in countries with low taxes.

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2) Transfer pricing (continued)b) Methods for countering:

i. Many states require affiliates to deal with each other at arm’s length.

a] An affiliated establishment is attributed those profits which it would earn if it were a completely independent entity dealing with another similar enterprise under ordinary market conditions.

i. Some US states use the so-called “unitary business rule.”

a] Defined: Multinational enterprises are taxed on a percentage of their worldwide income, regardless of where it was earned or by whom.

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3) Treaty shopping. a) Defined: “Shopping” for countries with

beneficial tax treaty provisions, and then setting up subsidiary enterprises in those countries to take advantage of their treaties.i. The subsidiaries are commonly known as “conduit

companies.”

b) Methods for countering. i. General rule: Suspend treaty benefits for non-

residents who seek to abuse the tax treaties.

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4) Thin capitalization. a) Defined: A company is purposely financed by

loans rather than by equity capital, so that it may deduct interest paid on its loans as a business expense.i. This arrangement results in lower tax payments for

the company in most states.

b) Method of countering on the domestic level: Disallowing the interest deduction when the debt to equity ratio exceeds a particular norm.

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2. Tax Evasion a. Defined: The willful and conscious

misrepresentation or concealment of one’s tax obligations, or the flight of a taxpayer to another country.

b. All States View Tax Evasion as Illegal

c. States Cooperate in Varying Degrees in Prosecuting International Tax Evaders

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2. Tax Evasion (continued)

1) Tax cooperation treaties.a) Council of Europe / OECD 1988 draft

Convention on Mutual Administrative Assistance in Tax Matters provides for information exchanges.

2) Tax amnesty: Allows delinquent taxpayers to pay all or part of their overdue taxes and thereby avoid possible prosecution.


Case: Kalo v. Commissioner of Internal Revenue : +Court +Facts +Legal Significance +Parties +Rational+Issue +Result

Time of Acceptance Clause

1 of 37 Lecture 13 TAXATION Topics covered: Income Taxes Double Taxation Tax Treaties Tax Incentives Tax Avoidance and Evasion.

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