In this article we will discuss about the principles of domestic tax systems.
General Principles of Domestic Tax Systems:
As early as 1776, Adam Smith prescribed the four principles of taxation in his book on the “Wealth of Nations” as follows:
The tax payable should accord with the ability to pay, or the taxable capacity.
The taxpayer should know exactly what is being taxed, how much he has to pay, and how and when he has to pay it. The law should be clear and unambiguous and the interpretation of it should be readily available.
The tax should be payable in a manner and at a time convenient to the taxpayer.
The enforcement and collection costs should be reasonable and proportionate to the receipts. Within these fundamental canons of taxation, the domestic tax systems in different countries vary widely to suit their economic, social and political needs. Under these systems, the tax laws and practices define the taxpayer, decide the tax scope, set the tax rate and determine the tax base.
They provide answers to questions like:
1. What taxing powers exist under the domestic law? Who is liable to tax? What income is taxable or tax-exempt? What are the applicable tax rates? When is the entity tax resident or non-resident under the domestic tax rules? What are the special tax rules affecting nonresidents or foreigners?
2. How should the taxable income be computed? What are the rules for revenue recognition? What expenses are deductible? What expenses are disallowed? What incentives and allowances or exemptions are available? What accounting policies are acceptable for tax purposes? What exchange gains and losses are allowed for tax purposes?
3. How are the tax losses treated? How long can they be carried forward? Can they be carried back? Is there a provision for tax consolidation? Are there separate rules for capital transactions? Can the losses be transferred on acquisitions or mergers?
4. What are the tax compliance and withholding requirements? When is the tax payable? Can the tax be deferred? Do the tax authorities give advance rulings on a pre or post transaction basis? How is tax compliance enforced?
5. How is double tax relieved unilaterally under domestic law? How are the relief provisions under the domestic law and tax treaties applied? What are the rules for computing foreign tax credits?
6. How does the tax treaty modify the domestic tax law? Does the treaty override domestic law? Are the benefits under the domestic law more beneficial than the treaty benefits? How does domestic law assist in treaty interpretation?
Thus, the role of the domestic tax system in a country is very wide. It governs all matters regarding how and in whose hands an item of income is taxed. The tax treaties can only limit its scope. They cannot expand it.
Domestic law alone decides the connecting factors, namely:
Who can be taxed? Or “Tax subject”.
What can each tax? Or “Tax object”.
The study of international taxation, therefore, requires the knowledge of domestic tax laws of more than one country as well as how they are applied in each country.
Connecting Factors of Domestic Tax Systems:
A State can only tax a person who has some connection with that country under its domestic law. Without this connection, a tax jurisdiction cannot exercise its taxing rights. In addition, there must be some connection between the tax jurisdiction and (a) a taxable person (“tax subject”) and (b) a taxable event (“tax object”) for a tax liability to arise.
There can be no tax due on a tax object unless there is a tax subject who is liable to pay the tax. Moreover, a person may be liable to tax but would pay no taxes unless there is a tax object, i.e. taxable income.
Generally, the tax laws impose a tax on tax subjects or persons (natural or legal) under the “charging provision”. However, it is not imposed on all persons, but only on persons who have taxable objects or income for the relevant tax period. Some countries levy the tax on tax objects or taxable income of persons. In such cases, the domestic law has an additional provision that requires a tax subject to pay the tax.
The connecting factors are generally based on residence, nationality or the domicile of the taxpayer for the tax subject, and on the source rules over the income or gain for the tax object. Other factors that can create a connecting factor include the situs of the transaction or asset, the nature of the transaction or business operation, or the character of the payment.
Resident vs Nonresident:
There are two main categories of tax subjects:
They are taxable on their worldwide income (“unlimited or full liability”); and
They are only taxable on the income and gains within the country (“limited liability”).
Normally, countries tax both residents and nonresidents on the domestic-source income derived from their tax jurisdiction. Tax residence rules extend the taxation of residents to foreign-source income (“residence based taxation”). As an exception, certain countries follow the territorial tax regime and do not tax the foreign-source income of residents. In such countries, the tax residence becomes largely irrelevant, except for treaty purposes.
A tax resident is defined under the domestic tax rules. By definition, a person who is not a tax resident under the domestic law is a nonresident. A nonresident normally pays tax on the income (actual or deemed) derived from that country only. His tax liability is limited to tax on the income derived, arising or accruing from domestic sources (“source based taxation”).
Nonresidents may also be treated differently from residents in other respects. For example:
(i) They may be taxed on a different basis from residents, e.g. higher or lower tax rate or base, no personal allowances or rebates, final fixed or flat tax, deemed profit basis, etc.
(ii) They may be required to pay additional taxes compared to a resident in the same circumstances, e.g. branch profits tax.
(iii) They may be exempt from taxes that residents would pay, e.g. no tax on certain interest or portfolio investments.
(iv) They may be subject to more rigorous tax withholding and compliance rules due to the practical difficulties in enforcing the tax laws on them.
(v) Since tax treaties only apply to residents of a Contracting State, they cannot claim treaty benefits.
In some countries, nonresidents are also taxed on foreign-source income remitted or received by them (Examples: Bangladesh, India, Israel, Jamaica, Malta, Singapore and Trinidad and Tobago).
There are also a few jurisdictions that treat a nonresident branch registered or operating in their country as a resident entity and tax it on its worldwide income (Examples: Argentina, Bulgaria, Ghana, Hungary, Mexico, Sri Lanka, Thailand, Taiwan, Tunisia, Ukraine).
Thus, the residence status is critical for tax purposes. Besides the scope of taxation, it usually affects the tax allowances and deductions, and subjects the taxpayer to special tax compliance rules. Moreover, only a person, who is a tax resident of a Contracting State, qualifies for treaty benefits.
Full vs Limited Taxation:
The reason given for residence as a basis for worldwide tax is that a person is expected to contribute for the privilege and the protection that the country of residence provides him.
A few countries also tax the worldwide income of their citizens, regardless of their tax residence. In their case, the diplomatic protection and the privileges that are provided by the country of citizenship are the reasons for taxing them. (Examples: Ecuador, South Korea, Liberia, the United States).
There are exceptions to the worldwide taxation of residents, such as:
(a) Nil tax regime:
There are several countries, which do not impose direct taxes on income. For example:
Andorra, Anguilla, Antigua and Barbuda, Bahamas, Bahrain, Bermuda, Brunei, Cayman Islands, Cook Islands, French Polynesia, Kuwait, Maldives, Monaco, Nauru, Nevis, Oman, Paraguay, Qatar, Saudi Arabia, Seychelles, Turks and Caicos Islands, St Kitts and Nevis, the United Arab Emirates, Uruguay (except agricultural income), Vanuatu.
Anguilla, Bahamas, Bahrain (except oil companies), Bermuda, Cayman Islands, Kuwait (local owned), Maldives (except bank profits), Nauru, Nevis, Qatar (local owned), Saudi Arabia (local owned), Turks & Caicos Islands, the United Arab Emirates (except oil and gas companies and foreign banks), Vanuatu.
(b) Territorial regime:
(i) Full territoriality:
The countries, which follow the full territorial tax regime, tax their residents only on the taxable objects sourced or deemed sourced in their jurisdiction.
Country examples include:
Bolivia, Botswana, Cambodia, Costa Rica, Djibouti, Dominican Republic, Ecuador (non-nationals), El Salvador, Ghana, Guatemala, Guyana (earned income) Hong Kong, Iran (non-nationals), Jordan, Lebanon, Lesotho, Macau, Malawi, Malaysia, Mauritius, Mozambique, Namibia, Nicaragua, Panama, Philippines (non-nationals), Singapore, Swaziland, Taiwan, Thailand, Zambia, Zimbabwe.
Albania, Brunei, Bolivia, Botswana, Cambodia, Cameroon, Congo, Costa Rica, Dominican Republic, Djibouti, El Salvador, France, Gabon, Guatemala, Guinea, Hong Kong, Ivory Coast, Jordan, Kenya, Malawi, Lebanon, Lesotho, Libya, Macau, Malaysia, Monaco, Morocco, Mozambique, Namibia, Nicaragua, Oman, Panama, Paraguay, Qatar, Senegal, Seychelles, Singapore, South Africa (pre 2001), Swaziland, Uruguay, Zimbabwe.
(ii) Partial territoriality:
Some countries apply a partial territorial tax regime on individuals, who are resident but not ordinarily resident. They may not be taxed on all or certain foreign-source income, unless they are ordinarily resident.
Ordinary residence denotes residence in a place with some degree of continuity and permanence due to a social or economic attachment. It is defined as “a man’s abode in a particular place or country as part of the regular order of his life for the time being (whether short or long) adopted voluntarily or for a settled purpose”.
British Virgin Islands, Cyprus, Guernsey, Guyana (unearned income), India, Japan (non-permanent resident), Jersey, Lesotho, Malta, St Lucia, the United Kingdom, Zimbabwe.
(c) Received or remittance regime:
(i) Some countries that follow the full territorial regime also tax certain or all the foreign- source income that is received by, or remitted to, residents.
Ghana, Guyana (earned income), Lesotho, Malaysia, Mauritius, Singapore, Thailand, Zambia.
(ii) Resident and ordinarily resident individuals, who are not domiciled under common law in certain countries, are taxed on their foreign-source income on a received or remittance basis.
Barbados, British Virgin Islands, Cyprus, Guyana, Ireland, Malta, Trinidad and Tobago, the United Kingdom.
Some countries make a distinction between received and remitted income. The term “receipt” implies “to take possession of”, while “remitted” requires a transfer of the foreign income. As a person can only receive the income once, the place of first receipt applies. Once the income is received then it moves merely as a transfer of money or remittance.
Thus, an overseas receipt is a remittance when it is transferred to a domestic bank account from an overseas account of the taxpayer. A remittance may be actual or constructive if the foreign funds are used to meet the liabilities incurred in the country of residence.