In this article we will discuss about the source of income of a country:- 1. Connecting Factors for the Tax Objects 2. Basic Source Rules 3. Taxing Source Rules 4. Conflicts in Source Rules.
Connecting Factors for the Tax Objects:
The connecting factors for the tax objects are the source rules. The source rules identify:
(a) Where the income arises and
(b) Which country has the taxing rights over it.
A country has the source taxing right only if there is an economic connection between a particular item of income and the country as a taxing jurisdiction. To be effective, the source rules should enable the tax jurisdiction to identify the income and its recipient, to quantify it and to enforce its taxing rights.
Each country has its own rules (“basic source rules”) under the domestic law to decide where the income arises for taxation purposes. They are normally based on the location of the economic activity that generates the income, i.e. where the profits accrue or arise.
In many cases, the domestic tax practice rather than the specific statutory rules determines the source. Very broadly, any income derived from the activities carried on within a country is sourced in that country.
For example, the location of real or immovable property generally determines its income source. The source of personal services is usually the country where they are physically performed or where they are used. Active business income follows the place of operations from which the profits in substance arise.
Passive income, such as interest, royalties and dividends, is usually (but not always) sourced in the country of the payer. Certain passive income may be treated as active if it is effectively connected with a business activity in a State.
The taxing rights are largely dictated by the country’s ability to enforce its tax laws (i.e. enforceability) and the principle of reciprocal sharing of tax revenues by nations (i.e. reciprocity). Under the public international law, every country has the primary right to tax the income arising or derived from an economic attachment or territorial link with that country (i.e. domestic-source income).
Therefore, a nonresident person is liable to pay a tax for the privilege of earning the income from a source in the host country. This taxing right does not extend to non-domestic source income (i.e. foreign-source income) derived from other countries. Whether an income should be treated as domestic or foreign-source for tax purposes is determined under the domestic law and practice (“taxing source rules”).
Generally, the income is classified by the type or nature of income before the source rules are applied. The rules that classify or characterize various items of income affect the applicable source rules on that income. They can change the basic source assigned to an item of income and the related taxing rights.
For example, a sale of computer software may be classified as business or service income, sale of a copyright or know-how, or a sale of a capital asset. Depending on the category, the basic source would change and the right to tax could be affected.
Basic Source Rules:
The basic source or origin rules vary widely, depending on the nature or character of the income. For example, intangible property rights are usually sourced either at the place where they are used or where the payer is resident. In a sale of tangible goods, the source is generally the place where the ownership changes or title passes.
It is usually the country of residence of the seller. However, these rules may specify the source as where the title passes, where the contract is signed, where the delivery takes place, or where the payment is made. Several jurisdictions regard income as sourced where the contractual offer is accepted.
The income from an overseas sale transaction may also have a taxable source in the importing country. In the United States, the production and selling profits may be split on cross-border transactions involving manufactured goods. In Canada, a person is deemed to carry on a business and may be taxable if he or his agent solicits orders or offers anything for sale.
The source of service income is usually, but not always, the place where it is performed. The source may also be the Residence State of the payer, or the place where the services are used, or where the payment is received. Occasionally, the source may depend on where the person is employed or the services are performed.
a. In Australia, the source rule for employment income can be either the place where the service is performed, or the place of the contract of employment or the place where the payment is made.
b. In Ireland, if the employment contract of a non-domiciled employee is negotiated and accepted abroad and the payments under it are made into a foreign bank account, the employment income is considered foreign-source even for work done in Ireland. It is taxed on a remittance basis.
National rules vary, depending on how source is defined. For example, a dividend distributed by a company may be deemed to have its source in the country of residence of the company distributing the dividend, or in the country or countries from which the company has derived its profits.
Another example is royalty, which may be deemed to have its source in the place where the underlying contract was signed, or in the place where any activities giving rise to the royalty were performed, or where the payer is resident. Thus, there are wide variations in the basic source rules applied under the domestic law by various jurisdictions. It is, therefore, difficult to provide a single set of source or origin rules that is followed globally.
Some commonly used source rules for various types or categories of income include:
(a) Sale of tangible goods or services:
i. Where the title passes
ii. Where the payment is received or delivery made
iii. Where the commercial cycle is completed
iv. Where the sales contracts are concluded
v. Where the business is carried on (OECD MC Art. 7)
(b) Sale of employment services:
i. Where the service is performed or rendered (OECD MC Art. 15).
ii. Where the results of the service are used.
iii. Where the payer is resident.
iv. Where the payment is received.
v. Where the service contract is made.
vi. Where the related sale takes place.
(c) Dividend income:
i. Where the paying company is resident (OECD MC Art. 10).
ii. Where the underlying profits are sourced.
iii. Where the shares are registered.
(d) Interest income:
i. Where the payer is resident (OECD MC Art. 11).
ii. Where the debtor is resident.
iii. Where the loan contract is entered.
iv. Where the money is lent.
v. Where the borrowed funds are used (OECD MC Art. 11).
vi Where the income arises from which it is paid.
vii. Where the debt can be enforced.
viii. Where the collaterised assets are located.
ix. Where the interest is remitted from.
(e) Royalty income:
i. Where the payer is resident (UN MC Art. 12).
ii. Where the intangible rights are used.
iii. Where the inventor resides.
iv. Where the intangible rights are registered.
v. Where the intangible rights are transferable.
vi. Where the agreement is made.
(f) Equipment/movable property rentals:
i. Where the permanent establishment is situated (OECD MC Art. 7).
ii. Where the assets are physically located.
iii. Where the payer is resident.
iv. Where the assets are used.
(g) Income from real/immovable property:
i. Where situated (OECD MC Art. 6)
(h) Capital gains:
i. Immovable or real property: where situated (OECD MC Art. 13).
ii. Shares and securities: where registered.
iii. Ships and aircraft: where the effective management situated (OECD MC Art. 13).
iv. Goodwill: where the trade, business or profession is carried out.
v. Copyrights, franchises, rights and licenses: where the rights are exercisable or used.
vi. Judgment debt: where the judgment is recorded.
vii. Gains other than from immovable property, ships and aircraft and permanent establishment: the state of residence (OECD MC Art. 13).
(i) Income from agriculture:
i. Where the asset generating the income is located.
In tax treaties, the source of income is usually referred to in an indirect manner. For example, the dividend Article in the OECD MC applies to “dividends paid by a company which is a resident of a Contracting State.”
In this case, it is only by implication that one may conclude that the company’s residence determines the source of the dividend. The dividend Article prevents tax on a dividend in a Contracting State only because the company’s profits are derived from that State.
Taxing Source Rules:
The taxing source rules decide whether the income is domestic or foreign-source. These rules serve two basic purposes.
Firstly, they specify the connecting factors for the taxability of the income by the host country.
Secondly, they affect the credit given by the home country for the taxes paid abroad on the foreign-source income. Thus, the taxing source rules decide the taxability of nonresident taxpayers in the source State, and their right to receive foreign tax credits on such taxes in their Residence State.
Most countries combine the taxing source rules with the basic source or origin rules under their domestic law. As an exception, the United States defines the taxing source rules separately from the basic rules for the different items of income and expenses.
It is, therefore, possible to either modify the categories of taxable income or vary the source or origin from domestic to foreign (or vice versa) by a change in the domestic law. Any change in these rules can effectively change the taxability of the income.
As mentioned, the taxing source rules normally refer to the income derived from the assets within a country or from the activities carried on within a country. This distinction is not always maintained.
Countries that follow the territorial tax regime often treat certain foreign-source income as deemed domestic-source income. Similarly, certain countries tax foreign-source income of nonresidents under a deemed-source provision.
(a) Deeming provisions in countries with the territorial tax regime may extend their taxing rights over certain foreign-source income. For example, the following foreign-source income is deemed as domestic-source in Namibia: foreign interest income, foreign income derived from a domestic trading activity, and royalty and similar payments for the use of intellectual property in Namibia.
(b) Several countries with the worldwide tax regime have extended their source rules to tax certain foreign-source income of nonresidents.
i. The United States taxes foreign income as US source if there is a nexus with a trade or business conducted in the United States. Prior to 2005, a pro rata share of the dividends paid by a foreign corporation was treated as US source, if 25% or more of its gross income in the three preceding years was effectively connected with a trade or business in the United States. On the other hand, interest and dividends from a domestic company may be treated as foreign-source income if at least 80% of the gross income during the previous three years was active foreign business income.
ii. India treats certain overseas income of nonresidents as taxable under its deeming provisions. They are deemed to accrue or arise in India. For example, foreign income is subject to tax if it is derived directly or indirectly through, or from, a “business connection” in India. Foreign interest, royalties and technical services for use in India are deemed to arise in India, if an Indian tax resident pays them to nonresidents.
iii. The income from unconnected activities undertaken by a nonresident entity may be taxable as business income under a “force of attraction” principle, if it has a branch in that country (Example: Japan, India, Indonesia, Latvia, The United States). This principle usually involves an independent set of source rules.
Conflicts in Source Rules:
As not all countries follow the same source rules, double taxation arises when they conflict. For example, the rental income may be taxed in the State where the immovable asset is situated and in the place where the contract is entered. Personal services may be taxed in the place where they are physically performed and in the Residence State of the payer.
Similarly, technical services performed at home may be taxable at home and in another country if paid by, or used in, that country. Thus, two or more jurisdictions may tax the same income as sourced in their country. Moreover, the Residence State may refuse to grant relief for the foreign taxes paid due to source conflicts.
Many of these conflicts are minimised through the explicit or implicit rules agreed under the source and assignment rules in tax treaties. The treaties classify or characterize the items of income, provide the basic source rules, and then assign the taxing rights to one or both Contracting States.
As the treaty rules normally override domestic law, they are de facto source rules. However, they do not avoid all source conflicts. For example, a treaty usually leaves the characterisation of income to the domestic law. As a result, two States may classify the same income or capital differently and apply different treaty provisions.
For example, equipment rentals may be classified as royalties in the source state and business income in the residence State. Similarly, loan interest paid to a partner may be treated as interest in one State and a share of partnership profits in the other State.
These conflicts of qualification (i.e. classification) often lead to double taxation or double non-taxation even when both Contracting States have acted in accordance with the treaty provisions.
When the taxable profits of an enterprise are shared between the Contracting States, the domestic-source rules also govern the expense apportionment methods.
For example, they decide the calculation of the attributable profits of a branch as a permanent establishment in the host State. The use of conflicting expense allocation or attribution rules in various jurisdictions could again lead to double taxation or double non-taxation.
Finally, the domestic rules affect the foreign tax credit calculations in the Residence State. The relief is calculated on the foreign income, net of related expenses, as computed under its domestic tax rules. These rules vary.
The allocation of additional costs (either as specific costs or as a proportion of general overheads) in the Residence State to the foreign-source income could reduce the foreign tax credit. Double taxation would arise unless they are also allowed as expense deductions in the host country.