In this article we will discuss about the source of passive income:- 1. Dividend Income 2. Interest Income and Expense 3. Royalty Income and Payments 4. Capital Gains.

Dividend Income:


Dividends are normally understood to refer to a profit share paid out by a company to its shareholders out of retained earnings. For tax purposes, they have a wider meaning. Broadly, a dividend is any distribution from a corporation to its owners by virtue of their ownership status.

Dividends refer to any economic benefit in any form provided to the shareholders. Besides profits, they include other payments to shareholders, such as the return of share capital or of capital surplus that are not made out of profits. They also include certain payments as dividend under the deeming provisions in the tax law, such as constructive dividends.

Undistributed profits of controlled foreign corporations may also be treated as dividends under anti-avoidance rules. Besides cash, dividends may be paid in kind, either as shares (e.g. bonus shares) or as assets.


Stapled stocks may be used to pay cross- border dividends directly from a subsidiary to parent company’s shareholders without withholding tax. The OECD MC Article 10 defines the term “dividend” to include all income from corporate rights taxable as income from shares under the domestic tax law of a country.

The definition of dividend under the domestic tax laws of various countries varies widely. For example:

a. United States:

The tax law generally follows a substance over form principle to determine if a payment is a dividend. A dividend is any distribution of property made by a corporation to its shareholders out of its current and/or accumulated earnings and profits (IRC S.316 (a)). Any excess is a return of capital limited to the capital contribution and the balance is treated as capital gains.


b. United Kingdom:

The term “distribution” includes, besides dividends, any distribution (whether in cash or otherwise) in respect of shares in the company unless it is a capital repayment. Tax law also lists several other payments as distributions as well as provides for exemptions.

c. Netherlands:


A dividend is any direct or indirect distribution to a shareholder. It includes any payment in excess of the capital contributed, whether made in cash or assets, or as a compensation or loan.

Thus, the meaning under the domestic tax laws of countries varies widely with the taxation needs of a country. In many cases, it also differs from the definition under the company law of the country. These differences can lead to both double taxation and double non-taxation.

Not all distributions are dividends. To qualify as a dividend, there must be a special relationship between the parties and the benefit must be transferred due to this relationship.

They may also be classified as interest or capital gains (or vice versa) depending on the domestic law. For example, the tax treatment of liquidation proceeds varies between dividends and capital gains. Hybrid instruments may also be classified differently as debt or equity in different jurisdictions.


The taxation rules on dividends vary. Generally, countries either provide lower tax rates or exempt the dividends from qualifying direct (i.e. non-portfolio) participations or shareholdings.

Tax treaties also impose a lower maximum withholding tax on such dividends (MC Article 10). The EU Parent-Subsidiary Directive provides for tax exemptions on qualifying dividend receipts and payments to encourage investment capital flows within the European Union.

Tax systems affect the taxation of dividends. Under the classical or separate tax system, corporate profits suffer from economic double taxation. They are first taxed in the hands of the distributing company and the taxed profits are then taxed again on the shareholders when distributed.

This double taxation is avoided in several countries using various forms of shareholder relief systems. They either fully or partly attribute the taxes paid by the company to the shareholders under an imputation system, or grant them partial or full tax exemption on the dividends. These shareholder relief systems include dividend exemption, half inclusion, flat rate and dual income tax system.

Constructive Dividends:


A variety of payments by companies to shareholders or associated persons may not be expressed as dividends. They may nevertheless be deemed by the tax law as distribution of profits and treated for tax purposes as if they were dividends. These payments are sometimes referred to as “constructive dividends” or hidden profit distributions.

Such distributions may be disallowed as deductions in calculating the taxable profits of the paying company and the tax authorities may recover any withholding tax, which would have been due, from the paying company. The paying company may be subject to penalties for late payment of tax or for tax evasion.

The kinds of payment that may be considered as a constructive dividend include amounts paid to an associated company in excess of an arm’s length price for goods or services, excessive payments of interest to shareholders, and loans or advances to shareholders.

They may also include interest payments on loans treated by the domestic law of the paying company’s country as profit distributions under rules designed to prevent tax loss through “hidden” capitalisation.


Such loans may include “convertible loans” (i.e. loans that are convertible into shares at some stage) or “participating loans” (i.e. loans with interest that depend on the profitability of the company) or loans that exceed a certain fixed proportion (the “debt/equity ratio”) of the total capital of the company.

The deemed dividend provisions under the tax rules are applied under several anti- avoidance measures. Interest payments may be regarded as hidden profit distributions under the thin capitalisation rules, while retained profits of controlled foreign corporations may be taxed currently as deemed dividends under certain anti-deferral rules. Constructive dividends could also arise as a secondary adjustment under the transfer pricing rules.

Domestic Dividends:

Tax treatment of dividends payments to residents varies widely. For example:

a. Certain countries do not tax dividend income under their tax law.


b. Many countries exempt intercompany dividends if they are paid out of taxed income.

c. Withholding tax on the dividend payments may be final or creditable against the tax liability of the shareholder.

d. Dividends received from qualifying shareholdings under their participation exemption or affiliation privilege rules are not taxable.

e. Countries grant a dividend-received deduction at varying rates to qualifying companies.

f. Resident shareholders receive an imputation credit to offset their tax liability on the dividend income.

Dividend Payments to Nonresidents:

Dividend payments to nonresidents are usually taxable. However, their tax treatment may vary. For example:


a. Dividends paid to nonresidents are subject to a dividend withholding tax that is final in many countries.

b. Several countries do not withhold tax under their domestic law on dividends paid to non-residents.

c. Few countries tax defers or exempt the dividend payment if the amount is reinvested in the country: (Examples: Colombia, Hungary)

d. Qualifying dividend payments to parent companies within the European Union are not subject to withholding tax under the EU P-S Directive.

e. Few countries have extended the withholding tax exemption on dividends under the EU P-S Directive to qualifying companies resident in non-EU treaty countries. (Examples: Denmark, Ireland, Luxembourg)

Dividends Received from Nonresidents:

Countries with a worldwide tax system usually tax the foreign dividend income of their residents.

However, several of them provide for relief of the economic double taxation on the dividend income. For example:

a. Several countries have extended the exemption under their domestic participation exemption rules to qualifying foreign dividend income or granted exemption under tax treaties.

b. Many countries give an indirect credit for the underlying tax paid by the distributing company, usually under tax treaties.

c. Foreign dividends from Member States in the European Union are either tax-exempt or granted indirect tax credit under the EU Parent-Subsidiary Directive.

d. Economic double taxation of dividends in the hands of the individual shareholder may be relieved through shareholder relief systems.

Dividend Source Rules:

The source of the dividend is generally the country of residence of the paying company or the country where the shares are registered. The origin of the income paid as dividends by the company is usually irrelevant.

However, there are a few countries (Example: Australia), which treat dividends paid out of the branch profits of a foreign company as domestic-source and apply a withholding tax. This “secondary withholding tax” is not permitted under the OECD MC Article 10(5).

Interest Income and Expense:


Unlike dividend, which is a return on equity, interest is a return on debt. Interest is paid on debt capital. Debt capital normally refers to capital raised through debt or loan instruments on fixed or floating interest payments. It also includes hybrid debt instruments such as convertible bonds, profit sharing bond, etc.

Few countries provide a statutory definition of interest. It is generally taken to refer to the return for the use of monies lent. OECD MC Article 11 includes a comprehensive definition of interest for treaty purposes. It means income from debt-claims of every kind, including bonds and debentures. Interest on participating or convertible bonds remains as interest until actually converted into shares, unless the debtor shares the business risks.

An enterprise can select either equity or debt, or generally a combination of the two, to finance his business activities. Although the financing mix is dictated by commercial considerations, debt is preferable to equity from a tax viewpoint. Normally, the interest payments are tax deductible while dividends are not.

Thus, a company financed by a loan has a tax advantage over a company provided with equity capital. Moreover, the interest paid to a non-resident investor are often subject to a lower withholding tax in the source State than a dividend under a treaty.

The use of loan capital rather than equity can, therefore, reduce the tax liability. An excessive use of debt can lead to the problem of thin capitalisation. Various approaches have been adopted to deal with this problem.

What is Debt and Equity?

Equity capital shares in the rewards of the business but also bears the entrepreneurial risks. The company does not owe the shareholder the money and cannot repay the capital invested except on share reduction or liquidation. As a shareholder, he receives income only when the company distributes it to him.

He is entitled to his share of the distributable profits as dividends without any limit, but only if the company makes a profit. He can lose his entire capital in business losses. Equity capital may also be of different classes or types, such as ordinary or preferred shares. The preference shares may or may not be redeemable. The shares may have equal or unequal rights over voting control, and/or distribution of profits, assets or liquidation proceeds.

Loan capital differs from equity capital both in legal and economic terms. The loan provider does not share the risks and rewards in the borrower’s business. The capital lent is a liability of the company and is repayable with interest, no matter what profits are made.

The lender can expect regular fixed repayments of interest on due dates and have the right to receive back the capital at the end of the loan period. The loan may be unsecured or secured by the assets of the company or by guarantees from the borrower or third parties. The rights of lenders take priority over those of the shareholders in respect of the interest and the repayment of their loans.

The distinction between debt and equity capital may be blurred in certain financial instruments. Loan capital can take the form of different types of debt claims with varying terms that depend on the interest payments, repayment periods and the financial risks involved.

They may also have the characteristics of both debt and equity and may be treated as debt in one taxing jurisdiction and as equity in another, such as in hybrid or derivative financial instruments. Profit-participating loans are sometimes, but not usually, treated as equity. Convertible loans are generally treated as loan capital until the time of conversion.

Taxation of Interest:

Cross-border interest is affected by the tax rules in:

(a) The residence country of the provider of the funds (e.g. lender), and

(b) The source country of the interest payment (e.g. borrower).

Both countries tax the lender. The source country applies a withholding tax on the interest when paid (unless exempt) while the residence country taxes it as interest income. The double taxation is relieved under domestic law or tax treaties. In addition, the source country usually provides a deduction for the interest expense to the borrower.

(i) Tax on the Lender

Some of the tax issues affecting the foreign lender include:

(a) Many countries withhold tax at source when it is paid or credited by the borrower. This tax is usually a final tax on the interest payment in the source State for the non-resident lender. In cases where the agreed interest is paid free of taxes, the withholding tax is levied on the grossed-up amount.

There are also several countries that do not tax or impose a withholding tax on cross- border interest payments. As from 2004, there is no withholding tax on qualifying interest payments within EU Member States under the EU Interest/Royalty Directive.

(b) The tax treatment of interest income in the source country could be affected by factors, such as:

i. The tax or legal status of the debtor or borrower;

ii. The terms of the loan;

iii. The currency of the loan

iv. A listing on a foreign stock exchange;

v. The nature of the source of the interest;

vi. The approval of tax, exchange control or other authority;

vii. The use of the funds; etc.

These considerations may grant special tax exemptions on the interest income in the source State. For example, several countries tax-exempt the interest on government bonds and/or government-approved loans when paid to non-residents.

There is no withholding tax on the interest paid to non-residents on ordinary commercial loans in certain countries. The interest on certain bank deposits, bonds and debentures is also tax-exempt in several countries.

The United States grants an exemption from withholding tax on portfolio debt obligations and bank interest paid to nonresidents. Switzerland does not tax the interest on commercial loans, including loans from a foreign parent to the Swiss subsidiaries, but taxes bank and bond interest.

No withholding tax is paid on the interest paid to nonresidents in Germany, except on certain bank loans. Spain exempts the interest on loans from European Union countries (unless listed as a tax haven), or if a public body or government is the payer or payee.

(c) The Residence State grants either a credit or an exemption relief for the foreign withholding tax suffered by the lender. This relief may not eliminate the double taxation fully due to conflicting source rules, the amount of foreign taxes suffered or the limitations imposed on the tax credits and deductions.

For example, several source countries apply the withholding tax on the gross interest payment. The foreign tax credit is given in the residence country usually on the net interest amount (gross interest less financing expenses). The net interest basis often results in excess foreign tax credits for the lender.

Double tax relief may also be restricted under the domestic law. For example, the Netherlands grant tax credit only on interest earnings from certain developing countries, and gives an expense deduction in other cases. Belgium limits the credit for the withholding tax to 15% gross-up rate.

(d) Both the withholding tax in the borrowing State and the income recognition in the lending State may follow different timing rules. The interest income may be taxable in the year when it is received (the cash method), or when it becomes due (the payable method), or when it is accrued (the accrual method). Most countries tax the accrued interest, even when it is not due.

On the other hand, many countries provide the foreign tax credit to resident lenders only when the tax is withheld and paid over by the borrower. Thus, the interest income of the lender may be taxed currently on the accrual method while the withholding taxes are creditable at a later date, when paid. The timing differences can lead to income tax liability and deductions in different tax periods.

(ii) Tax Deduction for the Borrower:

(a) Some of the tax issues affecting the foreign borrower include:

The borrower is affected if the interest is not tax-deductible in calculating his taxable profits. Generally, it is deductible as a cost if it is incurred to earn taxable income.

This interest expense may, however, be disallowed for several reasons, such as:

1. The expense deduction is given only when the interest is paid, i.e. on a cash basis.

2. The tax on the payment has not been withheld by the payer and paid over to the authorities, or it reflects a non-arm’s length transaction (e.g. excessive interest rate) between related parties, or it finances personal expenditure.

3. Thin capitalisation rules restrict the deductibility of interest expense.

4. The interest expense incurred on the construction or acquisition of certain assets is capitalized and amortized over their life: Argentina, Canada, Italy, Netherlands, China, Sri Lanka, The United States.

5. The expenses relating to a loan (e.g. refinancing interest and administration costs) taken for the purchase of foreign shares may not be tax-deductible. While some countries grant the interest relief on such loans against other taxable income, others disallow the loan interest and expenses incurred to finance overseas investments.

(b) The tax deductibility of interest expense may also depend on the use of the borrowed funds. Most countries require that the interest expense be incurred for income-earning purposes. Some of them use the tracing method to link the interest expense to the income or to a particular generic or geographic source of income.

Other countries apply the allocation method under either the ordering or stacking rules, or the apportionment rules. In the former case, the borrowed money is assumed to be used first for qualifying purposes (e.g. to earn income), and then for non-qualifying purposes (e.g. personal consumption).

Under the apportionment method, the borrowed money is allocated between qualifying and non-qualifying uses based on the cost or asset value. Many countries use more than one method.

Several countries allow an interest deduction if it is a business expense. There are a few countries that allow the interest expenses as tax deductible, irrespective of the use of the borrowed funds (Examples: Netherlands, Norway, Sri Lanka, Sweden, the United Kingdom).

In the United Kingdom, there is no purpose test that specifies that the interest should be incurred for a UK trade or to generate taxable profits. Non-trading interest expense is, therefore, deductible either as annual interest, wherever paid, or as interest payable to a UK bank.

Interest Source Rules:

There is no general rule that defines the source of interest. It depends on the domestic law.

For example, the interest income could be derived for tax purposes from any of the following sources:

1. Where the payer or borrower is resident or has a permanent establishment (“debtor principle”): Argentina, Brazil, France, India, Mexico, Peru, Turkey.

2. Where the loan or borrowed funds are used (“user principle”): Argentina, Brazil, France, India, Mexico, Peru, Turkey.

3. Where the money is lent: Australia, New Zealand, South Africa.

4. Where the debt can be enforced: the United Kingdom.

5. Where the real property or assets given as security for the loan are situated: Australia, Austria, Greece, Hong Kong.

6. Where the loan contract is entered: Australia.

7. Where the source of income out of which the interest is paid is located: the United States.

8. Where the interest is remitted from: Morocco, Tunisia.

The most common source rules follow either the debtor or use principle.

Royalty Income and Payments:


A royalty is normally a payment received for the use or the right to use any intangible right or know-how under licence. However, the term “royalties” covers a wide range of payments under the domestic law of different jurisdictions. The term normally refers to payments for the use, or the right to use, intellectual property, know-how or copyrights. Several countries regard income from equipment leasing as royalties.

The income from pre-packaged computer software is taxed by many countries as royalties from a copyright, and not a sale of a copyrighted product. Royalties are also paid for the exploitation of natural resources connected with land, most commonly mineral resources, gravel or timber.

Know-how refers to trade secrets and technical information, and the experience necessary to carry on the commercial activity. It is the existing knowledge and experience of the grantor. It is “what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique”.

The know-how contracts comprise the transfer of intellectual property or secret technical knowledge, which is not in the public domain. The supplier does not provide any service or assistance, and does not guarantee the results. The payments are usually determined based on a percentage of sales or profits.

Technical service and assistance differs from know-how. Examples of technical services include payments for after-sales service, services under product warranty and opinions given by an engineer, an advocate or an accountant. The provider executes a scope of work for which he takes responsibility.

Technical assistance involves a scope of services usually under the supervision and control of the customer. Both of them may include “show-how” or the process of transferring knowledge through instruction, training or supervision.

Technical advice provided electronically or through “trouble-shooting” databases are technical services or assistance. The payments for information concerning computer programming are know-how payments when made to acquire information constituting ideas and principles on condition of confidentiality.

Tax treaties usually limit the domestic definition to payments for the use of, or the right to use, intellectual property. As the treaty definition is comprehensive, the use of definitions under domestic law may not be appropriate.

The OECD Commentary mentions that income from equipment leasing should not be taxed as royalties, but as business income. The sale of computer software and related services is a business income and not royalty income.

The Commentary on software payments recommends:

(i) The sale of shrink-wrapped or canned software should be treated as a sale of a copyrighted article.

(ii) Payments for the transfer of complete ownership over the copyrights are not royalties. They are either business income or capital gains.

(iii) Payments for purchase of partial rights in the copyright may be royalties in certain circumstances.

As royalty income is essentially a payment relating to the usage of an intangible asset, a capital payment for the purchase of intellectual property normally will not be a royalty. It will be taxable as a capital gain. Similarly, the income received for creating the intangible right is a business or service income.

The OECD Commentary excludes technical service and assistance fees (“show-how payments”) from the royalty provision. They are treated as active business income. This tax treatment under the OECD MC is not followed by many countries.

Royalty Payments:

Royalty payments are generally a tax-deductible expense in the year in which they arise for the licensee or payee. Lump-sum royalties are usually spread over a fixed period or the period for which the lump sum is paid as an advance royalty.

Lump­-sum payments for know-how may not be deductible in certain countries (Examples; Australia, Canada, France, the United States), unless a period is specified. They may also be taken as a capital payment for an outright purchase of an intangible asset in certain circumstances.

Many countries levy a withholding tax on royalty payments made to non-residents under their domestic law. Under tax treaties, it may or may not be taxable in the source State. This taxing right is denied to the source State under treaties that follow the OECD Model (Article 12) since exclusive taxing right on royalty income is given to the Residence State.

However, many OECD Member States and several non-members have negotiated treaties that retain the taxing right of the source State over royalty income. The UN MC permits the source taxation of royalties.

Several source countries do not tax royalties paid to nonresidents. Certain countries limit the taxation to specific royalties only. For example, the United Kingdom does not levy withholding tax on film copyright royalties and equipment royalties paid to nonresidents.

Denmark excludes all copyright royalty payments to nonresidents from the withholding tax. The royalty income from the exploitation of artistic, musical and cultural works wholly developed and produced in Ireland is tax-exempt.

China exempts the royalty payments on advanced technology, or if technology is provided on preferential terms. As from 2004, qualifying royalty payments within the EU Member States are not subject to withholding tax under the EU Interest/Royalty Directive.

Royalty Income:

Royalties are generally taxed as income of the licensor in his Residence State. Credit or exemption relief is given for any withholding tax paid in the source State. When royalties are taxable in the source State, the tax is usually collected from the licenser by a withholding tax, either on the gross payment, with no current expense deduction, or on the net payment.

The latter amount may be computed with an expense deduction based on a flat rate derived from an estimated fixed percentage or on the actual expense incurred.

As foreign tax credits are usually given on a net income basis by the home State, unless the actual expenses are deductible the licenser can suffer excessive withholding tax in the host State on royalty income and end up with unusable foreign tax credits.

This problem is particularly significant on deemed royalties derived from technical services and assistance, where the work is performed on relatively low profit margins compared to the withholding tax rate.

Royalty Source Rules:

The royalty source rules vary widely. The most common rule is the residence of the payer (“pay rule”). Several countries also regard the source as the State where the intangible property is utilised (“use rule”). In a few cases, it is the residence of the inventor (Example: South Africa), or the place where it is developed (Example: Argentina).

It may also be the place of the royalty agreement, or where the intangible rights are registered or transferable. The royalties for trademarks and copyrights are usually sourced in the country of registration or the residence of the payer.

Some country examples include:

1. Australia:

In Australia, the source generally depends on the place of the contract and the place where the property is situated. For example, royalties are sourced in Australia if they are paid for conducting a business wholly or partly in Australia.

2. Germany:

Germany does not define royalties separately under its domestic law. Royalty income is classified under the existing types of income (e.g. business income, rental income, independent personal services or other income) and, therefore, may be taxed under different source rules. The income from a patent, copyright or know-how of the person, who develops or invents them, is deemed as an income from independent personal services.

3. India:

Royalty income is from a domestic source in India if it is payable by the Indian government (“pay rule”). For other resident or nonresident payers, it is from a domestic source if the payment for the right, property or information is for its use in a business or profession in India or for earning any income in India (“use rule”).

4. Japan:

Royalties are domestic income if a person, who is engaged in a business in Japan, pays them for his business use in Japan. The Japanese source rules use a mixture of the “use rule” and the “pay rule”, with the emphasis on the place of use principle.

5. United States:

The United States has specific source rules for royalties under its domestic law. Royalty income is domestic-source if the property is located within the United States, or if the intangible rights are used in the United States.

The royalty payments may be taxed under the “pay rule” in one country, and under the “use rule” in the other country. The definition and source conflicts can lead to double (or multiple) taxation for the licenser. An example of multiple taxation is the royalty received for technical services performed at home but paid abroad for the use in a third country.

Royalties may be taxable in the country where the services are performed, the country where the payer resides and the country where they are used. Such multiple taxes in the source countries may not be relieved in the country of residence under the domestic law or tax treaties.

Capital Gains:


Capital gains or losses arise from the disposal of capital assets. Very few countries provide a definition of capital assets in their tax law (Examples: France, Israel, the United States). They are characterised often by the circumstances relating to the transaction.

In certain countries, case law has established certain badges of trade. For example:

1. Certain jurisdictions base the distinction on the frequency of transactions or the type or character of the property (Examples: Denmark, Israel, Sweden, Switzerland, the United States). The number of transactions involving similar activities is used to distinguish be­tween revenue and capital assets.

Infrequent transactions would suggest a capital item with an intention to invest rather than trade, particularly if the asset is held for a long period.

2. The method of financing may decide the nature of the transaction. A purchase with borrowed funds may imply operating assets, while the use of own funds would suggest an investment.

3. Some countries apply the intention at the time when, and the circumstances in which, the property was originally acquired (Examples: Brazil, Canada, Denmark, Israel, the United Kingdom).

Some countries only levy capital gains tax on the disposal of certain assets, e.g. real estate, ships, securities and works of art. Other assets are exempt from the capital gains tax regime, e.g. the sale of a personal residence (although capital gains tax may only be deferred in certain circumstances).

If the capital gains tax is deferred until similar assets that are purchased to replace the asset are disposed of, the deferral is described as a “roll-over” relief.

Under the treaty, the OECD MC Article 13 allows the source country to tax nonresidents on the capital gains arising from immovable property located in their State and from movable property effectively connected with a permanent establishment.

Except for ships or aircraft in international traffic and inland waterways transport, the taxing rights on other gains are left exclusively to the State of residence. The UN MC provides for the sharing of these rights.

Taxation of Capital Gains:

Capital gains tax is levied only when the gain is realised on alienation (i.e. disposal) of the asset and not on accrual basis. As a rule, taxable gains are computed as the difference between the selling price and the price or value upon acquisition, plus the expenditure incurred on the asset between the time of acquisition and disposal.

In some cases, the gain is computed subject to certain adjustments, such as monetary correction, index-linked adjustment, etc.

The taxation of capital gains on the disposal (sale or exchange) of capital assets varies considerably from country to country. For example:

(a) Several countries do not tax capital gains under the domestic law.

(b) Many countries make no distinction between revenue and capital profits and tax both of them as ordinary income. The sale proceeds of a business enterprise are taxable, regardless of their nature.

(c) Certain countries follow the “fruit and tree doctrine” where the ordinary income is the fruit from the tree, which is taxed as a capital asset.

(d) Capital gains are normally taxed only on realisation. The gain may be computed differently from ordinary income and may be taxed at the same rate or a special (usually lower) rate.

The tax rate may again be different for specific assets and may be applied to each gain, or to the total gains of the taxpayer. The rate may vary for individual and corporate taxpayers. There may also be special rules for the carry-over of capital losses, which may only be offset against present and future capital gains.

(e) Long-term capital gains are generally taxed more favorably at reduced rates, while short-term gains are taxed as ordinary income. A long-term gain is based on the “holding period” of varying duration, depending on the asset. The preferential taxation often encourages tax arbitrage through the characterisation of business or personal income into capital gains. It also encourages the taxpayer to hold the asset until its disposal qualifies as a long-term gain.

For example, the United States taxes individuals on long-term gains at the lower tax rate of 20%, France taxes long-term gains of companies at the reduced rate of 15%. Italy allows the corporate taxpayers to spread the gain on assets held for at least three years over a five-year period. Canada taxes only 50% of the capital gains at ordinary tax rates. Denmark exempts the capital gains on the disposal of shares from tax if they are held for more than three years.

(f) Tax treatment also differs on gains arising from depreciating assets. Some countries treat the entire gain from such assets as ordinary business income, while others regard only the excess over the acquisition cost as subject to capital gains tax. The rest of the gain is added to ordinary income as a recapture of the depreciation allowances.

Several countries that use a “pooling basis” for capital allowances just deduct the sales proceeds, including the gain, from the pool (Examples: Australia, India, Finland, Greece, the United Kingdom). The asset base is, therefore, reduced by the capital gain for depreciation purposes.

(g) The method for calculating the gain varies. For example, several jurisdictions allow the acquisition costs to be adjusted for inflation in computing the taxable gains. Israel and Turkey tax-exempt the gain from the inflationary component, and tax the real gain at the regular corporate rate.

Mozambique allows for currency devaluation. India permits nonresidents to compute the gain or loss on shares in an Indian company in the foreign currency of purchase, instead of inflation indexation.

(h) Special rules often apply for the deferral of capital gains tax, in cases of approved reinvestment (“rollover relief”) of sales proceeds within a stipulated period. Other special rules include an “exit tax” in certain countries on the un-realised but accrued gains on assets when an individual emigrates, based on the deemed disposition of all his movable property at its fair market value.

A few of them allow the use of an uplifted base cost on assets and tax only the gain arising since the date of immigration. Special rules also apply to the gains arising in business re-organisations, acquisitions and mergers.

Liquidation proceeds are treated as capital gains in many jurisdictions.

(i) Certain countries exempt (or tax at reduced rates) the capital gains on the sale of specified assets held by nonresidents. For example, the gains on the sale of shares in qualifying shares may be exempt from tax under the participation exemption rules.

Certain countries do not levy capital gains on assets held by nonresidents, unless attributable to the trading operations within the country (Examples: Belgium, Hungary, Finland, Ireland, Luxembourg, the United Kingdom).

In Australia and Canada, nonresidents are taxed only on capital gains arising from certain assets connected with the country. The United States does not tax capital gains unless a nonresident is present in the country for more than six months in the year of the gain or the assets are effectively connected with a US trade or real property.

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