Territorial Systems of Taxation: historical background, current status and perspectives
Determining source of income
Many people believe that income arrives from where money is paid for goods and services, that is, the actual location of their clients. If we pursue this logic, a company that is a tax resident in the jurisdiction where the territorial tax system is applied, will not pay tax on income received from foreign customers.
The foregoing is not applied in general. While the definition of income from a foreign source may differ from jurisdiction to jurisdiction, yet overall, the source of income denotes the place where the activities generating such income are carried out, while the location of customers or payers is not relevant.
In different territorial tax jurisdictions, the scope of such foreign activities and the considerations as to whether the income derived from such foreign activities is taxable, may largely differ.
Some territorial tax jurisdictions use a more flexible approach to determine the level of commercial substance of foreign activity which would result in income from foreign sources, as well as whether such income from foreign sources is subject to local tax; other jurisdictions are more stringent – for example, if a certain income is considered to be income from foreign sources and, therefore, tax-free income, then it should be taxed elsewhere where it is received, and relevant confirmatory evidence of this will be required.
In this article, we will provide deeper insight into some concepts related to determining income from foreign sources, analyze key aspects and substantial variances between the key business centers which are using territorial principle of taxation in their corporate tax, as well as provide an overview of the latest developments in international taxation and specifically, in territorial tax systems. This article is intended to provide a general overview only, and if you are interested to learn more of the taxation system applicable to your specific business jurisdiction, please contact our specialists at [email protected].
Active income from foreign sources generated by permanent establishments
As mentioned earlier, income from a foreign source, as a rule, represents income derived from commercial activities outside the country of the company’s tax residence.
A company conducting business in another country may be considered to have a permanent establishment in that foreign country. A permanent establishment is usually deemed to arise when a company has a steady and constant presence in a given country and generates income by means of this establishment.
Most jurisdictions adhere to the OECD Model Tax Convention to determine permanent establishment. OECD criteria include three types of permanent establishment (hereinafter – PE):
- A fixed place of businessPE (article 5(1));
- A construction or projectPE, which is a special subset of the fixed place of business PE, with different requirements (article 5(3)); and
- An agencyPE, through the actions of a dependent agent (article 5(5-6)).
Commonly, fixed place of business is typically construed as a facility that the entity uses to conduct business with a certain degree of constancy. It can be a branch, factory, management center, or a mine or a warehouse, with some exceptions.
Facilities which are designated for the storage, demonstration or delivery of goods, for stockpiling or for the processing of such goods in another company are as a rule not included in the definition of a permanent establishment.
A permanent establishment in form of construction or project usually denotes a construction site or construction or installation that persists for a specific period of time.
Agents may include but not be limited to company directors, proxies, authorized signatories, employees, contractors working exclusively for this company, or other persons controlled by the principal.
Additional cases may be also envisaged by local tax laws or double taxation treaties between jurisdictions. For example, in some jurisdictions, a local Internet server may be construed as a permanent establishment.
Income earned by means of a permanent establishment is taxed in the jurisdiction where the PE is created, i.e. locally. Considering that in most countries entitites are taxed on their worldwide income, double taxation treaties are envisaged to eliminate the double taxation. Majority of these treaties usually exempt a company from taxation of income generated from a permanent establishment located in the country that is a party to the treaty.
However, there may instances when there is no double taxation treaty between the countries which means that both countries are entitled to impose taxes on income generated by the permanent establishment, which can lead to a double taxation situation. Nevertheless, in majority of cases, such countries provide tax credits on foreign taxes paid. However, these credits should be claimed, and the processing of such claims may sometimes be quite burdensome.
Countries where territorial tax system is applied, have dealt with this problem by granting exemption or directly considering income received from a foreign source, i.e. from a foreign permanent establishment, as a non-taxable income, which eliminates double taxation, irrespective of presence or absence of a double tax treaty.
However, consideration should also be given to whether such income from a foreign source received through a permanent establishment is taxed when it is repatriated to headquarters and received locally, and whether there are privileges for certain types of income.
Active income from foreign sources without a permanent establishment
There may be various instances, when a company may receive income from foreign sources without a permanent establishment.
For example, a company may be providing services in another country where its activities do not comprise PE, given the absence of a fixed place of business.
In this case, income may be considered as sourced locally in the country where the services were actually provided, which may lead to imposition of withholding tax. At the same time, that very income may be also subjected to taxation in the entity’s fiscal domicile country, if the worldwide tax system is in place.
As is the case with permanent establishments, agreements on avoidance of double taxation exempt from withholding tax or may have a reduced rate established for it. In the absence of an agreement, a tax credit may be granted on income tax paid on services abroad.
However, countries with territorial system of taxation, as a rule, do not tax such income arising from the provision of services in a foreign territory. Yet, such services are mandatorily to be provided abroad – if the service is performed for a foreign customer, but at a local level (for example, online services), remuneration for such services are usually considered as income from local sources in the country of residence of the company, as the type of activity that gave rise to such income would be carried out at a local level.
Determining the source of income in relation to trading in goods and commodities is more complicated, as different jurisdictions may apply varied interpretations for certain several aspects of such activities. Particularly, when determining the source of income, the place where goods or commodities are bought and sold, and the place where contracts are concluded and executed (in a larger context of execution), may give rise to different interpretations.
For example, if a company buys and sells goods within the same foreign country, this may imply that income has been generated from local sources in that country and therefore be taxed.
If a company enters into sales contracts and executes such contracts in a foreign jurisdiction, income from such contracts can be considered income from local sources. While, if such contracts are executed electronically, this is usually considered to be income from local sources in the country where the company conducts business and is a tax resident.
If the company is negotiating and concluding sales/purchase contracts abroad, but the goods sold are produced locally (in the country of the company’s tax residence), the sales revenue can be considered as income from local sources, regardless of whether the contracts were concluded abroad with foreign customers.
As we have seen, there are several facts that need to be carefully considered in order to correctly establish the source of income from international trade. In addition, each territorial tax jurisdiction applies different conceptual frameworks, methods of interpretations, and practical implementation of legislative framework. Therefore, it is imperative to implement individual approach to each separate case.
Passive income is usually defined as income derived from the possession or sale of assets, both fixed and mobile, without the active participation of a person with ownership of such assets.
Passive income streams generally include rental income, dividends, interest, royalties, and capital gains from the sale of assets.
In countries with territorial system of taxation, foreign-sourced dividends, such as dividends from foreign subsidiaries, portfolio companies, etc., are generally considered offshore and therefore are exempt from local tax.
In some jurisdictions, foreign dividends are treated as non-taxable income, while others offer tax exemptions, on the condition that some requirements are met: for example, it may be required that the company paying dividends should not be doing business locally or be subject to a certain level of taxation.
Interest income on deposits with foreign banks and / or foreign bonds is also usually considered as income sourced from abroad. However, in some countries with territorial taxation principle, foreign income in the form of interest received under loan agreements may be taxed if the company making the payment employs these financial resources to funds activities locally, or contracts are concluded at the local level, or lending is the company’s principal line of business.
Royalty income taxation is a complicated matter. Things can be tricky here as royalty income arises from licensing or permitting the use of certain intellectual property rights. Meanwhile, resources employed in the development of such intellectual property might have led to tax-deductible expenses at the local level. This can lead to inconsistencies when the expenses were used to reduce the local tax payable, but the passive income received as a result of such expenses is tax exempt.
In addition, a company paying royalty may use such IP rights locally in a jurisdiction of the tax residence of IP holding.
Thus, in some jurisdictions certain measures and requirements have been arranged to allow for a tax exemption from such royalty income received abroad. For example, foreign royalty income, whereby expenditures incurred to generate it are deductible for tax purposes, or a foreign royalty income which is generated from IP rights used at the local level, may be taxed at the local level.
It should be highlighted here, that most countries apply withholding taxes on dividends, interest, and royalties. Withholding tax denotes an income tax withheld (and deposited with the appropriate tax authority) by the company making payment on behalf of the recipient. This means that such income may be taxed in the country where the payer is located even if the country with territorial taxation principle does not levy a tax on foreign income.
However, Double Taxation Treaties (DTTs) usually help to minimize (or even exempt altogether) withholding taxes on transactions carried out between contracting states.
Rental income received abroad refers to the income received from real estate located abroad as a physical asset, and therefore is usually considered income from a foreign source and is not taxed in the countries with territorial taxation principle. Rental income is typically taxed in the country where property is physically located.
Following the same logic, capital gains from the sale of foreign real estate are, as a rule, exempted from local taxes.
Capital gains from the sale of securities or other financial assets can be considered as income from local sources, providing that assets that derive their value from contractual requirements are generally considered to be located where the holder of ownership right is a resident. You also should consider the location where negotiations, rulings and agreements in relation to the sale of such assets are carried out.
However, most countries with territorial tax principle envisage exemption from capital gains tax on both local and foreign sale of securities.
In some countries, an exception from the above approach is applied; thus, if capital gains are generated from securities listed on foreign exchanges, they can be taxed in the country of securities exchange location, and may be considered income from a foreign source in the holder’s tax residence.
Similarly, the source of income from the sale of other intangible assets, e.g. intellectual property, is usually the company’s place of residence, irrespective of whether the intangible asset is registered for protection in foreign countries (for example, patents, trademarks, utility models, designs, and so on).
Jurisdictions following the territorial taxation principle
Each country following the territorial taxation principle has its proprietary approach to determining the source of income, or assessing the composition of taxable income, or estimating whether an income tax exemption is provided for certain income flows received from abroad. Some countries offer straight-out exemptions for income derived from foreign sources, while others establish certain preconditions which the income should comply with, as well as determine different level of evidence required by particular tax authority.
In addition, some countries apply the territorial taxation model for corporate tax purposes, while the same would not work for personal income tax purposes, and other countries – vice versa.
Below we have outlined the territorial corporate taxation regimes applied by the major international business and financial centers.
As concerns companies owned by non-residents, Hong Kong is one of the major locations of preference for incorporation, after the BVI. One of the fundamental aspects of why Hong Kong has attracted so many foreign players is its tax regime, in addition to its robust financial system, its free port and the undeniable reality that it represents the key commercial and financial channel with China.
Hong Kong applies a territorial basis of taxation, i.e. it imposes taxes on profits that arise or are generated from trade, professional or business activities conducted on the territory of Hong Kong. The standard income tax rate is 16.5%, although a lower 8.25% tax rate applies to first profits in the amount of HKD 2,000,000. Capital gains from the sale of securities and dividends are as a rule tax exempt.
Profits that are not derived or generated from Hong Kong and/or from an entity that is not engaged in trade, professional or business activities in Hong Kong are not taxed in Hong Kong.
Although the IRD takes into account all the operational and commercial factors of the entity when evaluating the source of income, the key aspect taken into consideration is where the revenue-generating activities are carried out. Revenue- generating activities are specific activities carried out to derive income.
For example, revenue-generating activity for a service company can be the performance of specific services and, to a certain level, also sales and marketing activities in relation to the services. Other activities of the entity that are not directly related to income, such as staff training or accounting/bookkeeping, are not relevant in context of determining revenue generation.
If the service company provides such services from Hong Kong the profits from such services will be taxed in Hong Kong, irrespective of whether they are provided to a foreign customer or by electronic means. If the services are provided to a non-Hong Kong client who is located outside Hong Kong or, services are provided by a foreign agent or are outsourced to a foreign service provider, the profits generated from such services may be tax-exempt.
For trading companies, the main revenue-generating activities usually consist in negotiations, signing and execution of contracts.
If sales contracts (written or verbal) are negotiated, signed or executed within Hong Kong (the person is physically located in Hong Kong), profits from trading activities within the scope of these transactions are likely to be considered as derived from a Hong Kong source and therefore taxed in Hong Kong.
Typically, if the supplier or customer is from Hong Kong, profits will be treated as received from local sources. Similarly, a Hong Kong- based manufacturer is likely to be taxed on profits from the sale of such goods, irrespective of whether sales and purchase agreements are carried out abroad. If the goods are partially manufactured abroad, distribution principle may be applied, so that the company could pay tax only on a specific percentage of profit.
Other factors may also be required to consider, e.g. the place from which the company carries out its marketing and sales activities, or the place where orders and goods are processed, can also be important for determining the source of profit from trade.
Furthermore, some universal aspects are applicable to all companies irrespective of their activities. For example, if a company is managed from Hong Kong and / or has a principal place of business and operations in Hong Kong, it will in all likelihood be taxed in Hong Kong, unless it has a registered business presence abroad which can be used to attribute the profits.
Recently the need of such a business presence abroad has become more relevant, in particular, for the following reasons.
In order for a company to take advantage of income tax benefits from foreign sources, it must submit a tax calculation to the IRD requiring exemption from offshore taxes, together with a tax return and an audit report. The IRD will make its own investigation and, approve the application and issue a tax exemption letter, providing the investigation outcomes are positive. This process sometimes takes as long as six months.
A tax exemption may be granted for a certain period of time if a company derives offshore profits only, depending on the company’s activities, and providing the source of its profits remains the same which should be clearly stated in the company’s annual audit report. If a company earns revenue from both offshore and local sources, a tax exemption claim may need to be filed each year.
IRD can select a company’s transactions at a random sequence and dig deeper into the particulars of the transaction. Supporting documentation may be required from a Hong Kong company claiming an exemption from offshore taxes. The IRD is preliminarily deriving from the presumption that a Hong Kong company operates locally and therefore makes profit from local sources; hence the company will have to provide substantive evidence to prove the source of such profits as being derived from abroad.
This substantive evidence may include but not limited to:
- detailed descriptions and meeting minutes with customers and suppliers abroad,
- copies of passport visa stamps, airline tickets and boarding passes
- shipping documents,
- sale and purchase orders,
- confirmation of the presence of a business abroad, for example, documents on registration of a permanent representative offices (branches), or
- evidence that such profits are taxed or taxed abroad.
If the IRD is not satisfied with the documentary evidence provided by the company, the claim for exemption from income tax in the offshore zone will be rejected.
Recently, the tax inspectorate has adopted a more stringent model of operation, with the number of rejected claims increasing significantly. Moreover, thorough level of investigation leads to an increase in the processing time and a significantly higher costs of accounting and auditing.
As mentioned above, the main goal of the territorial taxation system is to avoid double taxation in the absence of DTTs. When profits are generated from foreign activities, income from such activities may be taxed in a foreign jurisdiction in accordance with its tax laws.
However, companies may sometimes try to “manipulate” or “abuse” certain schemes that result in “double non-taxation”, i.e. a situation when the profit is neither taxed in the country of the company’s tax residence, nor in the country where the actual business was carried out to generate income.
This practice has been severely censured and condemned by international organizations and institutions such as the OECD and the European Union, which will further elaborate later in the article.
Following the latest trends in international taxation, Hong Kong has not become an exception in this regard, and in order to protect its position as a well-known international financial and business community and avoid being blacklisted, the IRD has establishes tighter control measures over companies claiming exemption from income tax in offshore zones.
In addition, mechanisms have been established for the exchange of information through which the IRD can report and exchange information with the authorities of countries where profits were received as allegedly claimed by Hong Kong company as well as inquire and inform whether such profit was declared and/or taxed in that country.
In general, companies should carefully evaluate whether they have adequate standing for filing an application for income tax exemption in the offshore zone, and whether it is a worthwhile exercise, in view of the risks associated with potential rejection of application while still having to face the costs of accounting and audit related to the preparation of such application, as well as additional expenses related to inquiries and follow-up requests to and from the tax office in connection with the ongoing investigation.
Please note that if the offshore tax claim takes more than one year and is eventually rejected, the company may also incur fines and penalties as well as accrue overdue interest on taxes payable.
Therefore, a reasonable and effective approach would be to register a permanent establishment abroad. A Hong Kong company may try to open offices in certain strategic jurisdictions, for example, Labuan in Asia, Malta or Cyprus in Europe. Income from these PEs will be taxed locally at lower tax rates, and, confirming tax registration and liability, it is more likely that the IRD will provide tax exemption for such income. Read our article When is it beneficial to be a tax resident and pay taxes in Hong Kong in 2020? to learn more of the intricacies of this jurisdiction’s tax system. Our professionals at Offshore Pro will also be happy to guide you through your process of establishing a company in Hong Kong. Write us straightaway at [email protected] to seek professional help of our skilled consultants.
Singapore, being another large international financial and business center in East Asia, has been the jurisdiction preferred by a large number of entities conducting business in the region to set up their regional headquarters. This is especially the case in recent times, in view the political volatilities and turbulence which Hong Kong has been through.
As is the case with Hong Kong, Singapore, too, applies a relatively mild tax regime that follows the principle of territorial taxation. Unlike Hong Kong, however, Singapore is historically more stringent in terms of providing tax credits for income received from foreign sources.
In Singapore, corporate income tax is applied:
- on all income received in Singapore;
- on all income derived from Singapore sources;
- on all income from foreign sources transferred or recognized as being transferred to Singapore.
The general corporate tax rate is 17%, although various partial privileges apply, e.g. in relation to the first SGD 200,000 in profits. Capital gains on the sale of securities are generally tax-exempt, unless they constitute company’s normal business activity.
As defined by the Inland Revenue Authority of Singapore (IRAS), income from external sources consists in profits derived from trade or business activities carried out outside of Singapore, mainly:
- dividends from abroad,
- profits from foreign affiliates,
- fees for foreign services,
- Income from foreign property or interests may also be treated as income from foreign sources.
- Dividends distributed by a foreign company to a Singaporean shareholder will also be considered income from foreign sources.
When it comes to trade, income will be considered from external sources if it is received from a foreign branch, that is, a foreign permanent establishment whose income is taxed locally.
The service fees may be considered as an income from external source if derived from a fixed place of operation abroad, which can be, e.g. the venue from which management is carried out, or an office or some space where employees are stationed to provide services.
This fixed place of operations should be permanent, continuously accessible and used with the purpose of carrying out income-generating operations, rather than support activities. This “fixed place of operation” may be treated as a permanent establishment in another country.
Thus, a Singapore tax resident entity will not normally be positioned to avoid tax on its foreign trade or service revenue unless such income is taxed elsewhere. The “double non- taxation” on income from services and trade is rare when it comes to Singaporean companies. To ensure that income from foreign sources is not taxed in Singapore, it must be taxed in other places.
In addition, companies in Singapore are tax residents in Singapore if their place of effective management (for example, board meetings) is located in Singapore. However, for corporate tax purposes, IRAS is likely to be based on the presumption that the Singaporean company will be managed from Singapore and its income will be generated from local sources, unless it has a registered corporate headquarters abroad. Opposite to popular belief, it is usually impossible to use a Singapore company as “offshore” option.
We have clarified now what may be income from foreign sources that is exempt from Singapore taxes. However, as noted earlier, such income from abroad can be still subject to taxation in Singapore if such income is transferred to Singapore or considered to be transferred to Singapore.
The foregoing means that even if it qualifies as income from a foreign source, corporate tax is applied to such income if:
- it is transferred or received to a company bank account in Singapore; or
- it is used to pay off debts arising from a trade or business conducted in Singapore; or
- it is used to purchase any movable property that is transferred into Singapore.
However, certain tax incentives may be applied for dividends from foreign sources, profits derived from foreign branches and fees for services from external sources that are transferred to or received in Singapore by a resident company, providing the following conditions are met:
- the “taxable” condition;
- “General foreign tax rates at least 15%”; condition and
- The “preferential taxation” condition
The “taxable” condition is quite simple – foreign income should be qualified as taxable income in the foreign country from which it is sourced. Sometimes, IRAS may request paying company’s audited financials (in case of dividends), a tax return or withholding tax return (in case with branch profits and service charges).
The “taxable” condition can still be met even if foreign income is tax exempt in a foreign jurisdiction due to tax privileges established for core business activities carried out in that jurisdiction. In this case, the IRAS may request a copy of the tax incentive certificate or confirmation letter, after having investigated the tax return.
The condition “General foreign tax rates at least 15%” means that the highest corporate tax rate in a foreign country should be no less than 15%. For example, income from foreign sources from a tax-neutral jurisdiction transferred to Singapore will be taxed in Singapore.
Similarly, if income is taxed at lower rates due to a tax incentive (which should be substantiated by evidence), this condition still can qualify if the standard corporate tax rate in the country is at least 15%.
Finally, the “preferential taxation” condition is met if the IRAS believes that the tax exemption will be beneficial to the taxpayer.
Expenses related to exempted income from foreign sources received in Singapore cannot be used to deduct any taxable income.
Please note that in Singapore there are mechanisms to avoid double taxation when foreign tax is paid and local tax is levied on the same income. Singapore has a large set of double taxation treaties which usually envisage a tax credit on paid foreign tax, otherwise a one-way tax credit may be granted in respect of foreign tax on all income from foreign sources.
Visit our website to learn more of this particular jurisdiction’s tax system. Our professionals at Offshore Pro will also be happy to guide you through your process of establishing a company in Singapore. Send your requests at [email protected] and we will promptly get back to you.
Mainly owing to its tax system based on the territoriality principle, which is especially relevant in the shipping industry, Panama has historically been the jurisdiction of preference as an “offshore”.
In Panama, residents as well as non-residents are taxed only on income received from Panamanian sources. In Panama, the place of tax residence of the company is not taken into account when determining taxable income. Rather, the source of income is taken as a factor of relevance for determining taxable income.
Whenever a non-resident entity generates income from a Panamanian source, the tax is normally withheld at source. When a resident entity receives income from a Panamanian source, it is required to submit tax returns and pay tax on such income.
In Panama, taxable income is defined as income earned in the Panamanian territory, irrespective of the venue in which such income is received. Evidently, Panama employs a more extensive approach as compared to Hong Kong and Singapore.
Panamanian companies with place of businesses in Panama or earning revenue from local sources must receive a “Notice of Operation”.
Companies that receive Notice of Operation (onshore companies), as a rule, must submit annual reports and tax returns and pay taxes on their taxable income (income from local sources), while “offshore companies” without Notice of Operation which receive only income from foreign sources are relieved from most reporting requirements.
The Notice of Operation does not inherently give rise to tax liabilities; the company will still be taxed based on the territorial principle. However, this may generate tax liabilities for company’s shareholders. Payment of dividends to foreign shareholders from companies that have a Notice of Operation and generate income from foreign sources or export income may be subject to withholding tax at 5% (vs 10% standard rate).
From the point of view of the source of income, the income from the sale of goods that do not cross Panama inbound border is usually considered to be income from foreign sources and is not taxed, irrespective of whether purchase and sale agreements are concluded in Panama or managed by a local Panama office. Revenues from goods generated and exported from Panama are usually taxed if the company is not located in a special economic zone.
A service fee is considered offshore income, unless these services are provided in Panama to Panamanian customers. If services are provided from a Panamanian office to foreign clients, service fees may be exempt from taxes, providing the services are not attributable to the receipt of Panamanian source income by a foreign client.
Dividends received and capital gains from the sale of securities are also considered offshore income if the income of the base company is not a Panamanian source, irrespective of whether it is a company registered in Panama or a company registered abroad.
Interest income is also considered a foreign source income and is tax-exempt, if the company-borrower is located outside of Panama. Royalties from IP rights not used in Panama are considered non-taxable income, too.
In general, Panama applies a rather flexible system of territorial taxation, in which income derived from a wider class of operations with foreign customers is qualified as income from foreign sources and is thus exempt from tax.
However, Panama has not avoided suppression of “harmful tax regimes” by the Forum on Harmful Tax Practices (FHTP) and the EU Code of Conduct group (COCG) .
Requirements for economic substance were introduced to access tax benefits under the multinational headquarters regime and the Pacific Special Economic Zone, among other things. In addition, the COCG is currently investigating Panama’s territorial tax system, which may end up with the EU requesting amendments to tax legislation framework of the country.
A number of offshore jurisdictions have legislation on international business companies (IBCs) envisaging different tax treatment for companies owned by residents and non-residents.
IBCs were tax-exempt, while local companies were subject to higher corporate tax rates (25-35% towards global income). IBCs were legally or practically restricted in terms of doing business locally and transacting with residents. This was the case of Nevis, Belize, Saint Vincent and the Grenadines, Saint Lucia, Curacao, Antigua, Dominica, Seychelles and others.
FHTP and the EU have forced these jurisdictions to provide residents with access to international business structures and to abolish straightforward tax exemptions.
To preserve the industry of their corporate registrations, a number of jurisdictions such as Seychelles, Belize or Saint Lucia decided to introduce a territorial tax system.
Each regime had its own distinctions. For example, the provisions on territorial taxation under the Belize Income and Business Tax Act in Belize contain rather generic definition of what constitutes income from foreign sources that the EU qualified as ‘harmful’.
In order to avoid inclusion in the non-cooperating jurisdictions list for tax purposes (“ EU Black List ”), the Belize Income and Business Tax Act was amended in December 2019 to eliminate exemption from tax on income from foreign sources. Belize’s IBCs are now taxed on their worldwide income.
Authorities in jurisdictions such as Nevis or Saint Vincent have announced their intention to set up a territorial system of taxation. In light of EU feedback, these jurisdictions may have difficulty amending their tax laws so that they can support their offshore industry while meeting EU requirements.
In addition, the above made the EU focus not only on these new territorial tax regimes, but also on existing ones. The EU Code of Conduct group is currently reviewing the territorial tax regimes of large corporate and financial hubs to determine if they contain harmful elements.
Territorial taxation model: Outlook to the future
As mentioned above, one of the main issues considered by the EU Code of Conduct Group is the regimes allowing exemption on income from foreign sources.
As governing principles to jurisdictions, COCG has established new criteria and issued set of guidelines on what they view as a “harmless” territorial tax regime.
The main problem of COCGs are territorial taxation regimes, which often give rise to double non-taxation, i.e. when income is neither taxed in the country of “territorial tax” nor in the country of origin.
According to the COCG , such regimes are far too broad in terms of defining income from foreign sources without any conditions or guarantees, as well as provide no relationship definition corresponding to the ‘permanent establishment’ concept in accordance with the OECD Model Tax Convention on Double Taxation Treaties.
According to the COCG criteria, tax incentives for passive income from foreign sources can apply only in certain situations. The recipient company must have an economic substance or actual business operation in the jurisdiction in which it is resident in order to avoid aggressive taxation.
Therefore, the COCG demands that the requirements in relation to the economic substance and anti-abuse rules be introduced in order to avoid manipulative tax optimization schemes.
The COCG also noted that exemption from taxes on active income from foreign sources could result in situations not related to double taxation, and that such active income from foreign sources should be generated from a foreign permanent establishment in accordance with OECD standards.
The EU approach is that if active income from foreign sources is tax-exempt, it should be taxed in another place, i.e. the source of income. Countries should have adequate mechanisms for sharing tax information to prevent belligerent tax evasion or of direct tax avoidance from happening.
An entity claiming an income derived from foreign activities, should be able to prove having reported this economic presence and income in a foreign jurisdiction, so that the correct distribution of profits between jurisdictions and correct taxation models could be determined.
The COCG is now evaluating whether the territorial tax systems of the largest international financial centers do contain harmful characteristics. Countries which have been evaluated as of today, include Singapore, Hong Kong and Panama. Also other jurisdictions are under review, such as Malaysia, Costa Rica or Uruguay.
There are already tangible results from this trend internationally: particularly, as already discussed, the IRD in Hong Kong is imposing more stringent measures in considering whether to provide exemptions, and is consistent in requesting substantive evidence of taxes paid abroad and in exchanging information with tax authorities abroad.
Territorial taxation principle and source of income are generally misinterpreted by people with no or little experience in taxation.
The source of income, as a rule, is the country in which the operations are carried out that generate income, rather than the country in which the client or payer is located, or the country where the money is paid or accepted.
Thus, territorial systems of taxation are usually intended for companies to avoid double taxation when they have an economic presence in different jurisdictions, i.e. they would avoid taxation in the country of tax residency when the activities that generate income are carried out abroad.
Nevertheless, when a company has a permanent establishment abroad, it usually represents a permanent establishment, and it must be registered, for example, as a branch, and pay taxes on income earned by means of such PE presence.
Flexible tax regimes that applied the territorial principle have traditionally provided opportunities to companies to take advantage of non-double taxation.
However, the international tax environment is undergoing major shifts: OECD FHTP and EU COCG force jurisdictions to eliminate tax escapes and strengthen tax avoidance policies.
The relevant territorial tax jurisdictions are expected to follow EU and OECD guidelines and incorporate these “tax good governance” practices into their laws, setting more stringent rules for companies with regard to access to tax benefits.
Companies earning active income will have to substantiate their economic presence abroad by registering a PE and provide evidence that such income from foreign sources was taxed.
There are a number of mechanisms for sharing information, and more countries are becoming party to these bilateral and multilateral financial data sharing tools.
It is becoming increasingly difficult to legally manipulate loopholes and tax inconsistencies between countries with territorial taxation and other countries, as the regulations have become significantly more stringent.
Currently, tax structuring should be based not only on taxation aspects of business, but also commercial, operational, financial and tax strategies as a whole.
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