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Cost Accounting

by: Maxine Rogahn

Cost Accounting ACCT 321

Maxine Rogahn
GPA 3.76


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This 19 page Class Notes was uploaded by Maxine Rogahn on Monday October 12, 2015. The Class Notes belongs to ACCT 321 at Fayetteville State University taught by Staff in Fall. Since its upload, it has received 12 views. For similar materials see /class/221603/acct-321-fayetteville-state-university in Accounting at Fayetteville State University.


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Date Created: 10/12/15
WEEK SIX Tax Treaties Although this is not a course on international tax treaties these agreements play such a significant role in international taxation that they require discussion for this course Much of the taxation policy that has been discussed to this point is reliant on the existence of bilateral treaties between the US and trading partners or states as they are referred to in the context of treaties Treaties in general delegate taxing authority over certain income related to the treaty partners Once the taxing authority has been determined the domestic taxing laws come into play Treaties do not expand the taxing authority of the United States or any other country but in effect limit their jurisdiction They are designed to lower overall taxation which in turn will encourage international investment and trade Each state has a tax purpose in international trade right of residence or right of income source When treaties exist between states it allows the taxpayer to more carefully arrange their business and personal financial transactions and any clarification of tax rules can be resolved more readily Because the treaties contain provisions for exchange of information between contracting states the enforcement of domestic tax provisions is ensured International Double Taxation Defined The term quotdouble taxationquot is used in a variety of contexts so that the term may not always be appropriate The term is not defined in the OECD Model Treaty itself or in the Commentary to the treaty although the treaty identifies its main objective as quotthe avoidance of double taxation with respect to taxes on income and on capitalquot International double taxationquot has been defined as the imposition of comparable income taxes by two or more sovereign countries on the same item of income including capital gains of the same taxable person for the same taxable period This juridical or legal definition of international double taxation is a very narrow one excluding from its scope much of what commentators frequently refer to as double taxation It identifies what many commentators consider to be the necessary ingredients of international double taxation It is not always easy to determine whether double taxation exists under this definition in a particular case For example questions may arise as to whether the taxes levied by the two countries are comparable or whether the income items subject to tax are the same The legal definition of international double taxation must not be confused with the broader economic concept of double taxation Under the latter definition double taxation occurs wheneverthere is multiple taxation of the same items of economic income Under the legal definition taxation old a parent company by one country and of its subsidiary by another country is not international double taxation because the subsidiary corporation is a separate legal entity In the economic sense however double taxation may occur in this situation if for ex ample the parent is subject to tax on a dividend from its subsidiary because the parent and the subsidiary constitute a single economic enterprise Economic double taxation may arise when income is taxed to a partnership 1 and to the partners and when it is taxed to a trust and to the beneficiaries of the trust Individuals suffer economic double taxation when they are taxed on income as individuals and also as members of a household The methods for relieving double taxation use both the legal and the economic delineation of double taxation Double taxation relief sometimes extends to taxes paid by foreign subsidiaries and other foreign affiliates as dictated by the economic definition In most other contexts however the legal definition controls The reason is that the economic definition is exceedingly broad and difficult to specify with the precision needed for tax laws For example some economic double taxation occurs when income is taxed as earned and again as consumed Yet no country is prepared to extend double taxation relief to sales taxes or other consumption taxes Similarly countries are not prepared to grant relief from the economic double taxation resulting from the imposition of both an income tax and an estate or wealth tax International double taxation should be distinguished from internal or domestic double taxation The latter may arise for example when tax is imposed on the income of a person by both the central government of a country and one or more of its political subdivisions Double taxation by national and subnational governments is not necessarily objectionable Indeed when the levels of taxation are properly regulated to avoid excessive tax burdens such double taxation may be a useful feature of fiscal federalism Interaction of Tax Systems As mentioned repeatedly international activities by definition take place under more than one jurisdiction In particular transnational income flows fall under the jurisdiction of at least two countries and are thus potentially subject to at least two sets of tax rules The taxation of income arising from a foreign investment in a developing country is thus dependent apart from the host country tax rules discussed in the preceding chapter upon the tax laws of the investor39s home country The tax laws in the residence country of an investor provide the rules for taxing the income when received by the investor from a developing country If the recipient of the income is a company the income may be subjected to further taxation when it is realized by the shareholders Another aspect of home country taxation is the treatment of unremitted foreign source income this issue is primarily dealt with in the controlled foreign company legislation A tax treaty if one exists between the host country of an investment and the home country of an investor usually also has a significant impact on the taxation of income derived from the investment The main impact of a treaty is often brought about by limits imposed on taxation in the source country A nondiscrimination clause of a tax treaty can also influence the taxation of a subsidiary in its host country As for residence country taxation the role of treaties varies considerably among capitalexporting countries While the existence and wording of a tax treaty are crucial in many countries the United States does not let treaties affect the US taxation of its residents For some time now the tax treaty network between the OECD countries has been almost completed whereas developing countries have entered into tax treaties at a much slower pace However the treaty networks of LDCs have in recent years widened 2 at a considerably greater rate than before There has been a steady increase in the number of tax treaties between developed and developing countries especially since the 1970s This development was intensified by the work done by the Group of Experts within the United Nations in the 1970s The group prepared several reports on the subject and most importantly a model convention for tax treaties between developed and developing countries Until then the OECD Model Treaties although viewed critically by the LDCs had also served as the starting point for treaty negotiations between OECD countries and countries outside the OECD While this is still the case to some extent the UN Model at least provides guidelines for approaches which are potentially acceptable to both parties Although the contents of the UN Model eventually fell short of some developing countries39 hopes the model was a step in the direction generally preferred by Third World countries Among the industrialized countries the United States had for long been relatively slow to conclude such treaties but from the mid1980s on its network has significantly widened As for the developing nations the South and East Asian countries in particular entered into a great number of new treaties in the 1970s and 1980s Latin American States have traditionally been demanding in their treaty policies which is reflected in the relatively small number of treaties concluded by them with industrialized countries Model Income Tax Treaties Many European and other United States trading partners use a model treaty developed by the Organization for Economic Cooperation and Development OECD As international trade accelerated after World War II an organization known as the OEEC Organization for European Economic Cooperation formed a Fiscal Committee to address the potential problem of double taxation Eventually Canada and the US became members of the OEEC and the name was changed to the Organization for quot 39 f quot and l39 39 OECD Overt the years additional countries have joined the organization and numerous drafts were published prior to the 1977 OECD Model released in 1977 The OECD Model currently consists of 30 Articles that are aimed at the avoidance of double taxation It is used as a starting point to facilitate tax treaty negotiation between OECD member states In addition to double taxation and related matters it was recently revised to include articles on Multinational Enterprises and Tax Avoidance and Evasion The UN Model has had the task of facilitating the conclusion of tax treaties between developing and developed countries The developing countries felt they would be better served by a Model that favored capitalimporters to a greater extent than the OECD Model The UN Group follows the OECD Model very closely even though its goal was to express the view of the capitalimporting developing states The OECD 1977 Model has one additional Article that is related to Territorial Extension When designing tax treaties the US looks to blend its domestic tax rules with those of other states while preserving domestic tax jurisdiction over citizens and residents With this in mind the US has complied with a number of model income tax treaties to negotiate its treaties with other countries In recent years this has included the US Model developed in 1977 and revised in 1981 and 1996 US Model treaties were greatly influenced by the 1963 OECD draft and the current US treaties clearly resemble the 1977 OECD Model but contain significant deviations Most notably they include several rules that deal with perceived abuse of tax treaties contain a greater emphasis 3 on spelling out income source rules and contain different ideas related to the threshold rules for taxation of independent personal service income rental income for equipment leasing and auxiliary or preparatory activities under the permanent establishment concept While the two Models are very much alike the US Model and the OECD Model do not exactly mirror each other Dissimilarities include US maintains the right to tax citizens even when they reside in the other contracting state The OECD Model considers residence of a corporation the place of effective management US exemption for charities and pension funds for residents that the OECD Model does not The US Model assigns exclusive tax jurisdiction to the state where the recipient resides the OECD Model allows the source state a limited right to tax interest paid to a resident of the other state The US Model includes deferred profits in the profits of permanent establishment or fixed base even though it may have ceased to exist by the time these profits arise The US Model defines the term business profitsquot to include income attributable to derivatives and other financial instruments The US Model places more stress on treaty shopping by limiting the availability of treaty benefits to deter tax avoidance The US Model does not generally extend to state and local income tax laws the OECD Model does United States Treaty Making Process In the United States income tax treaties are negotiated exclusively through Executive Branch who has authority to conduct matters of foreign relations The Assistant Secretary for Tax Policy and the International Tax Counsel handle the negotiations and the President or their representative signs the treaty and passes it to the Senate for advice or consent Hearings are usually conducted by the Senate Foreign Relations Committee prior to approval or rejection then once approved the full Senate will vote for approval or rejection of the treaty The Senate may on occasion approve the treaty with reservations regarding certain provisions in which case the treaty will be in force except for the provisions in question The treaty will be in force once the exchange of instruments of ratification by the Executive Branch have taken place Income tax treaties are designed to avoid international double taxation by limiting the contracting States jurisdiction and though they can reduce taxes they should not increase them Treaty provisions should in no way be interpreted as ways to restrict exclusion exemption deduction or credit or any allowance that is allowed under the domestic law of the treaty partners Tax treaties should carry the same weight as domestic law Should conflicts with federal law arise the laterintime rule will apply for domestic purposes This rule may lead to violations in international law If Congress 4 enacts a statutory provision which overrides a preexisting treaty provision the latest statute outweighs for domestic law purposes However the US or any other contracting state must comply with treaty obligations or it will be in violation of international law under the Vienna Convention on the Law of Treaties Art 27 and Restatement of Foreign Relations Law of the United States 1351b Should a violation occur the only solution if for the other contracting state to terminate the treaty Neither the treaty provision or tax provision should have preferential standing RC 894a states code provisions should be applied with due regard to any treaty obligation the United Statesquot Income Tax Treaty Provisions Though income tax treaty provision variations do exist between the US and its treaty partners there are some provisions that are common to all US tax treaties Interpretation of Treaties Tax treaties have a dual status in that they are treaties between States and laws which can affect the domestic rights of taxpayers in those States Treaties between States are governed by public international law is their interpretation The principles of public international law that applies to treaties and their interpretation have been codified in the 1980 Vienna Convention on the law of Treaties Tax treaties are also incorporated into domestic law allowing the taxpayers to acquire rights and obligations through the states The interpretation of a tax treaty by a domestic court is governed by that State s domestic law It is clear to see that quot39 quot a 39 3939 o 39 may occur between public international and State levels Consistency requires that to every extent possible the approach to tax treaty interpretation be consistent as possible at both domestic and international levels All US tax treaties include a provision to establish hierarchy of interpretation rules that apply to the treaty terms Treaty terms are for the most part defined in each treaty and if not the context of the treaty may require defining Should the context of the treaty not require a particular definition the contracting state will apply its own domestic law Although domestic laws should not be changed arbitrarily for the purpose of altering the application of a treaty provision it is expected that the laws will change on occasion De nition of Key Terms The US Model treaty contains definitions of key terms that are used throughout the treaty The term resident is one of the terms that is central to any treaty application and must be clearly defined in each treaty since each contracting state may define residence differently under their domestic laws The importance of the term resident in the treaty is related to the fact that taxing authority is most often assigned to the state of residence Due to the different definitions of resident it is possible for a taxpayer to be resident in more than one state in which case the tiebreaker provisions would be applied If the taxpayer has a home in both states he or she would be considered resident where the center of vital interests such as economic and personal relations Treaty Scope The US Model Treaty Articles 1 2 and 29 discuss what the treaty covers in relation to territory people taxes and period of time US income tax treaties address federal income tax as might be expected but do not cover state and local taxes This is a sore spot to many treaty partners who would like protection from unfair state taxation in that some states tax income not connected to activities in that state Treaties have not fixed duration of time and can be terminated with six months notice by the contracting state Treaties generally will limit the amount of tax liability on the residents of contracting states but will ensure the ability to tax US residents and citizens on worldwide income through a saving clausequot In other words while a Canadian resident may be ensure that he does not pay US tax on interest paid by a US borrower the saving clausequot will allow a Canadian resident who is a US citizen to be fully taxed on interest income Though the US has the responsibility of ensuring that double taxation does not occur the US can tax the interest of the Canadian resident who is also a US citizen even if the interest is paid by a Canadian borrower Treaties are never to be intentionally applied in a manner that denies the taxpayer benefits that would be accrued if the treaty did not exist eg cannot increase taxes over what they would be without a treaty including deductions etc Taxpayers may divide categories of income so that some will be allowed the statutory treatment while other income would be allowed the benefits of the treaty Within Articles 621 of the US Model you will find the rules that classify the types of income and assign to one or the other of the contracting states the taxing authority Business Income Business income that is derived in the one contracting state by a resident of the other contracting is not taxed unless that is income is found to be attributable to a PE that is located in that state Without a PE any income that would be taxed in the state where the income is earned should there be no tax treaty is not taxable in that state In other words if a foreign business were doing business in the US but not from a PE that business would not be taxable in the US if an applicable tax treaty is in place Although there are some variances from treaty to treaty in the definition of permanent establishment it usually can be described as one that is a facility construction site or agency relationship that have some degree of permanence For a facility this would include Place of management Branch Office Factory Workshop Place of extraction of natural resources A construction site would include Building site Constructioninstallation project Drilling rig for exploration of natural resources if the project lasts more than 12 months A dependent agent of the taxpayer with authority to negotiate and finalize contracts as a representative of the company and one who regularly exerts assigned authority can be considered a permanent establishment of the company principle An independent agent who is only handling the normal business of an agent would not be considered a PE of the principle Should a parent company in state ABC have a subsidiary in state XYZ the subsidiary would not constitute a permanent establishment of the parent simply due the parent s ownership which enables state XYZ to tax some of the parent s profit If however the subsidiary acts as an agent of the parent with authority to regularly conclude contracts in the parent s name the subsidiary may be considered a permanent establishment of the parent When considering a partnership PE of the partnership or of any partner is attributed to all partners According to Article 54 of the US Model a permanent establishment does not include the following Use of facilities or the maintenance of a stock of goods or merchandise in a contracting state for storage display deliver Maintenance of a stock of goods or merchandise solely for processing by another enterprise Maintenance of a fixed place of business for the purpose of purchasing goods or merchandise or collecting information Maintenance of a fixed place of business solely for engaging in any other activity of a preparatory or auxiliary character Only the business profits that are connected to the permanent establishment are subject to tax in the state where the permanent establishment is located Attributable toquot is defined as net income that is produced by the permanent establishment as if it were an independent entity operating at arm slength Business profits are generally defined as those derived from the active conduct of a trade or business including rental of tangible property and services Deductions reasonably connected with income productions from the PE including overhead will reduce the amount of income that is taxable by the state where the PE is located Under US Model 1996 Art 78 counterpart to RC 864c6 if the permanent establishment is no longer in existence any income received by the resident that is generated by or connected to the PE will still be taxable income attributable to the PE The US Model does deal with certain income separately such as income from shipping and air transport in international traffic by a direct operation orfrom rental activities This income would be taxable in the state of residence of the of the person or entrepreneur conducting the business as opposed to the state in which the income is produced even if it is attributable to a PE in that state The reason for this is a concern that issues related to allocation could result in multiple taxation of shipping profits Article 6 is another example Income gained from real property may be taxed in the state where the property is located The income could also be taxed in the property owner s state of residence if relief from double taxation is allowed for any situs state taxation This applies to both business and investment income from the property Articles 67 and 8 of the US Model have to do with allocation of business profits within an enterprise Article 9 allows business profits to be allocated between associated enterprises to reflect the arm slength relationship and makes possible RC 482 and its related provisions Income from Personal Services Income derived by an individual resident of a contracting state for the performance of independent personal services is addressed under Article 14 of the US Model This income is taxable only in that state even if the services are performed in the other contracting state unless the income from these services is attributable to a fixed base in the other contracting state The term fixed basequot has much the same meaning as permanent establishmentquot however it does not require same amount of permanence to trigger taxation in the other contracting state Under US Model 1996 Art 15 should an individual resident of a contracting state perform dependent personal service as an employee in the other contracting state the state in which the service was performed has the taxing authority on any income received if certain conditions are met 1 the recipient of the income is present in the state where services are performed for more than 183 days during a taxable year 2 the pay is paid by or on behalf of a resident of that state or 3 the pay is deducted by a permanent establishment of fixed based that the employer maintains in that stated Any pensions obtained by an employee will be taxable only in the employee s state of residence per US Model 1996 Art 181 According to the IRS a pension is a pension if payments meet the following requirements 1 the recipient has been employed for at least 5 years or they are 62 years or older at the time the payment is made 2 the payment is made a on account of the employee s death or disability b as part of a series of substantially equal payments over the employee s life expectancy or c paid on account of the employee s retirement after 55 and 3 all payments are made after the employee has separated from service on or after the date at which the employee reached the age of 705 Any bonuses that are paid to an individual after retirement do not constitute pensions under Article 18 but are covered by Article 15 Rev Rul 71478 19712 CB 490 There are other provisions within the US Model that address income for personal services such as income earned by artists and athletes This income is taxable due to the size of the income even though it cannot be attributed to a PE or fixed base Fees for corporate directors and other compensation obtained by a resident of a contracting state for services rendered in the other contracting state is taxable in the company s 8 state even though the director does not maintain a fixed base in that state See US Model 1996 Art 16 Other special rules apply for students trainees and government employees Investment Income There are specific provisions in the US Model that address taxation of dividends interest royalties rental income from real property and capital gains If no treaty exists dividends from US sources that are paid to a nonresident of the US would normally be subject to a 30 percent withholding tax on the gross amount paid These rates are usually modified somewhat by US tax treaties in that a reciprocal rate reduction is imposed on dividends distributed to a resident of the other contracting state by the source state Under Article 10 of the US Model the maximum source state treaty tax rate on dividends is 15 Some treaties reduce the maximum rate to 5 for dividends paid to a corporation owning as little as 10 of the voting stock of the dividendpaying corporation In effect this limiting of source state rate of taxation by treaties reduces the incidence of double taxation If a dividend recipient is taxed both by the source state and the residence state the residence state is required to relieve any double taxation US branch profits tax was enacted to substitute tax for any tax that might be payable on dividends paid by a foreign corporation out of US earnings and profits Under the 1996 US Model the US may impose its branch profits tax on income repatriated from a US branch to a foreign corporation s home office Tax on that repatriation is the same as that which would be imposed on a US corporation making a dividend payment to its foreign parent corporation the tax rate would be 5 Interest under the US Model is treaty in a similar manner as dividends in that it limits the source state taxation The differences are that Article 11 does not permit any taxation of interest by the source state although those US treaties based on the OECD Model permit the source state to tax interest at a rate not exceeding 10 Similarly royalties derived and beneficially owned by a resident of a contracting state are taxable only in that state under the US Model Developing states that adhere to the UN Model do not allow limited source state taxation usually at rates not exceeding 1520 of the royalty Under US Model 1996 Arts 106 dividends 113interest and 123royalties should interest dividend or royalty income derived by a recipient be attributable to a PE that the recipient maintains in another contracting state the income is then treated as business profits fully taxable in the state where the PE is located Source state taxation of income form dividends interest and royalties is limited by the US Model However income obtained by a resident of a contacting state from real property situated in the other contracting state could be fully taxed under Article 6 in the state where the property is located If the domestic provisions of that state would tax income from real property on a gross income basis Article 65 would allow the recipient an election to tax the income on a net basis For determining taxing jurisdiction on gains from the sale of investment property the nature of the property would have to be considered If the gain from the sale of real property or an interest in an entity whose property consists primarily of real property it will be subject to tax in the contracting state in which the property is located under its 9 domestic law Income from the sale of personal property that is attributable to a PE is taxable in the contracting state where the PE is located Income from the sale of stock or securities is normally taxable only in the state of the seller s residence Other Income lncome that is not precisely covered in the US Model is subject to taxing authority only in the residence state of the recipient according to US Model Art 21 Limitation of Benefits Treaty Shopping I am sure it is of no surprise to any of you that foreign taxpayers investing or performing business activities in the US very often attempt to structure their business and personal transactions so as to take advantage of favorable income tax treaties Treaty shopping as it is known is also used by US taxpayers to lower foreign taxes on income earned in another jurisdiction Of course the US government frowns upon this practice and has spent an inordinate amount of time trying to resolve this problem There are two methods of treaty shopping A taxpayer of a state that has no treaty with the US may seek the coverage of a favorable treaty or a taxpayer of a US treaty partner may prefer the treaty of another state A foreign taxpayer investing the US may seek a treaty that provides a low rate of taxation by the US on investment income generated in the US Without restrictions a treaty with one state could become a treaty with any country in the world The US currently requires that a limitation on benefits provision be inserted in each treaty There are variations in the nature of these provisions however typically a treaty might provide that certain benefits are not available if 505 or more of a corporation s stock is held by thirdstate taxpayers unless publicly traded Nondiscrimination Since the primary purpose of an income tax treaty is to maximize the free flow of international trade by minimizing the impact of taxes treaties generally contain bilateral assurances that each treaty partner will not us excessive taxation as a projectionist device Residents and nationals of each state should have the same advantages and disadvantages as the residents and nationals of the other state The nondiscrimination commitment is a promise by each partner that in exercising their sourcebased and residencebased jurisdiction they will not tax nationals and residents of the other state more heavily than their own similarly situated nationals and residents The nondiscrimination article will provide that a citizen of one contracting state resident in the other state will not be treated less favorably than a citizen of the other contracting state given equal circumstances This is true for both individuals and corporate entities Also nondiscrimination articles prevent a contracting state from denying deductions for interest royalties or other disbursements paid to a resident of the other contracting state if the same payments would be deductible if paid to a resident of the state of a payor The nondiscrimination article does not mean however that all nonresidents will be taxed in the same manner as residents but only the same as similarly situated individuals The 10 article does apply to every kind of taxes including those imposed by states and other local authorities Mutual Agreement Procedure There is also a mutual agreement procedure provision that is contained in most treaties This allows for resolution of treaty disputes Should a taxpayer claim that the action of the tax authorities of a contracting state has resulted in taxation that violates the treaty competent authorities of both contracting states will attempt to reach an agreement to avoid double taxation These competent authorities can enter into an agreement which may modify domestic law to 1 resolve specific cases in which a taxpayer alleges violation of a treaty 2 agree upon interpretation and application of a treaty provision and 3 to eliminate double taxation in cases not expressly provided for in the treaty Competent authority in the US is the Secretary of the Treasury or his delegate which is the Assistant Commissioner Types of issues that make require resolution are 1 attribution of income to a permanent establishment 2 allocation of income between related persons 3 characterization of income items 4 application of source rules as related to income 5 definition of terms 6 application of domestic law relating to penalties fines and interest Probably the largest part of the competent authorities responsibility is related to business profits and deductions between permanent establishments in one state and home offices in another or the allocation of income and deductions between related taxpayers in different states Exchange of Information and Assistance Provisions obligating treaty partners to provide information to each other is also part of all US bilateral income tax treaties The partner is authorized to use any administrative information gathering powers to obtain any necessary information including routine and spontaneous exchange of information concerning names of payees and interest amounts dividends and royalties paid to residents of a treaty partner exchanges made upon request by a treaty partner examinations of related taxpayers exchange of industrywide information The taxpayer must be provided with notice allowing an opportunity to suppress any third party summons by the RS The RS does not have 11 to provide notice if it provides information in its own possession to a treaty partner although an opportunity for review may be allowed by the Treasury The US has also entered into tax information exchange agreements or TlEAs with countries that are not treaty partners in order to facilitate international cooperation of enforcement of tax laws The US has also ratified the multilateral OECD Convention on Mutual Assistance in Tax Matters which provides for information exchanges especially helpful in the area of tax avoidance and money laundering A treaty partner may choose not to provide information only if it would require administrative measures which violate the law or administrative practice of either treaty partner if the information is not obtainable in the normal tax administration of either treaty partner or if the information requested would disclose any trade or business secret As we have already discussed most countries tax on the basis of both the residence status of the taxpayer and the source of income So it is possible that foreignsource income earned by a resident of a country may be taxed by both the country of source and the country of residence unless there are relief provisions to prevent double taxation International double taxation can arise from a variety of causes Tax treaties typically provide relief from the three major types of international double taxation and from some of the other types as well Double taxation resulting from source source conflicts is addressed by seeking some uniformity in source rules For example Article 11 5 of the OECD model Treaty provides rules concerning the source of interest income Most tax treaties do not contain extensive source rules Instances of the source source type of double taxation that are not resolved by the specific provisions of a treaty may be resolved through consultation between the tax officials by the two treaty countries the quotcompetent authoritiesquot under the treaty39s mutual agreement procedures Resolution of such issues however is not always easy lndividual taxpayers almost always obtain relief from international double taxation resulting from residenceresidence conflicts through tax treaties Many residence residence conflicts involving legal entities are also resolved by treaty Article 42 of the OECD Model Treaty provides a series of quottiebreakerquot rules to resolve cases in which an individual is resident in both countries The question of dual residence of a legal entity is resolved under the OECD Model Treaty by deeming the entity to be resident in the country where the place of effective management is located This tiebreaker rule may be modified by countries using the placeof incorporation test for determining the residence of a corporation The mutual agreement procedure is available to deal with some dualresidence cases Relief from double taxation resulting from the imposition of tax by a residence country and a source country on the same income is generally granted by the residence country In other words the source country39s right to tax has priority over the residence country39s right Relief Mechanisms Although no international consensus has been reached on the appropriate method for granting relief from international double taxation Three methods the deduction method the exemption method and the credit method are commonly used in providing relief from 12 double taxation A country may use only one of these methods or some combination of methods Deduction method The residence country allows its taxpayers to claim a deduction for taxes including income taxes paid to foreign government in respect of foreignsource income Exemption method The residence country provides its taxpayers with an exemption for foreignsource income Credit method The residence country provides its taxpayers with a credit against taxes that would otherwise be payable for income taxes paid to a foreign country In some instances the credit extends to income taxes paid to foreign subnational governments Foreignsource income earned by residents of a country that uses the deduction method generally is assessed at a higher effective tax rate than it would be under either the credit method or the exemption method The exemption method and the credit method typically give equivalent results whenever the effective foreign tax rate is equal to or greater than the domestic effective rate The exemption method generally provides the most favorable results for the taxpayer when the foreign effective tax rate is less than the domestic effective tax rate 1 Deduction Method Countries using the deduction method tax their residents on their worldwide income and allow those taxpayers to take a deduction for foreign taxes paid in the computation of their taxable income In effect all foreign taxes are treated as current expenses of doing business in the foreign jurisdiction The deduction method provides the least relief from international double taxation The deduction method was popular in the early years of some State tax systems when worldwide tax rates were low As tax rates increased after World War II most countries have adopted either the exemption method or the credit method Only the exemption method and credit method are sanctioned by the OECD Model Treaty and UN Model Treaty as methods of granting double tax relief A number of countries that adopted the credit method have retained the deduction method as an optional form of relief and as a way of dealing with foreign taxes that are not creditable for one reason or another In addition some countries use the deduction method for taxes paid with respect to income derived from foreign portfolio investments Countries are using the deduction method whenever they tax residents on the net amount of the dividends they receive from a foreign corporation assuming the foreign corporation has paid some foreign income tax and a foreign tax credit is not allowed with respect to that tax The result of the deduction method is that residents earning foreignsource income and paying foreign income taxes on the income are taxable at a higher combined tax rate than the rate applied to domesticsource income The deduction method creates a bias in favor of domestic investment over foreign investment wheneverthe foreign investment is likely to attract a foreign income tax Not only is domestic investment encouraged but residents with equal net worldwide income are treated equally in that they will pay the 13 same domestic tax However when viewing the total combined domestic and foreign tax burden on a taxpayer39s worldwide income the deduction method does not achieve equal treatment of residents Although residents with equal net worldwide income will pay the same domestic tax they may pay widely different amounts of foreign tax The deduction method is not neutral in terms of the allocation of resources between countries 2 Exemption Method Under the exemption method the country of residence will tax its residents on their domesticsource income and exempts them from domestic tax on their foreignsource income Jurisdiction to tax rests solely with the country of source The exemption method completely eliminates residencesource international double taxation because only one jurisdiction is imposing tax Variations of the exemption method have been adopted by some States to deal with income derived by resident companies through foreign affiliates or foreign branches located in tax haven countries Under this method the exemption of foreignsource income from domestic tax applies only if the income is subject to tax by the foreign country or subject to a minimum rate of tax by the foreign country Another variation of an exemption system allows foreignsource income to be taken into account in determining the rate of tax applicable to the taxpayers other taxable income This is referred to as exemption with progressionquot In such systems the foreignsource income will first be included in income for the limited purpose of determining the average tax rate at which the taxpayer would pay if the foreign income were taxable The average rate is then used to compute the actual tax due on domesticsource income The exemption method is relatively uncomplicated for the tax authorities to administer and is effective in eliminating international double taxation where as the exemptionwith progression system is more complex This system requires the tax authorities to get information about the amount of foreignsource income earned by resident taxpayers though it does ease the unfairness of a pure exemption system Although the exemption method is widely used and is sanctioned by both the OECD and United Nations Model treaties see Article 23A of both treaties it does not meet the tax policy objectives of fairness and economic efficiency because foreign taxes are lower than domestic taxes Resident taxpayers with exempt foreignsource income are treated more favorably than other residents An exemption system also encourages resident taxpayers to invest abroad in countries with lower tax rates especially in tax havens and to divert domesticsource income to such countries A taxpayer residing in an exemption country who earns interest on investments in that country has a real incentive to move the investments to a foreign country that imposes low or no taxes on interest Income With all of this said it is clear that a full exemption method of relieving double taxation is hard to justify whereas a partial exemption system might be justified In a partial exemption system a country will exempt taxpayers on income derived from countries that are committed to imposing taxes at rates that are roughly comparable to its own rates and conditions If properly enforced the result will be similar to the result obtained under a credit system because a country using the credit method in such circumstances would collect little or no tax with respect to the income 14 The partial exemption system may minimize compliance costs for taxpayers and administrative costs for tax authorities The partial exemption system can only work effectively if States can prevent taxpayers from improperly treating income earned in tax haven countries as income derived from exempt countries and from allowing taxpayers to artificially shift deductions properly attributable to income derived from the exempt country to income derived in a tax haven country 3 Credit Method Under the credit method foreign taxes paid by a resident taxpayer on foreignsource income usually reduce domestic taxes payable by the amount of the foreign tax Credit countries invariably do not refund taxes when their taxpayers pay a foreign income tax at an effective rate that is higher than the domestic effective tax rate See for example Article 23B of the OECD Model Treaty Also they do not allow the excess foreign tax to offset taxes imposed on domestic income Various complex limitations may be used to prevent what are considered to be inappropriate uses of foreign tax credits Because of these limitations on the credit foreign income is usually taxed at the foreign effective tax rate whenever the foreign rate is higher than the domestic rate Under the credit method foreignsource income earned by residents is generally taxed at the higher of the domestic and foreign tax rates Under the credit method resident taxpayers are treated equally from the perspective of the total domestic and foreign tax burden subject only to an exception for the situation when foreign taxes exceed domestic taxes The credit method is neutral with respect to a resident taxpayer39s decision to invest domestically or abroad Many countries allow foreign income taxes that cannot be credited in the current year to be carried forward and credited against domestic taxes in future years The carry forward period differs from country to country Limitations on the credit apply to these excess foreign tax credits in those future years In terms of tax policy the credit method is recognized to be the best method for eliminating international double taxation It must be mentioned however that the operation of a foreign tax credit system can be complex from both the government and taxpayer sides Questions that must be resolved would include What foreign taxes are creditable How should the limitations on the credit be calculated On a sourcebysource basisOn a countrybycountry basis or on an overall basis with various special rules applicable to certain types of incomeOr some combination of these methods What rules should be adopted for determining the source of income and deductions Should a credit be allowed for the underlying foreign taxes paid by a foreign affiliate on its income out of which it pays dividends Detailed highly complicated legislative provisions are needed to resolve these and other matters if the credit method is to operate effectively The compliance and administrative burdens imposed on taxpayers and tax authorities as a result of these complex rules are necessary and justifiable for income earned in tax haven countries since domestic tax could be avoided by diverting domesticsource income to tax havens 15 If the domestic tax burden in a foreign country is comparable to the burden imposed on taxpayer s domestic source income a credit system may not be worth the trouble It is unlikely that a country will collect significant domestic tax amounts from those taxpayers with respect to their foreignsource income after allowing them a credit for foreign taxes Some countries have determined that the costs of a full credit system in such circumstances are too high It is possible that a foreign tax credit system could encourage a source country to increase taxes on income earned by nonresidents to that of tax in the country of residence Such a tax increase would not affect the aftertax return to nonresident investors and this would not discourage foreign investment It may result in a shift of tax revenues from the country of residence to the source country The United States includes provisions in its foreign tax credit rules to prevent the taxes of countries that discriminate against foreign tax credit countries from qualifying as creditable foreign taxes Credit method is currently used by many countries to eliminate international double taxation These countries may grant a credit for foreign taxes unilaterally others grant a credit only pursuant to bilateral tax treaties Most credit countries grant the credit both unilaterally and by treaty Some countries have extended their foreign tax credit mechanisms to encompass tax sparing which is discussed in another section A number of credit countries offer what is commonly referred to as an quotindirectquot foreign tax credit The indirect credit is a credit given to a domestic corporation for the foreign income taxes paid by a foreign affiliate It is given at the time the domestic corporation receives a dividend distribution from its foreign affiliate The amount allowable as a credit is the amount of the underlying foreign tax paid on income out of which the dividend was paid In most cases foreign tax credit is allowable only forforeign income taxes that a resident taxpayer pays itself The indirect credit rules ignore the separate corporate existence of the domestic and foreign corporations for the limited purpose of allowing the credit To claim a credit for taxes paid by a foreign affiliate the domestic corporation must own at least a minimum percentage usually 10 percent of the capital of the foreign corporation To avoid creating a bias against the repatriation of profits a credit country could tax the income of foreign affiliates on an accrual basis Accrual taxation eliminates the deferral of the residence country tax on the foreignsource income earned by residents through foreign affiliates Although numerous proposals have been presented from time to time non have been adopted in any country although the accrual taxation method is used in some circumstances The controlled foreign corporation rules impose domestic taxes currently on certain income earned through a foreign affiliate in what considered to be abusive situations The rules designed to govern the indirect foreign tax credit are typically the most complicated part of a foreign tax credit system The indirect credit is allowed only when a domestic corporation has received a dividend from a foreign affiliate The amount allowable as a credit is the amount of foreign income tax properly attributable to that dividend Difficult timing and income measurement issues must be resolved to allow a corporation to compute that amount For example the domestic corporation typically must determine the profits of the foreign affiliate out of which the dividend was paid 16 Those profits may have been earned many years in the past and may have been computed in a foreign currency under tax rules that differ significantly from the tax rules applicable to the domestic corporation 4 Treaty Considerations As mentioned above the OECD and UN model treaties authorize both the credit and exemption methods The deduction method is not authorized The treaty provisions only establish the general principle of exemption or credit Each country is left to establish detailed rules forthe implementation of the general principle Some countries provide in their domestic legislation a unilateral exemption for foreign source income or a unilateral credit for foreign taxes paid or deemed paid by a foreign affiliate in addition to the relief provided by treaty Treaty relief is still important however because it may be more generous than the unilateral relief and because it constrains a country39s ability to amend its domestic law to withdraw the double taxation relief afforded to nonresidents D Allocation of Expenses Whether a country uses an exemption method or a credit method in providing relief from international double taxation rules should exist for allocating a proper portion of the expenses incurred by its taxpayers between their foreignsource gross income and their domesticsource gross income Most countries recognize the need for such rules when they are taxing nonresidents on their domesticsource income They routinely deny such 39 39 a 39 39 quot for unless those expenses are properly related to the earning of the domestic income subject to tax Few countries seem to be as aware of the comparable need to apportion properly the expenses of their domestic taxpayers between domesticsource and foreignsource income For countries that exempt foreignsource income expenses incurred by the taxpayer to earn the income should not be deductible For example a taxpayer should not be allowed to deduct its interest expense on borrowed funds used to earn exempt foreign source income A country that allows such expenses to be deductible provides its taxpayers with an incentive to earn exempt foreignsource income rather than taxable domesticsource income In effect the country is providing an exemption not only for foreignsource income but also for a portion of domesticsource income Most countries lack specific rules for attributing expenses to foreign source income Two approaches that might be used for that purpose are tracing and apportionment A tracing approach involves a factual inquiry into the connection between the expenses and the foreignsource income Apportionment involves the allocation of expenses by formula either on the basis of the proportion of the taxpayer39s foreign assets to its total assets or the proportion of its foreign gross income to its total gross income Unlike tracing apportionment is based on an assumption that the relevant expenses were incurred to govern all of the taxpayer39s assets or income equally Countries that have a foreign tax credit system should allow resident taxpayers to deduct expenses incurred to earn foreignsource income because those taxpayers are taxable on their worldwide income As explained above however the foreign tax credit is invariably limited to the amount of the domestic tax otherwise imposed on foreignsource 17 taxable income The amount of foreignsource taxable income must be computed properly therefore or the limitation on the credit will be improperly inflated To compute foreignsource income properly the taxpayer should be required to deduct from foreign source gross income the expenses incurred to earn that income An appropriate amount of expenses should also be attributed to foreignsource income for purposes of computing the limitation on the indirect foreign tax credit In addition the indirect credit raises the issue of the timing of the deduction of expenses incurred by a resident parent corporation to earn foreignsource income through a foreign affiliate Residencecountry tax on foreignsource income earned through a foreign affiliate is generally postponed until the resident parent receives a dividend or other taxable distribution Interest and other expenses incurred by the resident taxpayer to earn that deferred income should not be deductible at least theoretically until the income to which they relate is subject to taxation These payments should become deductible when the resident taxpayer receives a taxable distribution of the related income from its foreign affiliate No country currently attempts to deal with this timing issue E Tax Sparing Some tax treaties as mentioned earlier provide for quottax sparingquot most often through a tax sparing credit A tax sparing credit allows the taxpayers to claim a foreign tax credit for a tax in the other contracting state not actually paid to the source country but that would have been paid under the country s normal tax rules The usual reason for the tax not being paid is that the source country has provided a tax holiday or other tax incentive to foreign investors as an encouragement to invest or conduct business in the country In the absence of tax sparing the actual beneficiary of a tax incentive provided by a source country to attract foreign investment may be the residence country rather than the foreign investor This result occurs whenever the reduction in sourcecountry tax is replaced by an increase in residencecountry tax Tax sparing is primarily a feature of tax treaties between developed and developing countries Many developed countries extend some form of tax sparing to developing countries by way of treaty as a matter of course Some developed countries have voluntarily granted tax sparing in their treaties with developing countries as a way of encouraging investment in those Countries Other developed countries have granted the tax sparing credits only reluctantly Some developing countries traditionally have refused to enter into a tax treaty with a developed country unless they obtain a tax sparing credit The United States is adamantly opposed to tax sparing and has not granted it in any of its tax treaties Consequently for many years it concluded very few tax treaties with developing countries The US position is that the grant of a credit for phantom taxes taxes not actually paid is inconsistent with the efficiency and fairness goals of its foreign tax law It has been characterized as quotarrogantquot quotimperialisticquot and quotpatronizingquot but it is a defensible assessment of the effects of tax sparing In recent years the hard line view of many developing countries has softened The credits cannot be divorced from the merit they encourage Although tax incentives have some enthusiastic supporters in the political arena they are impossible to justify on the basis of tax policy analysis Certain targeted incentives aimed at achieving some identified goal may be justified but those incentives are so narrowly drawn to prevent abuse that they tend to 18 generate little political conclusion to be drawn from and only rarely do the potential benefits justify the likely costs A developing country wishing to use tax incentives to attract foreign investment should not be thwarted by a failure to obtain a taxsparing article in its tax treaties Tax sparing obviously is not needed if the country of residence of the potential investors is using the exemption method to avoid double taxation For these investors the sourcecountry tax is the only tax Thus any deduction in source taxation automatically accrues to their benefit There are several ways that tax incentives may benefit residents of credit countries in the absence of tax sparing Many US multinationals benefit from host country investment incentives because of the way the US overall limitation on the foreign tax credit operates Under this limitation provision US corporations that have paid high foreign taxes in one country such as Germany can use what would otherwise be excess foreign tax credits to offset the US tax otherwise imposed on foreign business profits subject to low foreign taxes in another country such as Belgium


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