The Principles of International Tax Planning

Ankita Tiwari

16 Feb, 2023

Trade between two or more countries attracts international tax. In the current scenario, it is impossible for a country to not have any international transactions. The business structures have evolved and the transactions have become intensely intermingled. It becomes very important for the tax laws of one country to cope with that of the other country. However, it is an unrealistic scenario for countries to always have similar laws. The laws within a country might as well not be similar. Due to this tax evasion whether deliberate or not, has also risen. This makes tax planning very important especially while making international transactions. Tax planning is a method to mitigate tax liability by undertaking measures within the four corners of the law. Once these measures step out of the four corners of the law, it becomes tax evasion. Tax evasion is illegal as it is the commission of an act prohibited by law. In international transactions, tax planning becomes even more important due to the difference in laws among countries and the various international tax treaties which come into the picture. Tax planning is a combination of a financial and a business decision to minimize tax liability and avail maximum benefit.

Principles of International Tax Planning

The Principles that have to be followed while international tax planning is:

Double Taxation Avoidance Agreements (DTAAs)

Double taxation and double non-taxation are the main reason for the emergence of international tax planning. Double Taxation means tax is levied by both countries on one transaction. On the other hand, double non-taxation means that a transaction goes un-taxed in both contracting states. The purpose of tax planning is to remove the instances of double taxation and double non-taxation and promote international trade. This has led to the adoption of unilateral and bilateral reliefs. The unilateral reliefs apply when there is no mutual agreement between two contracting states and the home country provides certain reliefs to its residents. On the other hand, Bilateral reliefs are those reliefs in which two contracting states negotiate and decide on how and where to tax a particular income. These bilateral agreements are called DTAAs. DTAAs is a major source in tax planning.

The types of relief provided by DTAAs can be broadly categorized into four methods:

1. Exemption Method- Under this method, foreign income is exempt from tax in the resident country. Only the domestic income of residents is taxed in the resident country.
2. Tax Credit Method- Under this method, the residence country taxes the worldwide income of the taxpayer however it provides a tax credit on the income on which tax has already been charged in the source country. The tax credit offsets the tax paid by the taxpayer in the foreign country.
3. Deduction Method- Under this method, the tax paid in the source country is allowed to be deducted as an expense in the resident country.
4. Reduced Rate Method- Under this method, income from a source country is taxable in the resident country at a reduced rate.

Connecting Factors

The connecting factors help determine the jurisdiction where tax shall be levied. Tax planning helps identify whether the tax shall be levied on an individual or an entity. Further tax planning also helps identify under which rule an individual or an entity is to be taxed.

• Residence Rule and Source Rule

Two connecting factors determine the tax jurisdiction for individuals are:

1. The personal base of jurisdiction or the Residency Rule
2. The territorial base of jurisdiction or the Source Rule

The former depends upon the relation taxpayer has with the country, such as residence, domicile, or nationality. The latter depends on the place from where income generates. Most nations adopt a mixture of both wherein they tax residents on their global income and non-residents on income generated in their nation.

• Residency for companies

It depends upon factors like place of incorporation or place of registered office and place of effective management of business (POEM). When a jurisdiction’s residency determining factors are the place of incorporation or registered office, the company incorporated or registered in this jurisdiction shall be its resident. The state in which a company is legally incorporated or registered in its residence state. On the other hand, residence based on POEM means the place where key strategic and managerial decisions are taken shall be the resident state. Key strategic and managerial decisions signify the final decision-making power or superior control. It is a subjective concept and is ultimately based on the facts and circumstances of the case.

• Permanent Establishment (P.E.)

The presence of P.E. in a country primarily enables a country to tax the income generated in that country. It also means that in the presence of a P.E., the source country’s right to tax dominates that of the resident country. It means a fixed place of business through which a business of an enterprise is wholly or partly carried on. The term P.E. includes a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; and f) a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.

• Mutual Agreement Rule

The mutual agreement rule implies that the conflict arising between the Contracting States, due to differences in law, must be resolved by mutual agreement.

Tax Treaty and its interpretation

A treaty is an international agreement between States in written form and are governed by international law. Treaties dealing in matters related to tax are known as Tax Treaties. It generally applies to a person who is a resident of at least one of the contracting states between whom the tax treaty is concluded. There are two types of tax treaties i.e., either bilateral or multilateral. Bilateral tax treaties are treaties on tax matters concluded between two nations. Multilateral tax treaties are those that are concluded between more than two nations. As the main objectives of a tax treaty are: i) prevention of tax evasion and ii) avoidance of double taxation. Bilateral tax treaties become the most common form of tax treaties. While conducting tax planning understanding tax treaties is very important as avoidance of double taxation is a major purpose for entering into a tax treaty. For eg; In India, when a tax treaty conflicts with domestic law, the domestic law shall prevail. Proper tax planning helps the foreign entity transacting in India to understand the tax system of a country.

Tax structuring and Advance Issues

Taxing corporate structures has become a difficult task since they have evolved with time. Having a complex business as well as tax structure raises confusion as to which state should tax the income. Further, the wiping up of territorial borders and opening up of the economy to boost business has made it easy to dodge tax. Taxpayers take the advantage of the differences in tax laws so suppose an income is taxable in one country and is exempt from tax in another, then the income is shifted to the country which exempts it from tax. Tax planning is done to resolve the rising instances of tax evasion and to minimize the instances of exploitation by building a bridge between the gaps in tax laws. The OECD with the cooperation of states came up with BEPS Action Plans. BEPS stands for Base Erosion and Profit Shifting. BEPS Action Plans cater to the rising instances of BEPS. The Action Plans include various instruments which deal with advanced issues of tax. These instruments are:

• Special Anti-Avoidance Rules (SAAR): SAAR is a special rule which prevents tax avoidance. These rules specifically prescribe circumstances that result in tax avoidance. These SAAR rules are required to be incorporated into the domestic laws of countries for their application. SAAR rules contain various rules which describe which transactions lead to avoidance of tax and measures to prevent it.

1. Transfer Pricing arrangements
   Transfer price” simply means the price at which the goods and services are transferred. It is the price at which a certain value of goods or services is traded between different units of an organization. These units of the same organization are known as related or associated enterprises. The transactions between two associated enterprises are usually different from that of independent enterprises. Transaction between associated enterprises is capable of being manipulated or dictated and such transactions are termed “transfer pricing arrangements” or “controlled transactions”. The Arm’s length principle was introduced to determine transfer prices.
   Arm’s length principle means the transaction between associated enterprises should be at similar prices as that between unrelated enterprises. As per the OECD guideline, there are five methods are prescribed for the calculation of arm’s length price. The taxpayers are expected to apply the most suitable method. They ensure that the transaction between associated enterprises affects the commercial and financial relations in the same way as they affect a transaction between unrelated enterprises. The main motive of transfer pricing measures is to prevent tax avoidance. Tax planning helps analyze if the the transaction is with an independent party or a dependent party and then according enter into the transaction.
2. Advance Pricing Agreement (APA)
   Usually, international transactions between associated enterprises are computed applying the arm’s length principle. However, APA is an exception to the arm’s length rule.It is an agreement between the taxpayer and tax authority that can be used if ALP mechanisms are not yielding fruitful results. APA mechanism is according to BEPS Action Plan 14 which seeks effective dispute resolution and prevention of double taxation. In some rare cases, none of the methods prescribed for the calculation of ALP falls under the most appropriate category. Then the APA comes to the rescue. During tax planning, it can be ascertained whether the transactions fall under the ALP mechanism or the APA mechanism.
3. Safe Harbour Rules
   Safe harbour rules are rules which apply to a defined category of taxpayers or transactions. These rules relieve eligible taxpayers from certain obligations which are otherwise imposed by a country’s general transfer pricing rules. Safe Harbour rules mean circumstances in which the income tax authorities shall accept the transfer price declared by the taxpayer. The main objective of Safe Harbour rules is to ease the small taxpayers from some burdensome compliance. The risk of complex transactions is less with small taxpayers so the tax authorities can shift their focus to more complex transactions leading to tax avoidance. Tax planning helps determine whether the taxpayer falls under the defined category or not, to be covered under the safe harbour rules.
4. Notified Jurisdictional Area (NJA)
   In the absence of any tax treaty and when the other country does not cooperate to share information relating to the financial and commercial activities with that country. The country can notify such non-cooperating country as NJA. The repercussion of being an NJA is that: i) any transaction done with an entity located in NJA shall be deemed to be a transaction between Associated Enterprises irrespective of whether the international transaction with a resident of NJA, company incorporated in NJA or P.E. of a company incorporated in some other jurisdiction. Further, any sum credited or received from a person in NJA, then the source of the such sum has to be proved by the taxpayer in his resident country. A minimum TDS of 30% is deducted for any sum transferred or paid to a person in NJA. All transactions to and from such NJA shall be under the radar of tax authorities and the taxpayer shall have to produce all documents supporting the transaction. Tax planning will usually prevent transactions with an NJA jurisdiction.
5. General Anti-Avoidance Rules (GAAR)
   The tax base of a country can be eroded in numerous ways. When specific rules cannot be suitably applied GAAR^[1] can counter tax avoidance. The GAAR provisions were inserted in the OECD Model Convention as well as United Nations Convention in 2017 under Article 29(9) only because SAAR was insufficient in avoiding abuse of tax. Unlike SAAR, GAAR applies to all kinds of arrangements otherwise the rule will be inadequate and not efficient in curtailing the deficiencies of specific anti-avoidance rules. With GAAR, the focus is on the substance of the arrangement. Intention plays a key role while determining whether GAAR provisions are applicable or not. The transaction should be evaluated based on the substance of the arrangement rather than the form. Most importantly GAAR applies to intercept the aggressive tax measures which are ultra vires. The purpose or the intent plays the lead role in ascertaining whether GAAR provisions will apply or not. GAAR provisions are really important for tax planning as it will discourage a taxpayer to enter into a transaction that is prohibited under GAAR as these provisions attract huge penalties.

Conclusion

The Principles laid down in the tax treaties or any instrument formulated by the OECD are the basis on which every country formulates its tax laws. Understanding these basic principles will help in understanding the local tax laws of a country and will ease the tax planning process. Based on these principles, a person or an entity can decide which country to transact with and under which method will they be able to minimize tax liability most. Tax planning has become an important aspect in deciding a strategy for international transactions. Tax planning enhances the productivity of investments by utilizing the resources fully. Therefore, tax planning also contributes to the economic development of the taxpayer as well as the country.

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