Principles of international taxation & tax treaties
Module 3 looks at the international aspects of corporate tax law systems and international tax law.
International taxation depends on a country having sufficient connection to the taxed company. That nexus is usually established through one of three principles:
- the nationality principle, based on incorporation of a company under the legal requirements of a country (usually commercial law);
- the residence principle, based on establishment of a company’s effective management on that coutnry; and
- the source principle, which is based on the existence of significant activity of a company in a given country
Overlaps and ommissions on those criteria may lead to scenarios of double taxation or double non-taxation. Most countries apply a combination of the residence and source principles, while the United States replace residence with nationality as a guiding principle of taxation.
To avoid issues with double taxation, countries can negotiate double tax treaties that divide the taxing rights between both countries that have a claim to that income. Tax treaties, however, do not create a taxable basis; instead, their role is to attribute tax rights to each country.
Tax attribution may be done through tax splitting or it may also establish that a country loses all rights over a taxable fact; for example, country A may lose the right of taxing company C’s operations in country B if C’s operation there amounts to a permanent establishment as defined in the article 5 of OECD’s Model Tax Convention. The taxable basis itself must still be created by each country’s domestic legislation, but many countries align their concepts with the ones defined on their treaties.
Business income is usually attributed to the residence jurisdiction, while passive income normally can taxed by both countries. To quote the lecture video on distributive rules:
Generally, a double tax treaty will state that passive income paid by a company in country B to a company in country A may be taxed in country A without limitation. However, under certain circumstances, country B may also tax the income. Generally, the source countries will agree to apply no or only a low taxes source on payments to companies of another country. The rules relating to dividends, interest and royalty payments are included in Articles 10, 11, and 12 of the OECD Model Tax Convention, respectively.
Since passive income is mostly taxed at the residence country, minimising withholding income tax at the source is an important step for tax planning.
The attribution of capital gains usually follows the provisions of OECD Model Tax Convention’s Article 13, according to which capital gains from the sale of assets are usually taxed on the country of residence, while gains on the sale of immovable property or share holdings in companies that hold immovable property may also be taxed at the source.
Whenever both countries have taxing rights, tax treaties provide means for avoiding double taxation.
Avoiding double taxation
Based on the OECD Model Tax Convention, there are two usual models for avoiding double taxation:
- the exemption method, with its two variants:
- income exemption, achieved by excluding foreign income from the domestic base; or
- tax exemption, where the residence country allows its own domestic tax on foreign income as credit; and
- the credit method, in which the country of residence allows the taxpayer to deduct from their due taxes the amount of foreign corporate income tax paid over the doubly-taxed income, up to the attributable domestic tax.
Exemption arrangements achieve capital import neutrality, meaning that companies can operate in the source country in parity with the local companies. Credit arrangements, on the other range, result in capital export neutrality, which places the taxed company under the same conditions of other companies in its country of residence and ensures that the tax cost of operating in the source country is the same than the cost in the country of residence.
The choice between exemption and credit arrangements is left to the residence country. In general, exemption methods are used for relief of double taxation in active business income, while credit methods are employed for passive income, but specific countries may choose different arrangements: the U.S., for example, mostly uses credit-based relief, while Brazil has adopted credit and relief methods after adopting the source principle in addition to the residence principle.
Preventing treaty abuses
BEPS Action 6 proposes actions for preventing the misuse of tax treaties for double non-taxation. One category of treaty abuses comes from attempts to circumvent the limitations provided by the treaty, as is the case in treaty shopping, when legal persons are able to benefit from from treaties involving not only the source country and the residence country, but also third countries. Another category of abuses comes from people trying to use provisions from tax treaties to subvert domestic taxation laws.
To counter treaty shopping practices, two kinds of rules are usually adopted:
- principal purposes tests (PPT), which checks whether a company is incorporated in a jurisdiction for valid busines purposes, as opposed to simply aiming to benefit from treaties; or
- limitation on benefits provision (LOB), which allow the treaty signataries to restrict benefits for companies under certain circumstances.
The BEPS reports proposes that countries should adopt either a PPT rule, a combination of LOB and PPT rules, or a LOB rule supplemented by mechanisms for dealing with conduit financing arrangement otherwise not covered by treaties. As Tomazela (2016) points out, Brazilian tax law seems to be more amenable to a PPT approach; in fact, it adopted in 2001 a general anti-avoidance rule in the article 116 of its National Tax Code. That GAAR rule requires further regulation for its application, but the Brazilian National Congress has yet to approve ordinary legislation for this purpose.
Domestic abuse of treaty laws is addressed by other aspects of the BEPS Action Plan, notably Actions 2, 3, 4, and the Transfer Pricing trio of 8, 9, and 10. Those actions should be supplemented by changes on the OECD Model Tax Convention and its commentaries, so as to reinforce the rights of a state to tax its residents (except under the cases actually intended by the treaty itself) and avoidance of double taxation in exit taxes, while keeping the validity of this taxation category.
Controlled foreign company regimes
Most countries don’t tax the profits of foreign subsidiaries until the subsidiary distributes the income to its parent as dividends. Taking advantage of that, many companies try to set up subsidiaries in jurisdictions with lower taxes, transferring the mobile parts of their operations to places where they can defer paying corporate income taxes on high-tax countries.
In an attempt to prevent the erosion of their tax bases, many countries, especially those with high corporate tax levels, have created controlled foreign company (CFC) regimes, which can lead to parent companies being taxed at their home country when their foreign subsidiaries realize results that fall into the regime.
The course discusses the American check-the-box model and the OECD attempts to strenghten CFC regimes as part of their BEPS programme. As a comparison, I also included some basic information on Brazil’s recent CFC regime. To address issues identified on CFC regimes, the BEPS Action 3 has some proposals for the design of rule systems, in particular for dealing with hybrid mismatch arrangements.
The check-the-box model in USA
The check-the-box regulations, in place since 1997, allow eligible companies to choose whether to be taxed as a corporation or as a partnership. As put by Mullis (2011), entities may elect their taxation status if they meet three requirements:
the entity must exist separately from its owners;
it must be a business entity; and
it must not be a deemed corporation,
where the definition of deemed corporation is based on a comprehensive list in Treas. reg. section 301.7701-2(b)(8) that mostly include entities formed under state corporate statutes and foreign per se corporations.
A domestic entity that does not declare its preferred status is classified by default as non-corporate, while the reverse holds for foreign entities: they are taxed as corporations unless one or more of the owners hold personal liability.
Extending the CTB regulations to foreign business aimed to reduce the analysis of foreign law demanded by the Kintner regime that CTB replaced, but the resulting flexibility may lead to entities being classified in inconsistent ways at the U.S. versus abroad and opens opportunities for tax planning. Hybrid entities – that is, entities that are classified in one way by U.S. tax authorities and in another for foreign taxation purposes – are used to benefit from Subpart F’s anti-deferral regime and the foreign tax credit provisions.
Subpart F was created to reduce the benefits of deferring taxes through a foreign subsidiary by taxing U.S. shareholders of foreign companies on some types of income earned by that subsidiary. Mullis (2011) brings the example of a foreign subsidiary, rated as a corporation in its home country A, that takes a disregarded loan from a subsidiary located on a tax haven seen: for US purposes, the tax haven subsidiary is disregarded and the interest payments would happen within the same entity. However, country A sees that tax haven subsidiary as a corporation, allowing the foreign subsidiary to deduct the paid interest from the locally paid income tax.
Foreign tax credits were introduced to mitigate double taxation issues. However, arrangements involving hybrid subsidiaries and “reverse hybrids” (entities treated as corporations by the U.S. and as non-corporate entities on their home jurisdictions) can lead to the concession of U.S. tax credits for activities that are not taxed elsewhere, resulting in double non-taxation.
While the IRS tries to constantly adjust itself to the new possibilities of hybrid exploitation, companies are always devising new mechanisms for tax planning, leading to a increasingly complex environment that, as Mullis (2011) points out, runs counter to the original goal of tax simplification that led to the adoption of CTB.
Controlled foreign companies in Brazil
The current Brazilian regime for controlled foreign companies was introduced by the Law 12.973/2014, which alters the federal norms relative to IRPJ (corporate income tax), CSLL (social contribution on net profit) and contributions to PIS/Pasep and social security, revoking the RTT transition regime created by the Law 11.941/2009. This new regime is applied to both directly and indirectly controlled companies, as well as affiliated companies.
Controlled companies of either kind require adjustments on the accounts of their Brazilian controller: investments should be adjusted yearly to reflect the change in the investment value caused by the controlled entity’s profits or losses during the period, excluding exchange rate variations. (art. 77, caput, with some exceptions provided by § 3-5 of the same article related to oil and gas extraction)
Until the calendar year of 2022, taxpayers may consolidate positive and negative adjustments under the conditions established by article 78; among them, consolidation is denied to companies subject to sub-taxation regimes (defined in art. 84 as those with a nominal income tax inferior to 20%), privileged tax regimes, or resident in tax havens.
For those entities that are not consolidated, losses can be only compensated by future profits of the same foreign controlled entity, as prescribed on article 79. Article 77, § 2, allows companies to offset profits with accumulated losses accrued before this law came into effect, as long as the appropriated disclosure process and deadlines are followed.
Article 90 allows CFCs, under certain conditions, to pay the income in proportion with the profit actually distributed to the Brazilian controller. To quote pwc’s (2016) analysis:
Under certain conditions, taxpayers may choose to pay income tax due on the foreign profits proportionally to the profits actually distributed to the Brazilian entity, in subsequent periods to that in which such results were generated. However, in the first year, even where there is no distribution of profits, 12.5% of profits will be deemed to be distributed to the Brazilian parent. If no further profits are distributed, the remaining profits will be deemed to be distributed in the eighth subsequent year. Taxpayers choosing to postpone payment of income tax due should consider the impact of interest as well as foreign exchange rates.
When a Brazilian company earns profit through a foreign affiliate, article 81 says that profit will be taxable on December 31 of the year of distribution, provided that the affiliated company meets the requirements of articles 81, 82, and 82-A.
Both Brazilian controllers and affiliates may benefit from foreign tax credits on withholding income tax paid abroad on the distributed profits. Until the 2022 calendar year, Brazilian controllers may also deduct up to 9% as presumed credit over activities related to a series of industries indicated on art. 87, § 10, of this law.
Hybrid mismatches occur when there’s an asymmetry in fiscal qualification between countries. The OECD report on Hybrid Mismatches (BEPS action 2) identifies some typical hybrid mismatch arrangements:
- hybrid entities, which are entities classified as transparent and non-taxable by one country and as non-transparent in another, as one can see from the previous analysis of U.S.’s check-the-box regulations;
- hybrid instruments, when a financial instrument is classified as debt by one country and equity by another, leading to diferences in tax deducibility;
- hybrid transfers, which are arrangements seen as transfer of asset ownership in one jurisdiction and collateralized loans in another; and
- dual residence entities, that is, entities that reside in two countries for tax purposes.
Those four kinds of mismatches may lead to some scenarios:
- double deduction, when deductions related to a contractual obligation are claimed for tax purposes in both countries;
- deduction and no-inclusion schemes, where a deduction in one of the countries is not matched by the inclusion of the corresponding income into the tax base of the other country;
Those scenarios can be leveraged for tax planning, as pointed out in Prof. Douma’s lecture:
At this time, we can add two more strategies to our tax planning toolkit. First, any tax planning structure should strive for non-current taxation of the low tax profits at a level of Parent Co. In this respect, Country A’s control foreign company legislation should be taken into account.
Second, hybrid mismatch arrangements can provide particular benefits in reducing the tax level at Intermediate Sub 1, but also in creating a non-tax environment in Country C.
Johannesen (2014) presents an investigation on hybrid mismatch arrangements and their continued existence. Through a formal model of hybrid instruments, the author shows identifies the conditions under which a given instrument can be labeled in two different ways by the equity-debt demarcation rules of two countries. Given that difference in labels, that instrument can then be used as a cross-country hybrid instrument, avoiding effective taxation. While anti-avoidance rules might be possible, the paper also claims that adopting those rules might not be interesting for countries, as a formal model would show.
To address hybrid mismatches, the BEPS Action 2 final report proposes changes to domestic rules, with the enactment of linking rules that take into the account the tax status of a payment in another country when deciding how to treat the hybrid at the jurisdiction in question. Those rules should be formed by a primary rule for dealing with the hybrid mismatch; and a second rule that applies when the primary rule did not apply in the jurisdiction of the counterparty, acting as a defence against defection.
As an example provided by the lecture videos:
The OECD recommends that jurisdictions which offer and exemption for dividends do not extend their exemption to deductible payments.
For situations where the payee country either has not implemented this recommendation or the situation falls outside the scope of their participation in the exemption system, the report recommends the following linking rules to neutralize the deduction and no inclusion effect.
Firstly, the primary rule: deny a deduction of the payment to be extended. the payee does not tax the payment as ordinary income. And secondly, the secondary rule requires a payee to include any payment as ordinary income to the extent that the payer is entitled to claim a deduction for such payment or equivalent tax reprieve.
BEPS also proposes changes to the OECD Model Tax Convention to prevent hybrid entities and instruments from falling into a “blind zone” and benefiting from the treaties.
OECD (2015). Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 - 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
OECD (2015). Designing Effective Controlled Foreign Company Rules, Action 3 - 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
OECD (2015). Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.
OECD (2015). Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris
R. Vann. (1998) International Aspects of Income Tax. In: V. Thuronyi (ed) Tax Law Design and Drafting, volume 2.ed. V. Thuronyi, volume 2, chapter 18.
N. Johannesen.(2014) “Tax avoidance with cross-border hybrid instruments”, Journal of Public Economics, 112
K. Mullis.(2011) [Check-the-Box and Hybrids: A Second Look at Elective U.S. Tax Classification for Foreign Entities](Check-the-Box and Hybrids: A Second Look at Elective U.S. Tax Classification for Foreign Entities). taxanalysts.
Introduction to the CTB model and some of its issues when dealing with foreign subsidiaries.
pwc. (2016) Brazil: Corporate group taxation.
A summary of the Brazilian legislation about transfer pricing, thin capitalisation, and controlled foreign companies.
Deloitte. (2017) BEPS Actions implemented by country: Brazil.
A brief overview of how Brazil has approached its taxes practices to the proposed BEPS actions.
R. Tomazela. (2016) [“Brazil’s Approach Towards the BEPS Multilateral Convention”](“Brazil’s Approach Towards the BEPS Multilateral Convention”). Kluwer International Tax Blog.
A longer discussion of convergences and divergences between the Brazilian tax law and the BEPS actions.