Introduction Double taxation arises when an individual or business acquiring income in a foreign country is required to pay taxes on that income in both the foreign country as well as the country of origin. For example, an American company operating in a developing country, in the absence of a tax treaty between the two countries may have to pay a withholding tax to the government of the developing country, as well as corporation tax to the United States government (Howard, 2001, p. 259).
The purpose of this paper is to examine the merit of three basic systems, which is exemption system, credit system and deduction system. These systems are dealings with the essence of tax relief from international double taxation. A discussion of various countries on their practices on tax relief system and the rationale for using the system will be presented, followed by an analysis of the most advantages system to taxpayers. Finally identifies the system that most preferred by countries and the justification for adopted such system.
Systems adopted by countries to ameliorate the burden of International Double Taxation Double taxation is always considered to be one of the most important issues in international taxation. With the more and more business moving towards globalization and cross-border investment, double taxation is often cited as a major obstacle to liberate economic progress. There are basically three types of systems for double taxation relief, the exemption system, credit system & reduction system.
The globalization drive has led to an increased knowledge and understanding of the various taxation systems in countries around the world. ?The Exemption System Under exemption systems, a taxpayer of a country (the residence country), will not be taxed regardless of where the income is generated, instead, taxpayers are taxed based on the source of their income (the host country), that is, only the country where the income is generated has taxing authority over the income (Stephens, 1998, p.159)
With exemption system, it’s encourages resident individual or companies to venture outside their domestic environment and compete with their foreign competitors. Hence it is frequently used term of capital import neutrality. In general, it can be said that a tax exemption system encourages businesses to trade outside their home country, thus accelerating the trends towards globalization and increase of global welfare.
Countries that are purely on exemption system are often referred to as “tax havens” because the country does not tax any foreign source income (FSI) earned by individuals or corporations that have that country as their home country (Stephens, 1998). A tax haven is a place where foreigners may receive income or own assets without paying high rates of taxes. Generally speaking, the main characteristic of a tax haven is a very low effective tax rate on foreign income. Major tax havens are the Bahamas, Bermuda, Cayman Islands, Hong Kong, Panama, and Singapore.
Most tax havens are developing countries where governments believe that tax haven status would accelerate their rate of economic growth (Howard, 2001, p. 256). ?The Tax-Credit System The credit system allows tax paid in one state to be used as credit against a taxpayer’s liability in another state. The credit will be in the form of a direct credit or indirect credit (August, 2004, p 732) The philosophy behind a tax credit system is to allow international businesses to operate under the same conditions as domestic enterprises.
If a business ventures abroad, it must pay tax on foreign and domestic business income domestically at the same tax rate and tax basis. Foreign tax paid (dividend withholding tax and corporate income tax on the original profits) can be deducted against domestic tax due. This system is also referred as Capital Export Neutral system. Tax-credit systems have been implemented in the United States, OECD countries, and newly industrialized economies in which investment taxes paid to foreign countries can be deducted at home if the home tax rate exceeds the foreign tax rate.?
Deduction System Under a deduction system, a resident may deduct the taxes paid to a host country as deductions in calculating his taxable income in his residence country. The burden on taxpayer is very heavy if is using deduction system. A country that chooses the deduction system indicates that it prefers to increase tax revenues even though it will discourage the level of outbound investment and attract foreign investment into the country. The rationale underlying such a preference is that tax revenues are part of the countries main source of income.
System most advantages to Taxpayers The exemption system definitely is the most advantageous for taxpayers as foreign source income is exempted from paying taxes, which relief from double taxation of the same income. By being exempt from tax liabilities in one state, the taxpayer are subject to lower income tax charges (August, 2004, p. 733) System most preferred by Countries Today’s international tax system does not reflect a standardized system. No country in the world currently uses a pure form of exemption, credit or deduction system (Stephens, 1998, p.
159). For example, current tax system in the United States consists of aspects of two different economic theories: capital export neutrality: credit system and capital import neutrality: exemption system. The system is a hybrid, neither wholly capital export neutral nor wholly capital import neutral (Stephens, 1998). However, the United States is one of relatively few developed countries that do not provide meaningful relief from the double taxation of income from corporate equity (Gillis, 1989, p 369).
But because due to globalization trend and investor has been expose with many alternative choices especially developing countries, US government has realized that high taxation and increased regulation in developed countries have persuaded investors or corporations to search for more favorable countries for investing and doing business, therefore, now United States still taxes the worldwide income of domestic entities, but allows a credit against U. S. tax liability for foreign taxes paid (Salinas, 2003, p 531).
Another good example of countries changes their taxation system to better fit into globalization and stay competitive is the European Union (EU). The EU, in recent years has substitution of tax deductions with tax credit system; the introduction of the tax credit system has been preceded by a standardization of tax deductions. The objective of implement tax credit system is making taxation friendlier to corporations in order to not damage growth and to attract foreign investors.
According to these objectives, the standard tax rate has been reduced from 43 percent in 1991 to 16 percent in 2002, with the objective of a further reduction to 12. 5 percent in 2003 (Bernadi, 2003, p 173). Many countries generally adopt tax-credit system for tax revenues but offered many attractive tax incentives for relief international double taxation. The rationale behind this is that, a country is always seeking to attract foreign investment must compete with investment opportunities offered in other countries. In other words, if a country decides to tax high capital investment, investors will prefer other countries.
As a result, the increased tax revenues that the country earns will not compensate for the loss of greater foreign investment; that is, such a tax implementation would be economically inefficient. For example, tax credit method was adopted by China for the elimination of double taxation. As a developing country aim to attract more foreign investment, China has offer many attractive tax incentives to stimulate inflow of foreign investment and has generally succeeded in achieving its goals: securing tax revenue and improving the foreign investment into the country at the same time.
Because of the tax incentives offered to foreign investors, China has successfully persuaded all of its treaty partners, apart from the United States, to cooperate in making these incentives directly beneficial to investors by including “tax sparing credit” clauses in its treaties (Li, 1991, p 110). Many developing countries, including Barbados, Jamaica, and Trinidad and Tobago, have treaty withholding tax agreements with developed countries (Howard, 2001). As consequences, it is now the norms of many countries to use a unilateral, bilateral or multilateral tax treaty to ease the burden of international double taxation.
The basic objective of tax treaties is to ease the burden of taxation on international income; that is, on income, either personal or corporate, arising in one country and going to another country (Baker, 1960) Conclusion From the findings of KPMG’s Corporate Tax Rate Survey January 2003 – The global trend of decreased tax rates persists with Belgium and Ireland at the forefront, with tax rate decreases of 15. 38% and 21. 88%, respectively, the European Union (EU) and OECD member countries again show reductions in their rates.
Italy’s rates dropped below 40% (to 38. 25%), thus contributing to the average corporate tax rates falling to 30. 79% for OECD countries (from 31. 39% in 2002) and 31. 68% for EU nations (from 32. 53%). When economic integration increases, individuals and investors gain the freedom to take advantage of low tax rates abroad. As a result, countries with high tax rates face large economic losses when borders are opened because people and capital flow out. As capital and labor become more mobile, international “tax competition” increases (Edwards, 2003, o.26+).
Many developed countries such as US find it harder and faces many criticism to sustain excessively high tax rates. As a result of these developments, more attention is being paid to the various tax systems in use by countries to not only develop their own existing tax revenue but also to attract foreign investment which have regards beneficial to not only residence country but host country as well. List of ReferenceS August, Ray 2004, International Business law Text, Cases, and Readings, 4th edn, Prentice Hall, New Jersey.
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January 2003 Li, Jinyan 1991, Taxation in the People’s Republic of China, Praeger, New York Salinas, Javier G 2003, ? The OECD Tax Competition Initiative: A Critique of Its Merits in the Global Marketplace’ Houston Journal of International Law, vol. 25, Issue. 3, p. 531 Stephens, C Neil 1998, ?A Progressive Analysis of the Efficiencies of Capital Import Neutrality’, Law and Policy in International Business, vol. 30. Issue. 1. p. 159.