Income or profits which result from international activities such as cross border investment may be taxed where the income is earned (source country) or where the person who receives it normally based (Country of residence).
Residence taxation of income is based on principle that the people and firms should contribute towards the public services provided for them by the country where they live, on all their income wherever it comes from.
Source based taxation of income is based on the principle that the country that provides the opportunity to generate income or profits should have the right to tax it.
Source/Residence base and Double Taxation:
For example, if country A and country B both tax income at a rate of 50%, and a resident of A derives 100 units of income from a source within B, that income could first be taxed by B at 50% (paying 50 units in taxes) at source, and the remaining income of 50 units could be taxed by A at 50% (paying taxes of 25 units) on the basis of residence jurisdiction. So the taxpayer would be left with only (100-50-25) = 25 units, paying an effective tax rate of 75%.
The double taxation can be eliminated or reduced by completely exempting the income derived from foreign sources from residence taxes. But this could encourage business or investors to go abroad to countries where tax rates are lower than at home.
Alternatively, credit for foreign taxes paid can be provided so that if the source tax rate is lower, the investor would pay the difference in the country of residence.
Treaties and Double Taxation:
To prevent this double taxation, the League of Nations and its successors the United Nations (UN) and the Organisation for Economic Cooperation &Development (OECD) developed a series of model treaties that led to the current set of over 2,500 bilateral income tax treaties, which provide the framework of the international tax regime.
Fundamentally, the treaties strike a compromise between source and residence taxation. Some rights to tax are given to the source, and the residence country is required to relieve double taxation either by giving a credit for such source taxes paid, or by exempting the relevant income from its taxes.
Generally, source jurisdictions retain their right to tax active (business) income, except for short-term activities, but give up some of their right to tax passive (investment) income.
The main effect of the tax treaties is to reduce source-based taxation in favour of residence-based taxation of passive income (sometimes referred to as income from capital). The degree to which this is done depends on each treaty: capital-exporting richer countries prefer the OECD model treaty, which is more favourable to residence, while capital-importing developing countries tend to favour the UN model treaty, which is more favourable to source.
Principles in Income tax Act, 1961 relating to basis of taxation:
The provisions of sections 5, 6 and 9 of the Income Tax Act, 1961 provides for residence based and source based taxation principles. Section 5 provides that Residents are taxed on their worldwide income. Non- Residents are taxed on India source income (Income received in India or deemed to be received in India and Income Accrued in India or deemed to be accrued in India).
Residential Status of a person is determined with reference to the provisions of section 6 of Income Tax Act, 1961.
Section 9 of the Income Tax Act, 1961 provides for source based taxation on the basis of characterisation of income. Income from business connection or property or assets in India or from the transfer of capital asset situated in India is deemed to have their source in India
Dividends paid by the Indian company always treated as Indian source income. Interest payments received by a non-resident have their source in India if it relates to debt incurred in connection with payer’s business or profession in India. Royalty and fees for technical services, is also treated as having Indian source as long as underlying right, information, property or service is used in connection with the payer’s business or profession carried on in India.
If there is any conflict between domestic law and treaty rules, the domestic law to the extent benefit the tax payer will apply.
Which method to adopt?
Theoretically, one can imagine a world in which all countries adopted either pure residence jurisdiction or pure source jurisdiction. Economists tend to favour residence jurisdiction, both because they consider the source of income to be hard to pin down (income often has more than one source), and because they think residence jurisdiction promotes economic efficiency, since the decision where to invest should be unaffected by the tax rate.
However, pure residence taxation is unrealistic, for three reasons.
- First, countries are unlikely to give up the right to collect tax from foreigners doing business within their economy and
- Second, pure residence based taxation would reduce revenues in poor developing countries, who rely heavily on source-based taxation, in favour of the rich developed countries where investors reside. Most importantly, residence taxation is much easier to evade or avoid, by channelling international investments through tax
- Third strong protection of bank confidentiality and other secrecy provisions in heavens makes it hard for the residence country to get the information about its resident ’s foreign source income.
Pure Source Taxation enables investors to play countries off against each other t o obtain lowest source based tax rate. It also provides for problems of determining the source of income and of combating abusive transfer pricing (i.e shifting of profits artificially for a tax advantage).
Conclusion:
A compromise which gives primacy to source-based taxation but keeps the option of residence-based taxation, still seems the best option to preserve the revenue base of both developed and developing countries.
This article is contributed by Partners of SBS and Company LLP – Chartered Accountant Company You can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.
