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Tolley® Exam Training ADIT PAPER 1 Principles of International Taxation Study Manual 2020 EXAMINATIONS 340 Tolley® Exam Training CONTENTS...

Tolley® Exam Training ADIT PAPER 1 Principles of International Taxation Study Manual 2020 EXAMINATIONS 340 Tolley® Exam Training CONTENTS CONTENTS PART I BASIC PRINCIPLES OF INTERNATIONAL LAW CHAPTER 1 INTRODUCTION TO INTERNATIONAL TAXATION..................................................1 CHAPTER 2 TAX AND TAX SYSTEMS.......................................................................................13 CHAPTER 3 CONNECTING FACTORS.....................................................................................21 CHAPTER 4 CAUSES OF INTERNATIONAL DOUBLE TAXATION..............................................37 CHAPTER 5 METHODS OF RELIEF FROM INTERNATIONAL DOUBLE TAXATION.....................41 PART II DOUBLE TAX CONVENTIONS IN THE LIGHT OF THE OECD MODEL TREATY CHAPTER 6 TYPES AND NEGOTIATION OF TREATIES..............................................................55 CHAPTER 7 THE FORMAT AND STRUCTURE OF A TAX TREATY...............................................59 CHAPTER 8 OECD MODEL DTC PROVISIONS RELATING TO THE SCOPE OF A TREATY.........65 CHAPTER 9 OECD MODEL DTC PROVISIONS RELATING TO RESIDENCE...............................69 CHAPTER 10 OECD MODEL DTC PROVISIONS RELATING TO PES...........................................75 CHAPTER 11 OECD MODEL DTC PROVISIONS RELATING TO BUSINESS..................................91 CHAPTER 12 OECD MODEL DTC PROVISIONS RELATING TO INVESTMENT INCOME AND GAINS...................................................................................................................99 CHAPTER 13 OECD MODEL DTC PROVISIONS RELATING TO INDIVIDUALS.........................119 CHAPTER 14 OECD MODEL DTC PROVISIONS RELATING TO OTHER INCOME.....................123 CHAPTER 15 OECD MODEL DTC PROVISIONS RELATING TO ELIMINATION OF DOUBLE TAXATION..........................................................................................................125 CHAPTER 16 OECD MODEL DTC PROVISIONS RELATING TO NON DISCRIMINATION.........131 CHAPTER 17 OECD MODEL DTC PROVISIONS RELATING TO DISPUTE RESOLUTION............137 CHAPTER 18 OECD MODEL DTC PROVISIONS RELATING TO CO-OPERATION....................153 CHAPTER 19 OECD MODEL DTC PROVISIONS RELATING TO LIMITATIONS ON BENEFITS FROM THE TREATY..............................................................................................167 CHAPTER 20 TAX TREATIES, e-COMMERCE AND THE DIGITAL ECONOMY..........................185 CHAPTER 21 DOUBLE TAX TREATIES AND DOMESTIC LAW....................................................199 CHAPTER 22 APPROACHES TO APPLYING A TAX TREATY.....................................................203 CHAPTER 23 INTERPRETATION OF TAX TREATIES....................................................................207 © RELX (UK) Limited 2019 I 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 24 CONVENTIONS FOR ADMINISTRATIVE ASSISTANCE IN TAX ADMINISTRATION219 PART III HARMFUL TAX RULES AND INTERNATIONAL TAX AVOIDANCE CHAPTER 25 ENTITY CLASSIFICATION....................................................................................231 CHAPTER 26 TAX HAVENS AND HARMFUL TAX PRACTICES.................................................245 CHAPTER 27 CONTROLLED FOREIGN COMPANIES (CFC) RULES AND SOME OTHER ANTI- AVOIDANCE APPROACHES..............................................................................259 PART IV TRANSFER PRICING AND THIN CAPITALISATION CHAPTER 28 INTRODUCTION TO TRANSFER PRICING...........................................................271 CHAPTER 29 OECD MODEL DTC PROVISIONS RELATING TO TRANSFER PRICING...............283 CHAPTER 30 THE OECD TRANSFER PRICING GUIDELINES.....................................................289 CHAPTER 31 THIN CAPITALISATION.......................................................................................319 PART V MISCELLANEOUS TOPICS CHAPTER 32 TAXATION AND INTERNATIONAL HUMAN RIGHTS...........................................325 CHAPTER 33 MONEY-LAUNDERING LEGISLATION AND TAX EVASION................................335 CHAPTER 34 INDIRECT TAXES AND INTERNATIONAL TAXATION..........................................339 CHAPTER 35 CROSS-BORDER MERGERS: SOME OF THE ISSUES AND SOLUTIONS................349 CHAPTER 36 ESTATE AND GIFT TAXATION AND INTERNATIONAL ISSUES.............................351 APPENDICES APPENDIX 1 THE EU AND THE IMPACT OF THE ECJ...............................................................357 APPENDIX 2 THE EU DIRECTIVES RELATING TO DIRECT TAXATION.......................................369 APPENDIX 3 CASE LAW LIST...................................................................................................377 © RELX (UK) Limited 2019 II 2020 Sittings Tolley® Exam Training CONTENTS DETAILED CONTENTS PART I BASIC PRINCIPLES OF INTERNATIONAL LAW CHAPTER 1 INTRODUCTION TO INTERNATIONAL TAXATION..................................................1 1.1 Introduction.................................................................................................................. 1 1.2 The Jurisdiction to Tax..................................................................................................1 1.3 Taxation and International Law Concepts...............................................................3 1.4 The International Court of Justice (ICJ) and Sources of Law Used in Judgments 3 1.5 Tax Enforcement and the Rule in Dicey & Morris.....................................................4 1.6 The Concept of Universal Jurisdiction Within the Context of International Crimes7 1.7 A Brief History of International Tax Law and the BEPS Project.................................8 CHAPTER 2 TAX AND TAX SYSTEMS.......................................................................................13 2.1 Introduction................................................................................................................ 13 2.2 Federal Systems and Local-level Taxes...................................................................13 2.3 Adam Smith's Four Axioms for Efficient Tax Systems...............................................17 2.4 Trends in Taxation Globally.......................................................................................19 CHAPTER 3 CONNECTING FACTORS.....................................................................................21 3.1 Introduction................................................................................................................ 21 3.2 Concepts of Source and Situs, Residence, Domicile and Citizenship.................21 3.3 State Practice in Determining the Source of Income and Gains.........................22 3.4 Business Type Income................................................................................................22 3.5 Investment Type Income...........................................................................................23 3.6 State Practice in Determining Residence of Individuals........................................26 3.7 State Practice in Determining Residence of Companies......................................29 3.8 Implications of the Use of Citizenship as a Connecting Factor............................31 3.9 Tax Issues Arising From a Change in Residence/Citizenship.................................32 CHAPTER 4 CAUSES OF INTERNATIONAL DOUBLE TAXATION..............................................37 4.1 Introduction................................................................................................................ 37 4.2 Conflicts of Residence and Source.........................................................................37 4.3 Conflicting Definitions of Connecting Factors........................................................37 4.4 Other Potential Causes of Double Taxation, Including Citizenship......................39 4.5 Conclusion.................................................................................................................. 39 CHAPTER 5 METHODS OF RELIEF FROM INTERNATIONAL DOUBLE TAXATION.....................41 5.1 Introduction................................................................................................................ 41 5.2 Types of Double Taxation..........................................................................................41 5.3 The Classical System..................................................................................................41 5.4 The Imputation System..............................................................................................43 5.5 Relief by Credit: Withholding and Underlying Taxes, Tax Sparing........................44 5.6 Relief by Exemption: The Participation Exemption.................................................45 5.7 Relief by Deduction...................................................................................................46 5.8 Practical Issues (Benefits and Difficulties) in Applying Credit and Exemption Methods...................................................................................................................... 46 5.9 Economic Issues in Relation to Credit/Exemption Systems: CEN and CIN..........47 PART II DOUBLE TAX CONVENTIONS IN THE LIGHT OF THE OECD MODEL TREATY CHAPTER 6 TYPES AND NEGOTIATION OF TREATIES..............................................................55 6.1 Types of Tax Treaty.....................................................................................................55 6.2 Negotiating Treaties...................................................................................................56 © RELX (UK) Limited 2019 III 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 7 THE FORMAT AND STRUCTURE OF A TAX TREATY...............................................59 7.1 Introduction................................................................................................................ 59 7.2 The OECD Model Treaty............................................................................................59 7.3 The UN Model.............................................................................................................61 7.4 Specific State Model Treaties...................................................................................62 7.5 The Multilateral Instrument (MLI)...............................................................................63 CHAPTER 8 OECD MODEL DTC PROVISIONS RELATING TO THE SCOPE OF A TREATY.........65 8.1 Introduction................................................................................................................ 65 8.2 The Scope of a Treaty – Persons and Taxes............................................................65 8.3 Territorial Extension.....................................................................................................66 8.4 Entry Into Force...........................................................................................................67 CHAPTER 9 OECD MODEL DTC PROVISIONS RELATING TO RESIDENCE...............................69 9.1 Introduction................................................................................................................ 69 9.2 Article 4 of the OECD Model Treaty and Individuals.............................................69 9.3 Article 4 OECD Model DTC and Companies or Other Entities..............................71 CHAPTER 10 OECD MODEL DTC PROVISIONS RELATING TO PES...........................................75 10.1 Introduction to Permanent Establishments.............................................................75 10.2 Physical Presence PE.................................................................................................76 10.3 Construction Site PE...................................................................................................78 10.4 Exclusions from Definition of a PE.............................................................................78 10.5 Agency PE................................................................................................................... 80 10.6 Position of Subsidiary..................................................................................................82 10.7 Related Party..............................................................................................................82 10.8 Services PE................................................................................................................... 82 10.9 E-commerce Issues....................................................................................................83 10.10 The Multilateral Instrument (MLI)...............................................................................84 10.11 Relevant Case Law....................................................................................................84 10.12 Discussion Drafts and the BEPS Project....................................................................90 10.13 Double Taxation Relief...............................................................................................90 CHAPTER 11 OECD MODEL DTC PROVISIONS RELATING TO BUSINESS..................................91 11.1 Business Profits (Article 7 OECD Model Treaty)........................................................91 11.2 2010 and 2017 Updates to the Model Convention................................................92 11.3 Shipping and Air Transport (Article 8 OECD Model Treaty)...................................97 11.4 Associated Enterprises Article (Article 9 OECD Model Treaty)..............................98 CHAPTER 12 OECD MODEL DTC PROVISIONS RELATING TO INVESTMENT INCOME AND GAINS...................................................................................................................99 12.1 Introduction................................................................................................................ 99 12.2 Beneficial Ownership.................................................................................................99 12.3 Dividends (Article 10 OECD Model Treaty)...........................................................108 12.4 Interest (Article 11 OECD Model Treaty)................................................................110 12.5 Royalties Article (Article 12 OECD Model Treaty).................................................111 12.6 Capital Gains (Article 13 OECD Model Treaty)....................................................115 12.7 Income from Immovable Property (Article 6 OECD Model Treaty)...................118 CHAPTER 13 OECD MODEL DTC PROVISIONS RELATING TO INDIVIDUALS.........................119 13.1 Employment Income (Article 15 OECD Model Treaty)........................................119 13.2 Director’s Remuneration (Article 16 OECD Model Treaty)..................................121 13.3 Pensions (Article 18 OECD Model Treaty)..............................................................121 13.4 Independent Personal Services (Article 14 OECD Model Treaty Deleted).......121 13.5 Entertainers and Sportspersons (Article 17 OECD Model Treaty).......................121 © RELX (UK) Limited 2019 IV 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 14 OECD MODEL DTC PROVISIONS RELATING TO OTHER INCOME.....................123 14.1 Introduction..............................................................................................................123 14.2 Detail of Article.........................................................................................................123 CHAPTER 15 OECD MODEL DTC PROVISIONS RELATING TO ELIMINATION OF DOUBLE TAXATION..........................................................................................................125 15.1 Introduction..............................................................................................................125 15.2 Article 23A................................................................................................................. 126 15.3 Article 23B................................................................................................................. 126 15.4 Key Aspects that Apply to Both Systems...............................................................128 15.5 Tax Sparing................................................................................................................ 128 CHAPTER 16 OECD MODEL DTC PROVISIONS RELATING TO NON DISCRIMINATION.........131 16.1 Introduction..............................................................................................................131 16.2 Areas Affected.........................................................................................................131 16.3 “Triangular” Situations..............................................................................................135 16.4 Conclusion................................................................................................................ 136 CHAPTER 17 OECD MODEL DTC PROVISIONS RELATING TO DISPUTE RESOLUTION............137 17.1 Introduction..............................................................................................................137 17.2 Article 25 of the OECD Model Double Tax Convention (DTC) (MAP)................137 17.3 The Tax Treaty Arbitration Procedure.....................................................................144 17.4 BEPS Action Point 14.................................................................................................145 17.5 Dispute Resolution in the Multilateral Instrument (MLI)........................................147 17.6 EU Arbitration Convention.......................................................................................148 17.7 EU Directive on Tax Dispute Resolution Mechanisms...........................................150 CHAPTER 18 OECD MODEL DTC PROVISIONS RELATING TO CO-OPERATION....................153 18.1 Introduction..............................................................................................................153 18.2 Exchange of Information – Article 26 OECD Model Treaty.................................153 18.3 OECD Agreement on Exchange of Information on Tax Matters – TIEA.............158 18.4 EU Administrative Cooperation Directive..............................................................160 18.5 Cooperation: Enforcement and Collection of Tax Liabilities: Article 27 OECD Model Treaty.............................................................................................................161 18.6 Joint Investigations of Taxpayers............................................................................164 CHAPTER 19 OECD MODEL DTC PROVISIONS RELATING TO LIMITATIONS ON BENEFITS FROM THE TREATY..............................................................................................167 19.1 Introduction..............................................................................................................167 19.2 Base Companies......................................................................................................167 19.3 The OECD Report on Conduit Companies...........................................................167 19.4 Abuse Provisions in the OECD Model Treaty.........................................................168 19.5 Action Point 6 of the BEPS Project..........................................................................169 19.6 Article 29 OECD Model Treaty................................................................................170 19.7 Limitation on Benefits Articles Outside of the OECD Model Treaty....................174 19.8 Treaty Overrides, Abuse of Law Doctrines and Tax Treaties...............................178 19.9 GAAR......................................................................................................................... 182 CHAPTER 20 TAX TREATIES, e-COMMERCE AND THE DIGITAL ECONOMY..........................185 20.1 Introduction..............................................................................................................185 20.2 Earlier Reports: The OECD Advisory Groups' Work on Tax and E-commerce...185 20.3 E-commerce and Permanent Establishments......................................................187 20.4 The BEPS Project.......................................................................................................190 20.5 Implementation and Post BEPS Developments....................................................192 © RELX (UK) Limited 2019 V 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 21 DOUBLE TAX TREATIES AND DOMESTIC LAW....................................................199 21.1 Incorporation of Treaties into Domestic Law........................................................199 21.2 Dual Nature of Treaties............................................................................................201 21.3 Treaty Override.........................................................................................................201 CHAPTER 22 APPROACHES TO APPLYING A TAX TREATY.....................................................203 22.1 Introduction..............................................................................................................203 22.2 General Approach to Treaty Application.............................................................203 CHAPTER 23 INTERPRETATION OF TAX TREATIES....................................................................207 23.1 The General Approach to Treaty Interpretation..................................................207 23.2 The Vienna Convention on the Law of Treaties...................................................209 23.3 The Use of External Aids for Interpretation.............................................................212 23.4 The Application of Article 3(2) OECD Model Treaty............................................215 23.5 Competent Authority Proceedings Within the Mutual Agreement Article.......217 23.6 Dual Nature of Double Tax Treaties.......................................................................217 CHAPTER 24 CONVENTIONS FOR ADMINISTRATIVE ASSISTANCE IN TAX ADMINISTRATION219 24.1 Introduction..............................................................................................................219 24.2 The OECD/Council of Europe Convention...........................................................219 24.3 Regional Arrangements for Cooperation – EU Mutual Cooperation Directives220 24.4 FATCA and IGAs.......................................................................................................223 24.5 The Common Reporting Standard.........................................................................225 24.6 Other Developments...............................................................................................228 PART III HARMFUL TAX RULES AND INTERNATIONAL TAX AVOIDANCE CHAPTER 25 ENTITY CLASSIFICATION....................................................................................231 25.1 Introduction..............................................................................................................231 25.2 Introduction: Recognition of Foreign Legal Entities..............................................231 25.3 Entity Characterisation............................................................................................232 25.4 Partnerships...............................................................................................................236 25.5 Hybrid Entities............................................................................................................238 25.6 Conflicts of Qualification.........................................................................................241 CHAPTER 26 TAX HAVENS AND HARMFUL TAX PRACTICES.................................................245 26.1 Introduction..............................................................................................................245 26.2 Identification of Tax Havens....................................................................................245 26.3 Features of the Most Commonly Used Tax Havens..............................................247 26.4 OECD CFA Harmful Tax Competition Report........................................................249 26.5 Other Initiatives.........................................................................................................252 26.6 EU Code of Conduct...............................................................................................255 26.7 Conclusion................................................................................................................ 257 © RELX (UK) Limited 2019 VI 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 27 CONTROLLED FOREIGN COMPANIES (CFC) RULES AND SOME OTHER ANTI- AVOIDANCE APPROACHES..............................................................................259 27.1 Introduction..............................................................................................................259 27.2 Controlled Foreign Companies (CFC)...................................................................259 27.3 Main Features of CFC Legislation...........................................................................260 27.4 Rules Relating to Profit Apportionment of a CFC.................................................263 27.5 Foreign Personal Holding Companies...................................................................264 27.6 The Interaction of CFC Legislation and Tax Treaties............................................265 27.7 Mandatory Disclosure Rules....................................................................................266 27.8 Diverted Profits Tax...................................................................................................268 27.9 EU Anti-Tax Avoidance Directive............................................................................269 27.10 US Tax Reforms..........................................................................................................269 PART IV TRANSFER PRICING AND THIN CAPITALISATION CHAPTER 28 INTRODUCTION TO TRANSFER PRICING...........................................................271 28.1 Introduction..............................................................................................................271 28.2 Main Features of Transfer Pricing Legislation........................................................272 28.3 Advance Pricing Arrangements.............................................................................274 28.4 Transfer Pricing Case Law.......................................................................................276 CHAPTER 29 OECD MODEL DTC PROVISIONS RELATING TO TRANSFER PRICING...............283 29.1 Double Tax Treaties and Transfer Pricing...............................................................283 29.2 Article 9 Associated Enterprises OECD Model Treaty..........................................284 29.3 Transfer Pricing of Permanent Establishments.......................................................286 CHAPTER 30 THE OECD TRANSFER PRICING GUIDELINES.....................................................289 30.1 OECD Guidelines Content......................................................................................289 30.2 Arm's Length Pricing.................................................................................................290 30.3 Unitary Taxation/Global Formulary Apportionment.............................................292 30.4 Methodologies and their Application...................................................................294 30.5 Comparable Uncontrolled Price............................................................................294 30.6 Resale Price...............................................................................................................295 30.7 Cost Plus (C+)...........................................................................................................298 30.8 Profit Split................................................................................................................... 299 30.9 Transaction Net Profit Margin..................................................................................301 30.10 Intangibles and Cost Contribution Arrangements...............................................303 30.11 Intra-group Services.................................................................................................308 30.12 Business Restructurings.............................................................................................311 30.13 Documentation........................................................................................................313 30.14 EU Code of Conduct on Transfer Pricing Documentation..................................315 30.15 Dispute Resolution....................................................................................................318 CHAPTER 31 THIN CAPITALISATION.......................................................................................319 31.1 Introduction..............................................................................................................319 31.2 Tax Treaties and Thin Capitalisation.......................................................................319 31.3 Country Examples of Thin Capitalisation Legislation............................................320 31.4 BEPS Action Point 4...................................................................................................323 PART V MISCELLANEOUS TOPICS CHAPTER 32 TAXATION AND INTERNATIONAL HUMAN RIGHTS...........................................325 32.1 Introduction..............................................................................................................325 32.2 The International Covenant on Civil and Political Rights (ICCPR)......................325 32.3 The European Convention on Human Rights (“ECHR”).......................................326 32.4 Tax Abuse and Human Rights.................................................................................331 © RELX (UK) Limited 2019 VII 2020 Sittings Tolley® Exam Training CONTENTS CHAPTER 33 MONEY-LAUNDERING LEGISLATION AND TAX EVASION................................335 33.1 Introduction..............................................................................................................335 33.2 Application of Money Laundering to Foreign Fiscal Offences...........................336 CHAPTER 34 INDIRECT TAXES AND INTERNATIONAL TAXATION..........................................339 34.1 The Origin and Destination Bases for Indirect Taxes.............................................339 34.2 The EU Trade Area (and beyond)..........................................................................339 34.3 GATT and GATS Rules and the Limitation on Border Tax Adjustment................341 34.4 WTO Rules and Taxes: The WTO Dispute Resolution Regime...............................347 34.5 Subsidies.................................................................................................................... 348 CHAPTER 35 CROSS-BORDER MERGERS: SOME OF THE ISSUES AND SOLUTIONS................349 35.1 Cross-border Mergers..............................................................................................349 CHAPTER 36 ESTATE AND GIFT TAXATION AND INTERNATIONAL ISSUES.............................351 36.1 Taxation Issues of Cross-border Probate................................................................351 36.2 The OECD Model on Estates and Inheritances.....................................................352 36.3 EU Aspects of Inheritance Tax Issues......................................................................354 APPENDICES APPENDIX 1 THE EU AND THE IMPACT OF THE ECJ...............................................................357 APPENDIX 2 THE EU DIRECTIVES RELATING TO DIRECT TAXATION.......................................369 APPENDIX 3 CASE LAW LIST...................................................................................................377 © RELX (UK) Limited 2019 VIII 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 CHAPTER 1 INTRODUCTION TO INTERNATIONAL TAXATION This chapter discusses: – jurisdiction to tax, and the distinction between public and private international law – tax in the context of public international law – the International Court of Justice and sources of public international law – the limits of enforcement of overseas taxes: the rule in Dicey and Morris – universal jurisdiction of certain criminal acts – a brief history of international tax law, including the BEPS Project 1.1 Introduction A large part of this course is devoted to looking at Double Tax Treaties (DTT) and how they interact with domestic law. The simplest way to explain a double tax treaty is to say that it is a written agreement between two states setting down when and to what extent each has taxing rights over various forms of income that the treaty covers. The aims of the two states when they draw up the DTT are many; they include encouraging trade between the two nations by providing for relief from double taxation whilst preventing the avoidance of taxation. We will look at the role and nature of DTT in a later chapter. Before we can begin to look at DTT we must first consider some key concepts in international law as in order to discuss the interaction of DTT with domestic law we must first understand the limits to the jurisdiction to tax. We will explore this issue in this chapter. 1.2 The Jurisdiction to Tax At some point, you will have heard of the term ‘jurisdiction’ in relation to the right or power of a court of law to hear a case. Jurisdiction to tax has the same meaning – to what extent does a state have the right levy taxation. The jurisdiction to tax will to some extent be limited by the geographical limits of the state, however it is not that straightforward as the right to tax can be based on other factors such as residency. When we are looking at taxing rights we need to consider the connections that a person has to a state – we will look at these in more detail in a later chapter. There are a number of important general legal concepts to consider in reviewing a sovereign state's “jurisdiction” to tax within the context of “public” (to be distinguished from “private”) “international law”. “Jurisdiction” means the competence of a state to consider legal issues within its legal system. Its courts can clearly consider its own domestic laws – but the way they consider foreign or overseas law of another country comes within their accepted rules of interaction between the internal domestic laws and external foreign laws (ie “conflict of law” rules or “private international law”). Within this concept international law generally recognises three different types of jurisdiction. Prescriptive (or legislative) jurisdiction is the power to make rules and pass legislation, issue commands or grant authorisations that are binding upon persons and entities. Adjudicative jurisdiction is the power of a state’s courts to resolve disputes or interpret the law through binding decisions. Enforcement jurisdiction is the power to use coercive means to ensure that rules are followed, © RELX (UK) Limited 2019 1 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 commands are executed or entitlements are upheld – in essence this is the state’s ability to act in such a manner as to give effect to its laws (as stated by Coughlan et al. in “Global Reach, Local Grasp: Constructing Extraterritorial Jurisdiction in the Age of Globalization” (2007) 6 CJLT 29 at 32). The first two are what we might normally consider to be “jurisdiction” – the power to legislate within a territory, and the extent of the legal system’s ability to resolve issues and give binding judgments. Enforcement jurisdiction is also a key element, as once laws are passed the state must have the ability to give effect to them. With regard to tax matters this latter idea of jurisdiction is of relevance, as we shall see below when we consider the Rule in Dicey & Morris (the “Revenue Rule”) which considers the territorial extent of such powers. As we note below, where the limits are with regard to such jurisdiction is likely to become more relevant, and subject to dispute, as countries seek to extend their tax jurisdiction, and courts in other countries have to decide whether or not a state has jurisdiction to impose and enforce a tax. “Public international law”, also referred to as “customary international law” or plain “international law”, covers laws or understandings or generally accepted legal concepts that govern a sovereign state in the international sphere. “Private international law” is the branch of law dealing with a state's recognition of the existence of overseas law and how the domestic courts interpret overseas legislation in the context of domestic cases. We will look at this in a later chapter. Tax comes within the field of “public” law. This is as true for “common law” legal systems (eg England, the US, Australia and other former colonies of the UK) as for “civil law” systems where legal procedures are more formally codified (France, Germany and other continental countries). Common law jurisdictions tend to view tax as a separate area of law, whereas civil law countries view it as a part of public finance law or administrative law, which are both branches of public law. “Public” means pertaining directly to the state. A sovereign state may impose taxes – the law of taxation is directly administered by that state and disputes may therefore arise with the state on the interpretation of those laws. In France, for example, the system of administrative courts deals with public law issues (headed by the Conseil d'Etat). “Private” law disputes (ie those not directly involving the state) are dealt with separately (the ultimate court being the Cour de Cassation). Different countries may take different views as to what the customary international law is in a particular area. Unlike typical domestic court systems within a country’s legal system (referred to as “municipal courts” in international law) there is no formal framework of worldwide courts which govern sovereign states. There are, however, courts that are created out of international agreements between sovereign states. A state may submit legal issues affecting sovereign states to the jurisdiction of a non-national court for consideration by that court. Generally, however, such courts are a court of last resort. The prominent courts in this context are the International Court of Justice and International Criminal Court, which sit in The Hague (see below). Formal international law is wider than just taxation – typical areas governed by formal international law include crimes against humanity, such as war crimes, torture and hostage taking. The United Nations plays a leading role in this area and under its aegis various conventions have been put into place. The Charter that created the United Nations in 1945 also created the International Court of Justice. © RELX (UK) Limited 2019 2 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 In general terms, a country's law governs acts or persons that have a connection in some way with that country. This includes law formally incorporated under domestic statute and common rules, eg of English law, resulting from preceding court judgements (ie common law). 1.3 Taxation and International Law Concepts There are no formal laws (eg conventions) under public international law that inform a sovereign state how to raise taxes and from whom they should be raised. In this sense there is no such thing as “international tax”. However, it could be said that there are generally accepted principles that apply similarly to that commonly cited in international law of “territoriality” and “nationality”. The right of a state to tax income, profits or gains from transactions or sources arising within its territory is referred to as “source taxation” and is a territorial concept. Some states or municipalities tax purely on the basis of territoriality, eg Hong Kong. Most do not. All states, however, do apply the principal of source taxation within their tax regimes. Further, the right to tax “residents” of a particular state is similar to that of the “nationality” concept in that the place of “residence” of a person (including artificial persons, such as companies) determines whether a person is liable to tax in a particular jurisdiction. The methods for determining residence include physical presence in a state for a particular duration, a home and economic connections. In the case of the US it includes citizenship. “Source taxation” and “residence” are recognised by the model tax treaties of both the Organisation for Economic Co-Operation and Development (OECD), and the United Nations. These concepts are discussed later. The question arises as to which country has prior taxing rights. Is it the source country or the country of residence? The answer under the OECD and United Nations Model Tax Treaties is generally (within limits) the source country. Therefore the residence country will either give a credit for the tax incurred in another country on the same source of income, profits or gains, or alternatively will exempt it from tax. Both the UN and OECD Model Treaties and their commentaries have a profound influence on the conclusion of tax treaties internationally. The role of model tax conventions is looked at in more detail in later chapters. 1.4 The International Court of Justice (ICJ) and Sources of Law Used in Judgments The International Court of Justice (ICJ) is the principal judicial body of the United Nations. The Court has a dual role: to settle in accordance with international law the legal disputes submitted to it by states, and to give advisory opinions on legal questions referred to it by duly authorised international organisations and agencies. It is a court of last resort and therefore is unlikely to be used by a state in resolving such matters as the interpretation of tax treaties. The Court is composed of 15 judges elected to nine-year terms of office by the United Nations General Assembly and each other. It may not include more than one judge of any nationality. Elections are held every three years for one-third of the seats, and retiring judges may be re-elected. The Members of the Court do not represent their governments but are independent magistrates. © RELX (UK) Limited 2019 3 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 The judges must possess the qualifications required in their respective countries for appointment to the highest judicial offices, or be jurists of recognized competence in international law. The composition of the Court has also to reflect the main forms of civilization and the principal legal systems of the world. Only states may apply to and appear before the Court. The Member States of the United Nations are so entitled. Notably the US withdrew from the Court’s compulsory jurisdiction in 1986 and accepts the Court’s jurisdiction only on a case- by-case basis. The Court is competent to entertain a dispute only if the states concerned have accepted its jurisdiction in one or more of the following ways: 1. by the conclusion between them of a special agreement to submit the dispute to the Court; 2. by virtue of a jurisdictional clause, ie, typically, when they are parties to a treaty containing a provision whereby, in the event of a disagreement over its interpretation or application, one of them may refer the dispute to the Court. Over three hundred treaties or conventions contain a clause to such effect; 3. through the reciprocal effect of declarations made by them under the Statute whereby each has accepted the jurisdiction of the Court as compulsory in the event of a dispute with another state having made a similar declaration. The declarations of over 60 states are at present in force, a number of them having been made subject to the exclusion of certain categories of dispute. In cases of doubt as to whether the Court has jurisdiction, it is the Court itself which decides. Article 38 of the Statute of the ICJ declares that it is the function of the ICJ to decide in accordance with international law any dispute submitted to it. The following sources are to be used in this respect: 1. international conventions, whether general or particular, establishing rules expressly recognised by the contesting states; 2. international custom, as evidence of a general practice accepted as law; 3. the general principles of laws recognised by civilised nations; 4. within certain contexts the judicial decisions and teachings of the most highly qualified publicists of the various nations, as a means for the determination of rules of law. 1.5 Tax Enforcement and the Rule in Dicey & Morris Within the sphere of public international law the competence of a state's courts would generally not extend to the enforcement of another state's tax laws. This is also a principle of private international law (see rule 3 in, now, Dicey, Morris and Collins, The Conflict of Laws 15th edn, Sweet & Maxwell). The principle initially derives from case law with the earliest reported case being decided in 1729 concerning a claim for Scottish import duties in an English court. A foreign country could not in principle come before an English court and sue for tax liabilities owing to it. There is a limit to a state’s enforcement jurisdiction. A more modern enunciation of the principle is found in the case Government of India v Taylor AC 491. This is also known as the “Revenue Rule”. © RELX (UK) Limited 2019 4 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 In this case, the government of India claimed tax from the liquidator of a UK company. The liquidator rejected the written claims (“proofs”) for the tax. The House of Lords held that the liquidator had acted correctly. The case was covered by the rule that the courts of England would not enforce revenue debts due to another country. This rule applies in a number of jurisdictions besides the UK, for example, the US courts have similarly applied this rule with cases dating back to the 19th century, but in more recent times, see the 2001 case of A.G. Canada v R.J. Reynolds (268 F.3d103). This was an action for damages for lost tax revenue taken by Canada against American tobacco companies as a result of their participation in schemes to smuggle cigarettes across the Canadian border. The US courts dismissed the action as it was held to be an attempt by Canada to directly enforce its tax laws. It is important to note that the rule is limited to direct or indirect enforcement in a country of the revenue laws of a foreign state. As stated in Dicey and Morris, indirect enforcement is not easy to define; it is difficult to draw the line between an issue involving merely recognition of a foreign law and indirect enforcement of it. For example, in the Relfo Ltd v Varsani (2008, High Court of Singapore) case it was held that a UK liquidator's claim against the defendant, Mr Varsani was unenforceable in the Singapore courts. The UK Inland Revenue was the only creditor of the liquidated company and the claim was therefore in substance a claim to enforce a foreign revenue debt (through the liquidator). The line between what is direct or indirect enforcement of foreign tax law, and what may be seen as enforcement of domestic law is not always clear cut. In the US case of Pasquantino v US (2005, 544 US 349) smugglers were convicted for a scheme to smuggle liquor into Canada. It was held that the plot to defraud Canada of its import duties violated the US Wire Fraud Statute. Whilst the defendants tried to argue the Revenue Rule applied, the US courts held that the US statute had been breached, which was a matter of domestic law. Although the recovery of the Canadian taxes was a result of the case, this occurred under the provision of the US Victims Restitution legislation, and the purpose of awarding restitution was not to collect a foreign tax but to mete out appropriate criminal punishment for that conduct. The matter of the difference between prescriptive/legislative jurisdiction and enforcement jurisdiction was discussed in the case Jimenez v HMRC EWCA Civ 51 where the UK Court of Appeal confirmed that the UK tax authority, HMRC, has the power to issue an information notice to a taxpayer resident abroad. Mr Jimenez is a UK national living in Dubai but had resided in the UK previously. His residence was under investigation by HMRC and it had sent him an information notice to his address in Dubai. Mr Jimenez sought judicial review of HMRC's decision to issue the notice. He contended that the application of the UK’s information gathering provisions is based on the revenue rule which prohibited the UK exercising an enforcement jurisdiction within the territory of another sovereign state. The Court commented that the recognition of the principle that Parliament can be presumed not to have legislated in respect of persons resident or events occurring abroad does not prevent particular legislation from being construed as having some extra-territorial effect, if such an interpretation can be derived from the language of the statute and its purpose. Pursuant to this legislation, it is an individual's status as a UK taxpayer which matters, rather than his place of residence. The Court discussed the borderline between legislative and enforcement jurisdiction. However, as noted in Tax Journal (15 February 2019), the © RELX (UK) Limited 2019 5 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 more relevant question is the limits to the revenue rule principle, that one state will not assist another in the collection of taxes due to the other state. It has long been accepted that assistance in gathering information for tax purposes is less likely to interfere with state sovereignty on tax matters. Thus, merely sending a notice to supply information to a person resident in another state is not likely to be seen as an infringement of state sovereignty (and of the revenue rule). A recent Tax Court of Canada case, Oroville Reman & Reload Inc v R (2016) 19 ITLR 259, is another interesting case on the limits of tax jurisdiction, so along the lines of the Revenue Rule. The appellant was a US company which performed reloading services for softwood lumber originating from Canada. The company had no facilities, assets or operations in Canada – it simply received lumber originating in Canada and carried out various services on behalf of the owners of the timber. As a result of an agreement between Canada and the US the company became entitled to a repayment of duty by the US Government (it had been determined the duty had been incorrectly imposed and so it was being refunded). For various reasons the Canadian Government imposed a tax charge of around 18% on the refund. The company challenged the demand for the tax, on the grounds that Canada had no jurisdiction to impose the tax, and that the Canadian legislation was extraterritorial in its operation. The Court held in favour of the taxpayer, noting that the tax demand had been issued under the enforcement jurisdiction contrary to international law. The letters had clearly made coercive demands, indicating a compulsory process (to file a return) with the possibility of a penalty for non-compliance. The Court noted that enforcement jurisdiction can be exercised in a foreign state only with that state's consent. In this instance there was no indication, direct or indirect, of any consent by the US to Canada giving them the right to collect Canadian tax which they claimed the appellant in the US owed. However, as noted in the editor’s comments in the International Tax Law Reports (ITLR), the judgment is interesting in that it analyses the different kinds of jurisdiction, before treating the imposition of this charge as an example of enforcement jurisdiction. Whether or not Canada had jurisdiction to impose the tax depended upon whether there was a 'real and substantial link' between Canada and the activities giving rise to Canada's claim for tax. On the facts here, the trial judge concluded that there were insufficient factors to create a real and substantial link, given that the appellant was a US company, with no facilities, assets or operations in Canada, which performed no services in Canada. Whilst the company was a subsidiary of a Canadian corporation, that in itself was not sufficient to establish a real and substantial link. The company had paid duties in the past to the US Government, and was entitled to the repayment from the US Government. On that basis, the Canadian Government had no jurisdiction to impose the tax. In addition, the legislation sought to impose the tax extraterritorially; Canadian law contains a presumption against extraterritorial operation and there was nothing in the wording of the legislation to override that presumption. However this case does raise some interesting questions. The Court looked for a real and substantial link to establish jurisdiction, which is consistent with current academic thinking. As highlighted in the editor’s notes in the ITLR, the real question is: what is a sufficient series of factors to constitute a real and substantial link? In this case the judge considered relevant factors to link the US company to Canada were not present. However it should perhaps be considered that the factors that are relevant for other taxes, such as income tax (residence or source, for example) are not necessarily appropriate to establish a link for a different type of tax, such as a tax imposed on a refund of duty. It would seem logical that the factors that establish a real and substantial link (with regard to jurisdiction) need to be assessed © RELX (UK) Limited 2019 6 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 on the basis of the type of tax concerned: what is the taxable subject and what is the objective of the tax. What is notable in the judgment is that the Court did indicate that where two states had agreed to assist each other, and consented to collect the other state’s tax, then this would allow jurisdiction to be exercised in the other state. This reflects the approach taken in other cases, such as Ben Nevis (Holdings) Ltd & Anor v HMRC EWCA Civ 578 and Krok v SARS (2015) ZASCA 107 (see later chapter on Article 27) which comment on how the rule in Dicey & Morris (the Revenue Rule) can be abrogated by specific agreement (in those cases, within the double tax treaty) between the states. Therefore, where there are international agreements in force which direct otherwise, or where domestic law specifically allows a claim to be made for foreign tax, then this restrictive rule may not apply. In the case of UK law this is more likely where the foreign tax has been evaded, ie as a result of a criminal act in a foreign jurisdiction. Agreements such as the EU Mutual Assistance in the Recovery of Taxes Directive (2010/24/EU) (new version 2010), and the provisions of Article 27 of the OECD Model Treaty means this rule is gradually being eroded. Article 27 was introduced into the treaty in 2003, and more and more treaties now include such an article. It is notable that the UK-Singapore treaty does not contain such an article, which might have given rise to a different result in the Relfo Ltd v Varsani case discussed above. As already noted, see the later chapter on co-operation and the case Krok v SARS in the South African Supreme Court of Appeal, which discusses Article 27 and the application of the Revenue Rule. The move globally towards greater co-operation between states, as evidenced by the work of the OECD on the BEPS project (and the consensus achieved in that regard), and by the proliferation of information exchange provisions and the ever- growing examples of automatic exchange of data by tax authorities, would seem to indicate that arguably there is little place in the modern world for such a restrictive and inward-looking legal axiom. 1.6 The Concept of Universal Jurisdiction Within the Context of International Crimes To illustrate the degree to which the operation of public international law can be implemented in a national court, the UK Crown Prosecution Service's successful prosecution in July 2005 of an Afghan warlord, Faryadi Zardad, for acts of torture in Afghanistan is a good example. It is the first case of a foreigner being successfully convicted in a national court for offences committed overseas. He was given 20 years in prison, but was deported back to Afghanistan in December 2016. However, there have been subsequent developments in this area. There are concerns regarding politically motivated groups campaigning for the arrest of visiting foreign officials. For example, in December 2009 an arrest warrant was issued in the UK against former Israeli Foreign Minister, Tzipi Livni for her involvement in Israel's recent intervention in Gaza, which was later withdrawn when it was found she was not in the UK. In Spain investigations had been launched against Chinese, American and Israeli leaders. In 2010 the Spanish authorities charged one of their investigative judges (Baltazar Garzon) who was famous for his crusades against foreign leaders. Garzon was © RELX (UK) Limited 2019 7 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 expected to face three separate trials. In February 2012 he was declared not guilty in a case involving the investigation of crimes under the Franco dictatorship. However, he was found guilty in one of the three cases against him and has been disbarred from the Spanish Courts. These matters are clearly on the international political agenda. With regard to tax matters, see the comments in later chapters in respect of money laundering and tax evasion. Where evasion of tax is a criminal matter, as such, it may require to be reported under money laundering obligations. 1.7 A Brief History of International Tax Law and the BEPS Project Two of the most important international bodies are the United Nations (UN) and Organisation for Economic Cooperation and Development (OECD). As we will see both have had and continue to have important roles in the development of international tax law. The UN was created in 1945 out of the League of Nation (LON) which created at the Paris Peace Conference. See Margaret MacMillan Peacemakers, Six Months That Changed the World (2003 John Murray) for a discussion on the LON's creation. From Chapter 7: “Only a handful of eccentric historians still bother to study the League of Nations”, but it was the start to a series of discussions on double taxation issues. The LON drew up the first Model Treaty, “Bilateral Convention for the Prevention of Double Taxation”, in 1927. The LON became redundant once the UN was created. In 1946 the UN set up a general Fiscal Commission and a Fiscal Commission on International Tax Relations (FIUN). The FIUN was later replaced by the Organisation for European Economic Co-operation (OEEC) which became the OECD. The Fiscal Commission later became the OECD Committee on Fiscal Affairs (“CFA”). The CFA works to bring together the tax policy and tax administration expertise of its participating countries (both OECD and non-OECD) allowing its Working Parties and Forums to focus on both the evolution of tax policy and on good practice in all the key areas of tax administration. The first draft of an OECD Model Treaty was published in 1963. It took quite some time for the draft to be finalised and it was published in 1977 by the CFA as the “Model Double Taxation Convention on Income and Capital” (OECD Model Treaty). The OECD Model Treaty has been updated many times with the latest update being in 2017. We will look at the OECD Model Treaty in detail as we progress through the manual. Meanwhile the UN had recognised the importance of representing the needs of developing nations in formulating tax treaties. In 1967 The UN Economic and Social Council requested the UN Secretary General set up an “Ad Hoc Working Group of Experts and Tax Administrators”. The UN Ad Hoc Group of Experts, later renamed as the Committee of Experts on International Cooperation in Tax Matters (“the Tax Expert Group” for short and discussed in more detail below), was to review the progress of tax treaties between developed and developing nations, and to produce guidelines. Over the following years, members of the Tax Expert Group co-operated and met regularly with members of the OECD Fiscal Committees, to blend the needs of developed and developing countries. 1980 saw the publication of UN Model Double Taxation Convention between Developed and Developing Countries. This has since seen further updates with the latest being in 2017. © RELX (UK) Limited 2019 8 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 In addition to the Model Treaty, the OECD has issued many reports and discussion drafts. The topics covered include Transfer Pricing, Attribution of Profits to Permanent Establishments, Tax Havens and Clarification on the Meaning of “Beneficial Owner” in the OECD Model Treaty and E commerce. We will look at some of these in detail in later chapters. The OECD also operates a forum on Tax Administration which brings together the heads of tax administrations to share and exchange information and to discuss coordinated action between authorities. In May 2012 the OECD announced the creation of an OECD Global Forum on VAT. This was a response to work undertaken, in 2011, which identified obstacles in the way domestic VAT systems interact with one another. The forum considers the design and operation of VAT systems, and the maintenance of international VAT neutrality through consistent cross border interaction. The third meeting of the Forum took place in November 2015, where the focus was on the progress made in the development of OECD International VAT/GST Guidelines as a global standard for the application of VAT/GST to international trade. The Forum looked in particular at the collection of VAT/GST on services and intangibles bought by consumers from online sellers abroad. The policy and operational challenges faced by tax authorities in the era of digital globalisation has also been a key part of the discussions in later meetings, as such topic has similarly been with the OECD itself. The BEPS Project The work undertaken by the OECD on the Base Erosion and Profit Shifting (BEPS) project since 2013 is very important, as it has led to many changes in domestic tax systems around the world, changes in existing treaties, and updates to the OECD Model Treaty. This manual makes reference to the changes where they are relevant to the matter under discussion. In this chapter we provide an overview of the project, the work undertaken, and its global impact. The project began in 2013 when the OECD published a paper on BEPS which had been commissioned by the G20. This paper was part of a project looking at whether, and if so why, the current international tax rules allowed for the allocation of taxable profits to locations different from those where the actual business activity took place. The final reports from the project were published in 2015. The 2013 paper identified issues which needed to be addressed by the international community, particularly in terms of how international tax rules keep pace with modern business practices. It also identified two fundamental tensions. The first related to corporate behaviour. The report identified that there was a need to update the international tax rules to prevent tax driven structures that lacked real economic substance whilst ensuring that companies could freely choose the most efficient commercial structures. The second related to governments – it was necessary to stop harmful competition in tax policy while not breaching national sovereignty. The report was followed by the Action Plan also published in 2013. OECD secretary general Angel Gurría said that the Action Plan marked 'a turning point in the history of international tax co-operation'. At the G20 meeting which followed the publication it was commented that the effective taxation of 'mobile income' was a key challenge. One of the key problems identified in the Action Plan was that national tax laws had not kept pace with the globalisation of corporations and the digital economy, leaving 'gaps that can be exploited by multinational corporations to artificially © RELX (UK) Limited 2019 9 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 reduce their taxes'. The principle of coherence was highlighted in the plan with the intention that there should be neither double taxation nor double non-taxation. From a business point of view, coherence means all business income should be taxed once and all business expenditure should be deducted once. There were 15 Action Points as follows: Action Point 1: review the application of existing international tax rules to the digital economy (ie online businesses); Action Point 2: develop anti-avoidance provisions to neutralise the effects of hybrid entities and hybrid instruments; Action Point 3: develop recommendations for countries to deal with controlled foreign companies; Action Point 4: limit base erosion via interest deductions and other financial payments; Action Point 5: counter harmful tax practices more effectively, by improving information exchange, including mandatory spontaneous exchange on tax rulings; Action Point 6: prevent treaty abuse by introducing or strengthening limitation of benefit provisions, and a possible treaty GAAR; Action Point 7: broaden the definition of permanent establishment (PE), with particular focus on commissionaires, to prevent artificial avoidance of PE status; Action Points 8, 9 and 10: amend the transfer pricing rules, including broadening the definition of intangibles, to ensure transfer pricing outcomes are in line with value creation, risks and capital, including intangibles and high risk transactions; Action Point 11: establish methodologies to collect and analyse data on BEPS; Action Point 12: require the disclosure of aggressive tax planning arrangements; Action Point 13: re-examine and develop the rules on transfer pricing documentation requirements; Action Point 14: make dispute resolution mechanisms more effective, by amending treaty provisions such as the MAP process at Article 25 of the OECD Model Treaty; and Action Point 15: develop a multilateral instrument under which countries can implement the Action Plan proposals. The Action Plan did not propose any radical change. Instead, the plan relied on amending and strengthening existing mechanisms. The four minimum standards which must be implemented relate to Action Points 5, 6, 13 and 14. We will look at the outcomes of each of the action points as we work through the relevant topics throughout this manual. © RELX (UK) Limited 2019 10 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 It is generally considered that the BEPS project is likely to be extended, in particular with regard to the issues surrounding Action Point 1 on the digital economy. The G20 leaders issued a communique after the December 2018 Buenos Aires summit at which they reaffirmed their commitments to the BEPS project and promised to work towards a consensus-based solution to address the impacts of the digitalisation of the economy on the international tax system. It is quite possible that ‘BEPS 2.0’ may well go beyond this remit and consider other outstanding issues with regard to global tax. For example, during 2019 both France and Germany have suggested a globally agreed minimum rate of corporation tax which would ensure that the overall tax burden on business profits does not fall below a (politically defined) “acceptable” level, whilst the US sees its recent tax reform as a step forward which other states might replicate. BEPS and developing nations Another aspect of the BEPS project which has proven controversial is its implementation by developing nations. States that join the inclusive framework on BEPS must commit to the package and its consistent implementation, which can be onerous requirements for developing nations putting them at a disadvantage, considering the limited resources such nations have available. It is notable that developing nations were not part of the original smaller group of states which instigated the project and set the agenda and the points to be actioned. However, many developing nations did later join the inclusive framework, and therefore must equally implement the BEPS provisions. Yet the project itself does not address issues which might arise from its implementation, such as the needs of the developing nation for the allocation of taxing rights between source and residence. In addition, the technical resources (such as personnel, expertise, applicable systems) required for implementation and monitoring of the actions of multinationals in their territories inevitably means that resources are diverted away from other important issues in such nations (such as dealing with the informal economy, or tax evasion by individuals). Other problems also arise as many of the OECD points, for example the minimum standard of exchange of country-by-country reports, are based on automatic information exchange. This is set within a complex framework and requires a developing nation to convince a developed country to sign an international agreement with them, or for them to become a signatory to a much wider (and arguably more onerous) multilateral administrative assistance agreement (such as the OECD/ Council of Europe multilateral convention) in order to access the useful information provided in such reports. Some of these issues are discussed in an article of 20 March 2019, by Irma Valderrama, Kluwer International Tax Blog, ‘What do the current OECD proposals say about global tax governance?’. It is noted there that to provide legitimacy for the implementation by developing nations of the BEPS requirements a link should be made between BEPS and the goals in the Sustainable Development Agenda such that the outcome of the project will benefit these countries. Calls are made for further research to be undertaken establishing such a link by bodies such as the OECD and the Platform for Collaboration on Tax (this platform for collaboration is discussed further below and in later chapters). © RELX (UK) Limited 2019 11 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 1 UN Committee of Experts (Tax Expert Group) This group's main task is to review the UN Model Convention. There are continuing discussions to increase the role and scope of the UN Tax Expert Group, so that it can feed further into OECD developments. The OECD CFA has had a greater impact on international agendas for reform of tax systems and co-operation between tax authorities. The UN would like to re-establish the position it held prior to 1954. The Tax Expert Group has 25 members nominated by governments and appointed by the UN Secretary General for a term of four years. They are drawn from the fields of tax policy and tax administration, and meet biannually, once in the spring in New York, and once in the autumn in Geneva. The Tax Expert Group advises on the UN Model Convention – recent updates include revised Article 26 (Exchange of Information); new Article 27 (Assistance in Collection); revised commentary on Article 11 (Interest); revisions to Article 13 (Capital Gains) and revised commentaries on Article 1 (Scope) and Article 5 (PEs). The meetings in 2017 covered the updated 2017 edition of the UN Transfer Pricing Manual, and also the proposed update of the UN Model Convention. The sessions in 2018 covered the final version of the 2017 Update to the UN Model Treaty, noting the changes, and also matters such as the first global conference on the Platform for Collaboration on Tax (February 2018) which considered taxation and sustainable development goals. More recent sessions in 2019 focussed on further updates to the UN Practical Manual on Transfer Pricing, and to the UN Model Treaty. © RELX (UK) Limited 2019 12 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 CHAPTER 2 TAX AND TAX SYSTEMS In this chapter we will explore: – common factors inherent in federal and municipal tax systems – Adam Smith's four axioms of efficient tax systems: equality, certainty, convenience and economy in collection, including lack of intrusion – global trends of lower tax rates and widening of the tax base 2.1 Introduction In this chapter, we will look at some elements of taxation law that can be found around the world. This chapter is important as it gives an understanding of some of the ways in which domestic tax law can operate. Later on in the manual we will see how domestic rules operate when a DTT is in place. 2.2 Federal Systems and Local-level Taxes We can subdivide tax systems into the following areas, which are applicable to tax systems at both the federal and local levels in a sovereign state: Direct taxes Indirect and transaction taxes Branch profits tax Source and residence concepts Income determination Losses Group taxation Tax incentives Anti-avoidance measures Withholding taxes Tax sparing Double taxation relief Let’s look at each in turn. Direct Taxes These are taxes on income, profits and gains. They can be: “flat” ie a single tax rate applies, “progressive” ie increasing rates of tax apply on higher levels of income and gains, and © RELX (UK) Limited 2019 13 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 “regressive” ie decreasing rates apply to higher levels of income or gains, which are less common in practice. Many tax systems distinguish between: profits arising from “capital” assets (ie those that are held as investments or as part of a trade to enable the trade to be carried on) and those from “revenue” activities (ie on-going activities which provide an income, eg a trade or rental activity). Sometimes capital gains are not taxed (eg in Jersey and other low tax jurisdictions). Different taxes apply to different “persons”, ie individuals, companies and corporate bodies. Income tax, corporation tax, social security, wealth and inheritance taxes are common. Determining which people or bodies are liable to which taxes is sometimes not straightforward. Some corporate bodies are “opaque”/“non-transparent” in nature and subject to a corporation tax, others are regarded as “transparent” and the individuals or companies that own those bodies are subject to tax (eg in the case of many partnerships) but not the body itself. The distinction between “transparent” and “opaque” entities, ie “entity characterisation”, is discussed in more detail in later chapters. Indirect and Transaction Taxes These are taxes on the proceeds of transactions. They include sales taxes, value added tax, registration and stamp taxes. Generally, unlike a direct tax, the tax is applied to the proceeds of the transaction with no regard for deductions against the proceeds. As in the case of direct taxes, sometimes there is a distinction for a transaction that is “exempt” from tax and one that is subject to “zero rate” – the UK value added tax makes such a distinction. As much as any other tax, these taxes may take into account whether the items being taxed are an economic necessity or a luxury. The latter are generally subject to higher taxes. The reason why certain taxes are called “indirect taxes” is that the customer does not pay the tax directly to the tax authorities; the supplier of the goods or services does so. In a wider economic sense all taxes can have an indirect effect; the price of goods can be a reflection of direct taxes as well as indirect taxes. Branch Profits Tax Some states apply a higher rate of tax on foreign companies with a permanent establishment or branch in their state. The US does (30% on after-tax net profit, additional to “normal” tax, applied to foreign companies). There is a strong contention that in the case of the EU such a tax is discriminatory and contravenes the freedom of establishment concept. In the case of other © RELX (UK) Limited 2019 14 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 countries a possible line of argument is infringement of the non-discrimination article of a tax treaty. The application of such an article is discussed in a later chapter. The question then arises, as in the case of the US, whether subsequent domestic law enacted after the ratification of a tax treaty overrides the terms of a tax treaty. The additional amounts payable under a branch profits tax may be held to be equivalent to a dividend withholding tax, which would have been payable by a local company if a distribution had been made of the same amount of profits made by the branch. If that is the case a taxpayer could still claim discrimination if the dividend withholding tax under the relevant tax treaty would have been less than that charged under domestic law. Source and Residence Concepts These are the connecting factors applied by a state in taxing income and persons. We will look at these in more detail in a later chapter. Income Determination This covers a whole host of issues in relation to the different factors that affect income measurement, ie what deductions can be offset against the gross income (eg depreciation: see below), what valuation factors are used in deriving income (eg stock valuation), how inter-company dividends are assessed, how foreign income and dividends are assessed, to what extent the tax rules follow international accounting standards. A state may allow the depreciation shown in the accounts as a deduction for tax purposes (typically in continental Europe), or there may be specific rules giving different rates of depreciation for different assets. In the UK depreciation for tax purposes is referred to as “capital allowances”. It may be possible to obtain a 100% first year allowance for certain capital expenditure, which is possibly subject to a claw-back at a later date when the asset is sold by the business. There are rules that allow the written-down values to be preserved on mergers or take-overs or reorganisations, so that the capital allowances due remain the same despite changes in ownership. Losses Tax losses are treated in different ways. Most jurisdictions allow such losses to be offset against other income in the same period or future periods (for example, indefinitely in the UK against total profits, subject to a restriction, or in the US, pre- 2018 up to twenty years, post-2018 indefinitely). Some jurisdictions permit losses to be carried back. In the UK trading losses for companies can be carried back against total profits of the previous 12 months. In the US pre-2018 net operating losses could be carried back two years - this carry back was removed in the 2018 tax reforms. Group Taxation In certain countries losses of one company can be offset against another's profits where they are within the same group or consortium as defined. In the UK a group relationship can exist where there is a 75% (or less in the case of a consortia) relationship between companies whereas the US requires an 80% relationship between group members. Unlike the UK, the US has a formal tax consolidation system whereby a company's tax results are included in the parent company or representative company's results. Intra-group transfers of assets can be tax free and so can the payment of dividends. © RELX (UK) Limited 2019 15 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 Tax Incentives Every country has different degrees of economic advantage, as the famous nineteenth century economist David Ricardo's exposition of “comparative advantage” made plain. Some countries are more able to provide certain products or services than others. Natural advantages arise from geographic location and climate. Imposing tariffs tends to hinder the process of trade between nations and therefore can lower overall global output to the disadvantage of all nations. The purpose of the 1947 General Agreement on Tariffs and Trade (and subsequent agreements) was to provide a global framework for worldwide trading stability. These issues are addressed in Part V of this manual. Besides tariffs, some countries employ tax incentives to try to gain a competitive advantage. These may or may not be to the benefit of global trade. Typically, a number of countries provide tax credits for research and development. For example, UK companies may obtain a tax credit on certain R&D expenses. These credits can be in addition to the normal tax deduction of those expenses. In the UK small and medium companies receive an enhanced deduction of 230% for R&D expenses as well as a payable tax credit of 14.5%. The Australian R&D system gives a (refundable) R&D credit of currently 43.5% for companies with group turnover less $20m, 38.5% (non-refundable) for all other eligible entities. Other incentives exist to encourage specific economic behaviour, such as increasing employment or exports or conversely inbound investment, eg in the form of tax holidays or tax-free zones. The OECD or EU may regard some of these state incentives as “harmful conduct”. However, this is a highly controversial area as such incentives may in economic terms also advantage other nations. Anti-avoidance Measures As we will see in later chapters, the OECD, EU and the UN are increasingly encouraging countries to introduce anti-avoidance measures to counter “harmful tax practices” by taxpayers within states or between taxpayers in different states. Withholding Taxes Worldwide tax guides produced by professional advisers generally provide details as to the rates of withholding taxes applying to the payment of dividends, royalties and interest. Under domestic law a state can require a person to withhold tax on making a payment to another person. The tax is normally applied to gross payments (eg subject to the terms of a tax treaty, the US applies a 30% tax on dividends, interest and royalties; similarly the UK applies a withholding of 20% to interest and royalties, subject to treaties and certain statutory exclusions). As we will see in a later chapter, the domestic rates can then be reduced by bilateral double tax agreements with other countries. In some cases the rates can be reduced to 0% eg if the EU Directives on the payment of dividends between parent and subsidiary companies in EU Member States (2011/96/EU) and on the payment of interest and royalties (2003/49/EC) apply (we will look at this in a later chapter). © RELX (UK) Limited 2019 16 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 Tax Sparing Some tax treaties enable an investor to obtain a tax credit for foreign tax not actually paid, but which would have applied but for the existence of a tax holiday of some sort. Typically, this incentive, known as tax sparing, was designed to encourage inbound investment in developing countries. However, the availability of such relief is now less frequent as those countries become more developed. There is more detail on tax sparing in a later chapter. Double Taxation Relief Such relief is either available under domestic law (referred to as “unilateral” relief) or under the terms of a tax treaty (“bilateral relief”). There are three ways of obtaining relief for foreign tax charged on income subject to tax under domestic law: 1. Exemption. A typical example is the Dutch participation exemption from Dutch tax on dividends received by a Dutch company or the UK dividend exemption system applicable from 1 July 2009. Similarly, in the UK capital gains on the sale of qualifying shareholdings might be exempt from tax. 2. Credit relief. The foreign tax reduces the charge to domestic tax by being set off against that tax – typically there is a cap on the foreign tax available for credit equal to equivalent domestic tax rate on the income assessable to tax. The UK system is in the main based on a credit relief (or deduction where it is not possible to obtain credit relief: see below). 3. Deduction against assessable income. This is normally the least beneficial way of relieving a foreign tax except where there are overall losses. Foreign tax is treated here as a deductible expense which may be included in losses. The above methods may equally apply to the relief of local municipal taxes against federal level tax. In the US local state taxes may be deducted for federal tax purposes. Certain foreign local state taxes, as well as federal taxes, can also be credited for UK tax purposes. Again each of the above will be considered in more detail in a later chapter. 2.3 Adam Smith's Four Axioms for Efficient Tax Systems Over 240 years ago (in 1776) the Scottish economist Adam Smith's The Wealth of Nations was published to great acclaim. Besides the famous concept of the “invisible hand” and the advantages of the division of labour, the main focus of the text is on the economic history of nations. It includes a significant exposition on taxes in the chapter headed, “Of the sources of the general or public revenue of the society” (Book V, Ch 2). To quote: “All nations have endeavoured to the best of their judgement, to render their taxes as equal as they could contrive; as certain, as convenient to the contributor, both in the time and in the mode of payment, and in proportion to the revenue which they brought to the prince, as little burdensome to the people.” © RELX (UK) Limited 2019 17 2020 Sittings Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2 The above comments follow on from four stated axioms, or maxims (accepted truths), that should be present in all efficient tax systems. These are: equality; certainty; convenience of payment; and economy in collection. These are discussed in turn below. Equality. Taxpayers should pay tax in proportion to their respective abilities to pay tax, ie in proportion to their relative earnings. Adam Smith compared this to the joint tenants of an estate who should pay maintenance payments in accordance to their interests in that estate. Certainty. It needs to be clear as to the amount of tax that needs to be paid, the timing of the payment and the manner of the payment. If these are not certain, but are arbitrary, then “every person that is subject to that tax is put more or less in the power of the tax-gatherer, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisite to himself”. Uncertainty leads to corruption. In Adam Smith's eyes, uncertainty was a far worse evil than inequality in the burden of tax. Convenience of payment. Tax ought to be levied at a time which is most likely to be convenient to the payer. In this sense taxes on consumables (ie indirect tax, such as value added tax) are a convenient tax for the consumer (and may be argued to be convenient to the supplier since he has earned the revenue from that sale to pay the tax). Economy in collection. The cost of raising taxes should be minimised. Adam Smith made a number of observations as to factors that affect such costs: 1. The number of tax officers and their pay needs to be proportionate. 2. The levying and assessing of taxes can divert the attention of businesses from dealing with their day-to-day commercial activities, which can benefit the nation far more by increasing employme