I
N T E R N A T I O N E L L AH
A N D E L S H Ö G S K O L A NHÖGSKO LAN I JÖNKÖPI NG
B e s k a t t n i n g a v I n t e r n a t i o n e l l a P o r t f ö l j e r
- Juridisk Analys -
Magisteruppsats inom internationell skatterätt Författare: Stefan Palm
Handledare: Juan José Nieto Montero, João Félix Pinto Nogueira samt Ulrika Rosander.
J
Ö N K Ö P I N GI
N T E R N A T I O N A LB
U S I N E S SS
C H O O LJÖNKÖPI NG UNIVER SITY
Ta x i n g I n t e r n a t i o n a l P o r tf o l i o s
- Legal Analysis -
Thesis in international tax law Author: Stefan Palm
Tutors: Juan José Nieto Montero, João Félix Pinto Nogueira and Ulrika Rosander.
Magisteruppsats inom internationell skatterätt
Titel:
Beskattning av Internationella Portföljer
– Juridisk analys
Författare:
Stefan Palm
Handledare:
Juan José Nieto Montero,
João Félix Pinto Nogueira samt
Ulrika Rosander
Datum:
2009-01-15
Ämnesord:
Internationell skatterätt, Utdelning, Kapital
beskatt-ning, Europeisk beskattbeskatt-ning, Portfölj inkomst.
_______________________________________________
Sammanfattning
Magisteruppsatsen är inriktad på utvecklingen inom beskattnings neutraliteten inom områ-det direkt beskattning för portfölj inkomst inom EG-rätten. Frågan är av stor betydelse ef-tersom den juridiska behörigheten inom EU är otydlig och efef-tersom den internationella skatterätten är ett komplext område, påverkar den även portföljer. Problemet är ofta be-skrivet i termer om dubbel beskattning och det är av särskilt intresse för denna uppsats att undersöka hur en portfölj är påverkad av gränsöverskridande investeringar som har relatino till EU.
Termen portföljinkomst är på den internationella arenan använd med stor variation och somliga länder använder sig inte av en speciell beskattning för portföljinkomst. EU har ing-en positiv integration som kan bygga upp ing-en skattelagstiftning och därmed försvinner dess möjlighet att bestämma hur portföljinkomst skall beskattas. EG-domstolen har istället en exklusiv möjlighet att ruinera den hantering av skatt som är orättvis enligt den fundamenta-la fria rörligheten för capital i EG förordningen. Problemet med en brist på positiv integra-tion inom EU gör det svårare att harmonisera skattesystem till ett. Länder är rädda för att förlora makten över sin viktiga finansieringskälla och problem finns även utanför unionen då CIN och CEN används olika. En använding av dem gemensamt verkar idagsläget vara en utopi.
För att ge en lättnad inom dubbelbeskattningen är bilaterala metoder i använding. Ofta an-vänds dock unilaterala metoder. Båda erbjuder Credit-metoden (Avräkningsmetoden), Ex-empt-metoden (Friställningsmetoden) och Deduction-metoden (Avdragsmetoden).
EG-domstolen har i sina mål favoriserat Credit-metoden, vilken ser ut att vara samma me-tod som används inom Direktiv, såsom Sparande direktivet om informations utbyte samt i enighet med doktrin.
Problemen på området är svåra p.g.a. att en osäkerhet uppkommer för de investeringar som skulle störa den globala handeln och en skatteplanering om inte t.o.m. skattemissbruk skulle kunna uppkomma, som gör att en trend införs och orsakar allvarliga konsekvenser för en av de största ekonomiska motorerna i världen; aktiemarknaden. G20 mötet har i sin “Declaration summit on financial markets and the world economy” från den 15 november 2008 be-slutat bl.a. att på medellång sikt fortsätta med sitt arbete inom organ såsom OECD att för-stärka ett informationsutbyte om skatt sinsemellan och vidare att stora konsekvenser skall utövas vid brist av detta. Bestämmelsen ger en praktisk insyn på skattens betydelse inom ett gott skattesystem för att utveckla en global ekonomisk välfärd.
Master’s Thesis in International Tax Law
Title:
Taxing International Portfolios – Legal Analysis
Author:
Stefan Palm
Tutors:
Juan José Nieto Montero,
João Félix Pinto Nogueira and
Ulrika Rosander
Date:
2009-01-15
Keywords: International taxation, Dividends, Capital taxation,
European taxation, Portfolio income.
______________________________________________________
Abstract
The thesis is concentrating on the development of tax neutrality in the area of direct taxa-tion of portfolio income within the EC Law. The questaxa-tion is of great importance as the ju-ridical powers of the EU are unclear and as the international tax law is a complexed area, it does affect portfolios. The problem is often described in terms of double taxation and it is of special interest for this paper to see how a portfolio is affected by cross-border invest-ments with relation to the European Union.
The term portfolio income is on the international area widely used and not all countries are using a special taxation of portfolio income. The EU has no positive integration to build a tax legislative platform and thereby to decide how portfolio income should be taxed. In-stead has the ECJ an exclusive possibility to destroy tax treatments which are unfair due to the fundamental free movement of capital in the ECT.
Problems in regard to the lack of positive integration for the EU makes it harder to unify the union into one tax system. Countries are afraid of loosing their important source of fi-nancing the state and the two generally used methods of CIN and CEN are used in differ-ent countries, even outside the union. To use them synchronised seems today to be a utopy.
To relieve the double taxation, are often bilateral methods used, and sometimes unilateral methods. Both of them are using the Credit method, Exemption method and Deduction method. The ECJ has in its case law favoured the Credit method, which seems to be the same method used by the Directives, such as the Savings Tax Directive about information exchange and in accordance with the doctrine.
The problems in the area are difficult as an uncertainty appears for the investments which could interfere the global trade and a tax planning, if not even tax abuse could appear mak-ing a movement which would have severe consequences for one of the biggest economical engines in the world; the stockmarket. The G20 meeting has with its ‘Declaration summit on financial markets and the world economy’ from the 15th November 2008 decided among other
things, to continue the work within organisations such as the OECD decided to, among other things, strengthen the exchange of information on taxes on a middle-long time schedule and to give severe consequences if this will be nonchalanced. This decision shows how the importance of taxes on a practical view of the importance of developing a good tax system to get into an economical global wealth.
Table of Contents
Appearances ... 1
Thank you... ... 1
1
Introduction ... 3
1.1 Background ... 3 1.2 Purpose ... 41.3 Method and Material ... 5
1.4 Disposition ... 5
2
Guidelines for a Good Tax System of Portfolio Income ... 5
2.1 Territorial Tax System and Worldwide Tax System ... 6
2.2 More Guidelines ... 7
2.2.1 Capital Import Neutrality (CIN) ... 8
2.2.2 Capital Export Neutrality (CEN) ... 9
2.2.3 CIN v. CEN ... 9
2.2.4 Critics ... 10
2.3 The Issue ... 10
3
Portfolio Holding and the EC law ... 13
3.1 Portfolio Income ... 15
3.2 Portfolio Taxes ... 17
3.3 No Capital Gain Tax ... 20
3.4 A Jurisdiction’s Right to Tax Portfolio Income Under International Law ... ... 21
3.5 The EU and International Capital ... 21
3.5.1 Free Movement of Capital ... 22
3.5.1.1 Free Movement of Capital and Portfolio Investments ... 23
3.5.1.2 Free Movement of Capital in Relation to other Fundamental Freedoms 24
4
Taxation of International Portfolio Holding ... 25
4.1 Portfolio Holders ... 25
4.1.1 Individual ... 26
4.1.2 Entity ... 26
4.2 Internal Approach ... 27
4.2.1 The Unilateral Methods ... 27
4.2.1.1 Foreign Tax Credit Method ... 28
4.2.1.2 Exemption Method ... 30
4.2.1.3 Deduction Method ... 32
4.2.1.4 Conclusion ... 33
4.3 International Approach ... 34
4.3.1 Double Tax Treaties (DTT) ... 34
4.3.1.1 The OECD Model ... 36
4.3.1.2 The U.N. Model ... 39
4.3.1.3 The U.S. Model ... 42
4.3.1.4 Do We Need DTT? ... 43
4.3.1.5 The Relation Between Tax Treaties and the ECT ... 44
4.4 European Approach ... 48
4.4.1 Positive Integration ... 49
4.4.1.1 Savings Directive ... 49
4.4.1.2 Exchange of Information Directive ... 53
4.4.2 Negative Integration ... 55
4.4.2.1 Case-Law ... 55
4.4.2.1.1 How does the EC law deal with Double Taxation for Inbound _________Dividends of Portfolio Investment? ... 56
4.4.2.1.2 Capital Gains on Ordinary Shares ... 63
4.4.3 Conclusion ... 64
5
Summary ... 65
Appearances
ECJ European Court of Justice.
ECT Treaty of the European Community.
EC law European Community Law.
EU European Union.
IBFD International Bureau of Fiscal Documentation.
MS Memberstate of the European Union.
OECD Model OECD Model Tax Convention on Income and on Capital; July 2008.
UN Model United Nations Model Tax Convention between Developed and Developing Countries; 2001.
US United States of America.
US Model United States Model Income Tax Convention; November 2006.
Thank you...
‘The hardest thing in the world to understand is the income tax.’ -Albert Einstein
The day has come when the accomplishment is done. The period of my thesis will always be close to my heart, as it has been a time I consider to be similar with the ‘Camino de Santi-ago’ with many curious crossings, each leading to cotter and reaching closer to the goal. The camino1 has thus also given some blisters, as the long journey has had a heavy back-pack, regardless of up-hill or down-hill. The information has been like a mountain to get through. Sometimes has it been relatively the same or not necessary, and sometimes has it been a real test.
The fact that the camino was having crossings is stimulating as there still is much out there to discover, and it would be fascinating to try another way in the future from the camino. The camino resulted in stimulating my passion for finance and law. The law is always there by your side as it is like a world, with its own language, its own culture and its own history and future. The Finance is fascinating as we are on a daily basis impacted by it, and we no-tise it especially in these times of regression in the world economy.
My decision to walk the camino, have been done by my passion to the subjects of financial law, but I wouldn’t have reach the destination Santiago de Compostela, if not for the peo-ple I’ve met on my patch.
I want to thank especially João, a light in the dark and a friend, for all from intelligent stimulation to help with ordering good coffee in Spain.
Thanks to prof. Nieto and Ulrika Rosander who made it possible to write this thesis at both the universities and to get this paper accredited.
I want also to give special thanks to Mireya as I wouldn’t be in Spain if not for you. An in-telligent woman with an optimistic mind and stubborness and who gave stability and love. Finally, I want to thank my beloved family, for being there despite the miles between us. And once I was back in Sweden, all the help I got there.
I wouldn’t deliver my best without all of your support, thank you.
January 2009, Stockholm Stefan Palm
1 Introduction
‘Taxes are what we pay for a civilized society’2
1.1 Background
Since the first known taxation in 1200 B.C Egypt, has the evolution sharply increased.3 In
present, there is a sophisticated global financial market, meaning a more complex tax sys-tem.
By the fact of an era of enormous exchange of information channelized mainly through the Internet the World has became even more global. Our physical boundaries are decreasing as we are more united, by for instance the European Union, making impact on the national jurisdictions.
The Global Financial Markets are in fact the biggest engines in an economy which is having its own life and is impacting more and more people and governments, from a regional level to an international level. Nowaday it is especially remarkable by the effects of the crisis bloomed out from the U.S subprime loan system.
The Players4 in the financial markets are the financial institutions also known as banks,
pension funds, investment funds other financial companies. To the term of players should also individual investors be added as it has became significantly easier to participate and to get information in the market. The majority of the players are trying to maximize the eco-nomical-wealth as well as offer investments to a risk which their clients can handle, mean-ing in fact a bigger wealth of our richness in savmean-ings and pension funds. The impact to a single person’s life is from an economical-wealth point of view, with a mild term, huge. Nowaday, when it comes to the size of the pensions funds it is an actual topic for people retirering as the difference in for instance: a person retirering this year in the UK that has a pensions fund exclusively invested in the national index has seen a drop in the lifetime sav-ings with 32 %5 in comparison with have been retired one year earlier. In Sweden, Spain
2 p. 1 Adams. 3 p. 6 Adams.
4 The term player is used as it refers to actually be taking a part of the market while a participant may be an
observer without being “in’ the market.
and Poland the drop has been 35 %6, 23 %7 and 46 %8 respectively. The people are getting
major in age9 and are facing tops and bottoms in their life long savings.
With the introduction to the Euro, the EU has started to debate the desirability and feasi-bility of more co-operation in the field of capital income.10 With a more united economic
policy it could be more safe, by less risk, to invest capital and more alternatives could open up for investments. However the market will look like, will the capital market be accompa-nied by a tax system.
The present tax system is designed by a business income instead of a portfolio income per-spective, at least in the US, and as the legislators haven’t thaught much about taxing portfo-lio income.11 One of the fundamental questions appearing, is how the taxation should func-tion in the financial market, and further if it is fulfilling its purpose?
1.2 Purpose
The paper will concentrate on the recent development within the European Union: be-tween the MS and its relation to third countries with respect to portfolio holdings.
The matter is dealing with Neutrality for portfolio holdings which are on an international level and appearing as a double taxation, by the later it is meant that an affection of at least one jurisdiction’s tax rules will be existing. The view will be from the perspective of a resi-dent country. The Neutrality will be presented by the used methods, from a theoretical ap-proach in Guidelines and in practise by uni- and bilateral methods. The Neutrality will fur-ther be analized in relation to the EC law.
This paper does not consider any issue on permanent establishment and it is not entering in-depth any national tax system nor explaining the roles within the financial markets.
6http://di.se/ [2008-10-14]
7http://www.bolsamadrid.es/esp/bolsamadrid/publicacion/estadisticas/key_200710.pdf [2008-10-14] 8http://www.gpw.pl/wykresy/wykres.asp?ticker=WIG20&BW=r [2008-10-14]
9 2007 World Development Indicators. 10 p. 1 in the conclusion of Cnossen (2000). 11 p. 229 Graetz (2004).
The essay is on an international area of tax law with a delimitation from inter-governmental legislation of money laundry, bank regulations as well as to Civil law.
1.3 Method and Material
The paper is following the hierarchy of legal sources where the statutory legislation is fol-lowed by preparatory acts, case law and finally doctrine. The method for the mentioned material in use is also known as traditional legal methodology12.
1.4 Disposition
In chapter 2 is a statical approach taken where Guidelines are presented for a good tax sys-tem with respect to portfolio income. The reader will obtain a theoretical understanding of the complex issue.
In chapter 3 will the portfolio holding be defined from an international tax law perspective and how the EC tax law is situated in relation to the portfolio holding.
The analizing part of how the modern EC tax law is dealing with the taxation of the port-folio holding is made in chapter 4.
The final chapter 5 will give the author’s conclusion and a summary of the thesis.
2 Guidelines for a Good Tax System of Portfolio
In-come
Taxes are present in our lifes and impacting us and our wealth. We cannot avoid the fact according to the saying that taxes are as sure as death.13 As we cannot avoid them, the
ques-tion arises of what then the tax is for. The main funcques-tion of a tax could be understood as
12 Swedish term; Rättsdogmatisk metod. 13 Benjamin Franklin, 1706-1790.
the need to finance the public administration.14 This financing is regulated, and the
regula-tion of the taxes can be considered to follow guidelines.
The guidelines intend to establish a good tax system for portfolio income.15 A good tax
sys-tem, has at least the following characteristics – Equity, Legal effectiveness and Economic efficiency. 16
The first characteristic: Equity, is distinguished between vertical and horizontal equity. The later addresses fair tax base and the earlier addresses a fair distribution of income after tax. Within international taxation does specific aspects such as the inter-individual equity and inter-national equity also excist. The inter-individual equity is understood to determine the tax treatment in the country of residence.17 The inter-nation equity on the other hand, es-tablishes the right for the source country to receive a fair share of the tax revenue.18
The second characteristic: Legal effectiveness, regards the validity of a norm by correct leg-islation and an obey of the society.19
In this paper does an Economic efficiency refer to that taxation should not be influencing an economic decision for a portfolio holder, planning to make an investment, it should be indifferent both in the portfolio holders own country and a foreign country. By this it is meant that the taxation should be as neutral as possible: a principle of Neutrality.20
2.1 Territorial Tax System and Worldwide Tax System
In theory, there excists two common basic types of a national tax system: a Territorial Tax System and a Worldwide Tax System.21 A jurisdiction is positioned towards one of them depending on its political goals of achievement with their tax.
14 IBFD International Tax Glossary; ‘Tax’. 15 p. 1 McIntyre. 16 p. 25 Juusela. 17 p. 12 Panayi. 18 p. 25 Juusela. 19 Ibid. 20 p. 25 Juusela. 21 p. 109 European Parlament.
The Territorial Tax System is based on taxation of income derived within the national ju-risdiction, irrespective of the residence of the taxpayer.22 This system relies on the funda-mental principle of source. It allocates the tax jurisdiction over income by letting the coun-try tax income having source in its jurisdiction. This regardless of the residence of the tax-payer. The tax system is also referred to as the principle of limited taxation.23
In the Worldwide Tax System, the worldwide income is taxed of individuals and entities, regardless of where the income derives from.24 This system relies on the fundamental prin-ciple of residence. Another popular name is the prinprin-ciple of unlimited taxation for this tax sys-tem.25 It considers the resident taxpayer as a subject26 to tax on her27 worldwide income and
treating the non-residents as subjects to tax on domestic-source income.
The basic types of national tax systems are in practise different from theory as there is no country having a pure system of any of the mentioned types and is either a mixture or comes in hybrid forms.28 All tax systems have though features allowing them to be charac-terised as either one of the types. Both the systems are set as a framework for making Neu-trality and Equity.29 Sofar only equity has been described and below it is described how the neutrality exists in the systems.
2.2 More Guidelines
It is assumed that the fundamental goal of international income tax policy is to advance worldwide economic efficiency and that tax should be neutral.30As tax equity relates
22 Ibid. 23 p. 2 Panayi. 24 Ibid. 25 p. 3 Panayi.
26 The definition of a tax subject is described in chapter 2.3.
27 By the lack of a neutral word for ‘his’ and ‘her’ should the reader understand in the following that both
terms could be used.
28 p. 14, Staff of the Joint Committee on Taxation. 29 p. 4 Cnossen.
marily to the relationship of taxpayers to each other, neutrality refers to the relationship be-tween the taxpayer and the State.31
With respect to the operation of residence taxation in general, and the relief of double taxa-tion in particular, it should be noted that the traditaxa-tional debate is formed in terms of capi-tal-export neutrality (CEN) and capital-import neutrality (CIN). They are established for fulfilling the purpose that economic decision should be made without regard of the tax consequences. In other words, the mentioned concept of economic efficiency.
A country’s net flow of capital is making a country to either a net capital importer or a net capital exporter. Therefore, all countries in the world are either CIN or CEN, depending on if the cash flow is exported or imported to a country. Both the CIN and CEN focuses on world welfare by promoting free movement of capital.32
2.2.1 Capital Import Neutrality (CIN)33
CIN focuses on the impact of tax on imported capital to one country from another. The objective of CIN is to ensure that the total tax imposed on investment returns in a given country is the same irrespective of the residence of the portfolio holder34. CIN
there-fore advocates equalizing the tax imposed on all investors, from whichever country they may be. By the lack of concentration on the portfolio holder, I suppose by the term resi-dence which is widely used, it also means that an exclusion is made from nationality.
CIN is attained when the total tax imposed on foreign investments by the portfolio holder’s country of residence and the capital-importing country equals the tax imposed on domestic investments, in other words the tax the capital importing country imposes on its residents' investments at home. For instance should, a tax burden of 30 % should rest on a portfolio holder’s income, whether (s)he is resident or not.
31 p. 23 Rohatgi. 32 p. 23 Ibid.
33 para. 5 European parlament.
On an international area could CIN be achieved if: all countries imposed an identical rate of taxation on source principle and exempt35 residents from tax on their income produced abroad.
2.2.2 Capital Export Neutrality (CEN)36
CEN is developed within the OECD and it concentrates on the tax subject.37 The portfolio holder is subject to the same tax level on capital income, regardless of the country in which income is earned. According to this method, will a resident have the same tax choice when (s)he chooses an investment generating income from abroad or being domestic. The in-come could be taxed with for instance 30 % on her total inin-come from the investment. The Neutrality via CEN could be achieved on an international level if all countries were us-ing a taxation on their residents and taxus-ing their worldwide income.
2.2.3 CIN v. CEN
As different interest exists, either CIN or CEN occurs in a jurisdiction. When it comes to choosing an approach, should the jurisdiction in question, observe the effects of CIN and CEN respectively.
Jurisdictions are, despite the lack of evidence, afraid of using CIN as it could diminish the national tax base. For multinational companies would CIN be preferred as it establishes a better international competition.
CEN on the other hand, seems to be more favoured by academics as distortion in the loca-tion of investments are thought to be more costly than distorloca-tions in the allocaloca-tion of sav-ings.38
35 See 4.2.1.2.
36 para. 5 European Parlament. 37 Sheppard.
It could however be possible for CIN and CEN to co-exist if the tax base and the marginal effective tax rates on capital income would be identical around the world’s jurisdictions, but this seems to be an utopy, or atleast in present, unreachable because of the different goals with taxation.39
2.2.4 Critics
As long as it doesn’t excist a completely harmonised global tax system, a full neutrality un-der both CIN and CEN are not achievable, and that is why a pure form of CIN or CEN doesn’t exist.40 Using both CIN and CEN in one jurisdiction is also impossible as the re-quired measures would conflict with each other because CEN favours worldwide taxation while CIN encourages a territorial tax system.41 Not using neither one of the methods
would not fulfill the fundamental purpose of neutrality, which would ultimately lead to a lack of a good tax system.
The pure forms of CIN and CEN are constituting a dilemma of how to approach neutrality in international taxation. In practise are the pure forms of CIN and CEN however rarely used. Countries follow a combination of CIN and CEN principles depending on their overall economic policy, of which tax is one of the components.42
2.3 The Issue
The central issue in this paper is the issue due to Double taxation. One of the two forms of the issue appear when jurisdictions are overlapping one another because of different na-tional tax laws.43
The overlap arise as an economic activity connects jurisdictions. This means that one and the same person44 becomes taxed more than once for the same income arisen from the
39 p. 227 Graetz (2004) and p.12 Panayi. 40 p. 227 Graetz (2004).
41 Ibid. 42 Ibid.
same period.45 The collision appears because of different definitions of the principles in the
domestic law.
An observant reader can distinguish three key components of a tax transaction which con-nects the jurisdictions to find a tax liability:
Tax subject. The identity of the taxpayer, or a person’s relationship to the taxed object that creates a tax liability:
Tax object. The identity of the subject matter, or the facts that cause the tax liability: and Connecting factor. There must be a ‘reasonable connection’ between the taxing powers of the State, and the taxpayer or the transaction. Without a connecting factor between either the taxpayer or the business activity and the tax jurisdiction, a State cannot levy its tax.46
The collision can for instance occour when a non-resident brings a foreign-source income to a country where (s)he is having a citizenship. The worst scenario would lead to a tax li-ability in three different countries on condition that all the three principles would be in use.47 The mentioned issue is labelled as juridical double taxation or international double taxation
due to its nature. 48
An efford has been made to address specificly the issue. The OECD defines international double taxation as:
‘[T]he imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods.’ 49
UN defines a double taxation as ‘the imposition of similar taxes in two or more States on the same taxpayer in respect of the same base.’50
44 By person in this sentence it is referred to any subject on whom a tax burden can rest, including entities. 45 para. 169 European Parlament.
46 p. 16 Rohatgi.
47 The problem can also appear as one country can use more than one of the principles. 48 para. 169 European Parlament.
49 para. 1 OECD Model. 50 para. 2 UN Model.
The wording informs that a double taxation can appear also when more than two jurisdic-tions claim their right to the tax: a ‘multi-taxation’ can occour, though it has the same char-acteristics as a double taxation. The definitions are similar to each other but the UN defini-tion is more general as it doesn’t mendefini-tion anything about the period. However shouldn’t any greater importance be given as both definitions are used for the same purpose in prac-tise.
The juridical double taxation occours on an international level as the tax issue is involving at least two jurisdictions. A national level can also appear when one and the same nation uses more than one of the mentioned principles from the guidelines. For instance by re-gional taxes that are taxing the same income levied from one region to another, where the taxpayer is resident, despite being in the same nation. This issue is referred to as legal iden-tity of subject.51
Another tax problem of importance is labelled as economical double taxation. It refers to a double tax on the same income in the hands of different persons. It excists for instance in situations such as between husband and wife, partnership and partners, company and shareholder as well as parent and subsidiary.52 An economical double taxation occours
more often on national level but international cases can excist in situations such as, when the company and the owner are residents in different States, or when one country taxes a legal entity as such, whereas the other country disregards the entity for tax purposes and taxes the income in the hands of the resident owner.53
It is possible to refer to the economic double taxation issue as to an economic identity of subject.54
A country would gain from avoiding a double taxation as each country gets its share of tax revenues, the bilateral and multilateral trade grows and the overall tax collection also in-creases as a result of which both countries tend to benefit. It would however be unfair for the taxpayer to have a double taxation as it would be an obstacle for investments abroad, as
51 p. 15 Rohatgi. 52 Ibid.
53 p. 86 Barenfeld. 54 p. 15 Rohatgi.
investors would keep the investment in the jurisdiction and moreover damage the relation with a specific country. Therefore is any double taxation prohibited.
Despite it being by policy prohibited does the OECD also finding it ‘scarcely necessary to stress the importance of removing the obstacles that double taxation presents to the development of economic rela-tions between countries’.55 By working with these issues a hope is to reach a bit in what is known as the principle of tax harmonization.56
3 Portfolio Holding and the EC law
As this study concentrates on portfolios, of importance is the definition of it. In present, there is no universal definition of a portfolio, and the definition may vary in the different jurisdictions. Due to its nature it is also difficult to give an effective definition.
In this paper the portfolio will therefore be defined as a flow of Dividends from holdings by an investment in a limited number of shares, and other securities. Securities are the fi-nancial instruments that are negotiable and has a recognised fifi-nancial worth.
Shares are as well defined on a domestic law area, and might be simplified explained as an ownership in a company, a stock. Shares are equal per value and bear equal rights and obli-gations. They lead to the possibility to make a participation and a right to vote on decisions during shareholder meetings. They do also entitle to profits which means to get Dividends which is connected to the invested capital. Further, it is a proportionate share of the pro-ceeds upon liquidation and subordination to creditors, which would be referred as the mentioned obligation.57
To get ownership in a company an investment must be done with either own capital or by loan, where the previous is known as equity capital while the later is labelled as debt capital. The distinction between equity capital and debt capital is of important value to recognise as equity capital is subject to tax and the later is not. In this paper will therefore only equity
55 para. 1 OECD Model.
56 p. 6 McIntyre; For more info about tax harmonization see for instance “European Community Law on the
free movement of capital and EMU’ by Sidek Mohamed IBSN: 9041111530.
capital be of consideration as it is a tax object. To note is as well that difficulties to qualifi-cate capital do however appear be the complexity of rules of qualification of capital.58 Most frequent in portfolio holding is the investment in shares and therefore the focus will be on them. Shares can come in two forms: ordinary shares that are equity capital and pre-ferred shares, where the alter are in the category of hybrid financial instruments59.
Some jurisdictions have made an approach to distinguish between direct investments and pas-sive investments for finding a definition on the category of the capital. A portfolio investment, which is the opposite of a direct investment, does not own a controlling interest in a for-eign entity. The ECJ defines a portfolio investment as owning less than 10 % of all the votes in a company.60 Further, ECJ has developed its definition about a portfolio by the Golden Share case61, where it finds a portfolio investment to ‘mak[e] a financial investment
without any intention to influence the management and control of the undertaking62‘. The ECJ has not
clearly specified if a small stake held as a portfolio investment enables the shareholder to effectively participate in the management but it has referred to the domestic courts to rule on this issue.63 A critical reader should not be misslead by the ECJ’s definition of a portfo-lio as the court may only rule in the given case, and the definition should not be considered to be absolute. The definition is of value as different tax rules are implemented depending on the nature of the investment and therefore needs to be distinguished. A refinition should also be defined between trading income and portfolio income, as the earlier is a form of a business income and subject for all its financial activity, in other words on a mark-to-market-basis.64
To further understand the complexity of a portfolio, the reader should understand two of the characteristics of a portfolio, starting with the mobility. It can be seen that the goal of a portfolio is to make a financial investment, and develope a wealth. A portfolio holder can sell its shares when being unhappy with the company’s business decision.65 By selling the
58 p. 105 Mintz (2004).
59 International Tax Glossary; ‘Hybrid financial instrument’. 60 C- 446/04 – FII Group; and p. 1581 Graetz (2007). 61 C- 282 and 283/04 – Commission v. Netherlands. 62 European Law term for entity.
63 C- 101/05 – ‘A’ case. 64 p. 106 Mintz.
holding does the movement lead to volatility66 in the market which is influenced by the
portfolio holder’s accepted level of risk.67 In economic science is risk divided into positive and negative risk, where the positive risk leads to unexpected profits and negative to unex-pected loss. Both are co-existing with each other. The risk is upcoming because of a lack of information or misunderstood information. Mobility in cross border situations involves different jurisdictions and their tax rules, which gives good opportunities for tax planning. According to an economic study, has the mexican financial crisis had a connection between a country’s financial and currency vulnerability and the composition of its capital inflows.68
This fact shows the importance portfolios make in the economy.
The second characteristic for a portfolio is the liquidity. The term is from the economic sci-ence, however does it affect the rules of taxation as they are concentrating on the amount the portfolio is holding onto. The liquidity is referring to the amount of capital the portfo-lio is having for investing, and that amount is not stabile due to the consequences of in-vestment. Because of this characteristic it is more complex to grab the solid definition of the capital within the portfolio.
3.1 Portfolio Income
In tax policy is the fundamental concept of income necessary to be defined as it is on the income that a tax is based. From an economical aspect, and the adopted definition for IBFD, can income be defined as the algebraic sum of ‘(1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question’.69
Another approach to define an income is as an in rem-tax, which means that a tax is attrib-uted to specific items which could be included in the tax base, such as for instance ordinary shares.
66 Economic term for a change of value of a financial instrument within a specific time horizon. 67 p. 549 and 552 Graetz (2003).
68 p. 553 Graetz (2003).
69 National tax systems are in practice a bit modified from this formula. ‘The Federal Income Tax’ H. Simons
As the portfolio investment is in this paper a holding of shares, they tend to generate tax-able income. This income is labelled as Dividends.
Dividends. The OECD Model70 defines Dividends in art. 10 as ‘[...]the residual definition includes
income from other corporate rights than in general tax law, such as income from shares in the country of dis-tribution’. The income is therefore coming from shares, jouissance shares or jouissance rights, mining shares or founder’s shares. Also other rights, not being debt claims, partici-pating in profits are included. Further on are other corporate rights that are subject to the same tax treatment, such as income from shares under the laws of the State of residence of the company making the distribution included. By the wording of the definition ‘other corpo-rate rights’ the distinctive elements to classify a payment on hybrid financial instruments seems to be targeted. Further, derivative financial instruments and financial instruments who are not characterised as debt capital seems to be captured.
Dividends in the OECD and UN Model, could also be understood by using three parts ac-cording to Helminen.71 The first two parts of the term are autonomous, meaning that they
have to be interpreted by the art 3(2) of the relevant Model. The article is referring to the law of the State which is applying the treaty if the context does not otherwise require. The third part of the definition refers to the definition of the law of the source country. This would mean that a domestic definition of Dividends not necessary would be the same in the source country as in the home country, which would constitute a loophole to try to classificate the income to Dividends, if it was preferable by the portfolio holder. The US Model treats Dividends differently. It treats Dividends broadly and flexibly, with intention to cover all arrangements that yield a return on an equity investment in a corporation as de-termined under the tax law of the State of source, as well as arrangements that might be developed in the future. It includes income from shares and other income not treated as debt under the law of the source State.72
70 Explained in 4.3.1.1. 71 p. 49 Helminen (2007).
3.2 Portfolio Taxes
As shares are defined as income from Dividends, it makes it to a tax object. When an in-vestment is done in a foreign company, in a source country, by a resident of another jurdiction, the income can consequently be object to a withholding tax. This constitutes an is-sue in a cross-border situation.
Withholding tax. The tax is made by a withheld amount from the source country where it is deducted from income. The tax may be provisional or final. If it is provisional it will be credited against the taxpayer’s final tax liability. If it is final, no subsequent adjustments will be made. The rates of withholding tax are frequently reduced by double tax treaties.73 Some jurisdictions distinguish between withholding tax on resident and on non-resident. As an example of a withholding tax on Dividends for a foreign portfolio holding in an investment fund situation could be when an investment fund declares a Dividend of 100 % of their share on its 50 000 shares of stock, giving a total of € 5 000 000 which is reportable as in-come by the shareholders. Of this amount could for instance 80 % be paid out to the shareholders while the rest-over of 20 % to be taken as tax. It would give the amount of € 4 000 000 to the shareholders and € 1 000 000 to be withheld for taxes. The aim in a cross-border situation of Withholding tax is to avoid double non-taxation, or tax avoidance.74 The problem with the tax occurs when a portfolio holder that is obliged to file a tax return within a specific period has to do this in both the country of residence and the country of source whom require a tax return and no information exchange or, if misunderstanding oc-curs, the portfolio holder would be taxed in both countries for the same income. Another problem would occur if the shareholder level taxation does not exist in the country of resi-dence of the shareholder. (S)he would be treated in another way than other residents it its jurisdiction.
The tax can also be considered as a corporate tax which affects the shareholder. It consti-tutes an economic double taxation as the corporate tax income is taxed at both the corpo-rate level and can be taxed in the hands of the shareholder if not a relief would be estab-lished.
73 IBFD International Tax Glossary; ‘withholding tax’. Read chapter 4.3 to understand double tax treaties. 74 By double non-taxation it is meant that no country is taxing the income. Tax avoidance refers to a
behav-iour aimed at reducing tax liability which falls short of tax evasion. The behavbehav-iour refers often to illegal measures, while double non-taxation is a consequence of a lack of rules, not a cause of the investor.
Another tax that appears with respect to shares is the Capital Gains tax (CGT).
CGT. The tax occurs in the wording of art. 13(2) in OECD Model and is defined as: ‘[g]ains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment, may be taxed in that other State.’75
The wording of CGT in the US Model76 is slightly different, but is not of value for this
pa-per.
The OECD seems to be using the term ‘alienation’ for a wider scope than just ‘sale’.77 An
ex-change is included in the term alienation.
The function of the tax is however that CGT is levied only when the asset is resulting in a gain when realised on alienation of the asset and not on accrual basis. This means that the tax is not exclusive for shares and further it can also occur on the taxation of trading in-come78. The definition of gain depends on the entitled Contracting State’s domestic defini-tion of gain in its tax law. By recognising Capital Gains and capital losses it follows the principle of realization.79 The tax follows this principle because of two reasons. First, it would otherwise violate the principle of ability-to-pay. Secondly, some assets, such as shares from not stock-listed companies are difficult to value as no market price exists. The tax rate of CGT may be different depending on who is the taxpayer as well as special rules may be implied on the period of the holding. Jurisdictions may define a long-term capital holding and when it is disposed for CGT it may be more favourably taxed by a re-duced rate in comparison to short-term Capital Gains which may be taxed as ordinary in-come.
For example does the USA, tax its individuals who are disposal to long-term CGT at a lower tax rate of 20 %. France reduces the rate to 15 % for company tax payers. In Italy it is possible for a corporate taxpayer who have held a holding for a minimum period of three
75 The wording of the US Model is in general the same and the difference is without any value in this study;
p._249 Avery Jones.
76 art. 13 US model. 77 p. 249 Avery Jones et al.
78 Business tax for financial intermediation dealing with derivatives, financial instruments and hybrid financial
instruments.
years, to spread the gain over a period of five years. In Denmark it exists a possibility to ex-empt the gain on shares when the holding period is over three years.80
To give an example, under the terms of a double taxation treaty, can the country where the tax is levied deduct its share of the tax first. The country of residence could then levy its tax and person A would be required to pay the balance due. For instance, if a share is sold with a net Capital Gain of € 100 000 in a country where CGT is levied at 20 % for all tax payers, the liability for CGT in this country would be € 20 000. As person A is resident in the UK, (s)he may also be liable for British CGT at 40 %, € 40 000. However, as (s)he has already paid CGT in the source-country, (s)he may only be liable for € 20 00081 in the UK. Person
A may also be able to deduct CGT allowances.82
A holding does not always result in a gain, in fact it is said that investors do face losses. In the taxation of Capital Gain, it may exist special rules leaving a possibility to carry-over capital losses to make the tax more fair. Is so can the tax be offset against present and fu-ture Capital Gains. The function of the rules on capital losses depends on the jurisdiction but it can give the possibility of ‘saving’ the loss for future gains and some jurisdiction al-low a reduction from past gains. An example would be that person A made a € 100 000 gain in the fiscal year 2006 but may reduce this with € 50 000 because of losses in the fiscal year of 2007. A total amount of € 50 000 would then be taxable with a tax rate of for in-stance 20 %.
The explained CGT is in practise used in different forms, for instance are the Common Law systems separating capital from income, while other systems such as the Continental Law systems sees the capital as a part of an income.83 A hybrid system in the EU is the
‘Dual income tax system’84 which separates the gains which are instead added to income
from capital and are subject to capital income tax. The OECD is aware of how the tax oc-curs and has offered jurisdictions the choise to have the OECD’s approach to distinguish between CGT and capital. The tax is by OECD Model discerned from capital: Art.13 and 22 OECD Model. Art. 22 OECD Model applies to taxes on capital from the possession or
80 pp. 254-255 Rohatgi (2005). 81 €40,000 - €20,000.
82 Built on the example given from http://www.obeliskfinance.eu/news22/Double_Taxation_Explained. 83 p. 220 Avery Jones et al.
ownership of capital, and not the income or the gains from capital.85 The US Model
ex-cludes capital since there are no federal capital taxes in the US.86
3.3 No Capital Gain Tax
A country not using a capital income tax do so of a number of reasons. First, a host coun-try that excempts capital income may find that it is difficult to impose taxes on income ac-cruing to non-residents when neighbouring countries continue to asses an income tax. For instance, would foreigners from neighbouring countries prefer to earn capital income in the host country rather than other forms of compensation to avoid paying taxes to both the host and home countries, in other words the country of source and the country of resi-dence.
Second, some capital exporting countries could allow their taxpayers to claim a credit for withholding taxes paid to foreign governments against the taxes in the state of residence.87 Many jurisdictions have chosen not to have any Capital Gain tax, and where it exists, is a tax subject often levied with a lower effective rate than the income tax on Dividends. As a result of this bias in favour of retentions, equity funds may be ‘trapped’ within particular companies rather than allocated between companies in the most efficient manner by finan-cial markets, according to the investment opportunities that the company face.
Taxation on Dividends doesn’t frequently appear as Dividends, received by financial insti-tutions from other companies, already have been subject to tax when a company distributes income from after-tax profits. An additional tax on Dividend income of financial institu-tions would result in a double taxation of income.88
85 p. 174 Rohatgi. 86 Ibid.
87 p. 14 Mintz (1992). 88 p. 103 Mintz.
3.4 A Jurisdiction’s Right to Tax Portfolio Income Under
In-ternational Law
There is no established international law which can interfere in a nations sovereign right to tax income which accrues, arises or is being received on its territory. The tax subject has not signed any physically existing agreement between her and the country, instead the agreement exists by conclusive action89 which means that by living or making business in a
jurisdiction, the person has accepted to be taxed by that jurisdiction.
As a consequence of the right, is a ground laid for a double taxation as countries have the possibility to tax income on the basis of the established principles of residence and source. Due to the consequences, jurisdictions are observing the present principles and are trying to solve the matter by negotiated agreements90.
3.5 The EU and International Capital
International tax law is claimed not to be an autonomous area of law, as nations try to ne-gotiate and harmonize their taxation with respect to each others tax systems and laws. As tax law is a sovereign right it therefore also is a national law, but since many european countries have entered the EU some of the sovereign rights have been given to the supra-national jurisdiction.91 Although direct taxation92 falls within the competence of each
Member State, Member States must none the less exercise that competence consistently with EC law.93
In this paper is the term EC law used instead of EU Law as the author considers the EU to be built on three pillars where the first pillar is the oldest pillar by the established ECT. The ECT has been updated to the present Treaty of Nice, but however will it be referred to the ECT as the Treaty of Nice has not changed the established case law and use of the rules which will be discussed below.
89 Swedish term; ’Konkludent handling’.
90 Double tax agreements, will be discussed in 4.3.1.
91 Direct effect is given to the EU law which overruns the national laws.
92 A tax which is directly paid to the government, contrary to an indirect tax such as VAT.
3.5.1 Free Movement of Capital
The EU has by the ECT established four fundamental freedoms which makes the heart of an internal market94. The internal market makes the MS come closer and erases the physical
borders. This is done by integrating and opening up for competition within European fi-nancial markets and services. One of the four freedoms is the free movement of capital which is presented by art. 56-60 ECT. The freedom had a full liberalisation in 1988 by the Directive 88/361/EEC, where the effect came into force in 1990. The liberalisation of capital movements has accompanied the development of EMU. In present has the Lissabon Treaty, which is under debate of integration, presented the freedom under its art. 63-66 ECT. Art. 56 ECT has the wording:
‘(1). Within the framework of the provisions set out in this Chapter, all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited.
(2). Within the framework of the provisions set out in this Chapter, all restrictions on payments between Member States and between Member States and third countries shall be prohibited.’
The article has in its formulation included third-countries, meaning countries whom are not members of the EU. The analyzing reader would find the question how is it possible to or-der another nation to have the fundamental freedom of the EU without entering such an agreement?
The answer is art. 57, 59 and 60 ECT, whom present specific restrictions, safeguard meas-ures and sanctions in respect of third countries. To further make the fundamental rights possible to work in practise, bilateral and multilateral agreements between EU and the third-countries are negotiated on continual basis. 95
A recent case96 has shown how the EC law interprets the freedom with respect to third
countries. The legal background informs of a Swedish individual A, who owned shares in a parent company X, a resident of Switzerland. X considered distributing a Dividend to A in the form of shares in its subsidiaries. Under Swedish rules, income tax is levied on such a
94 Some documents from the EU is using the wording ‘single market’, instead of internal market, as in the
ECT. They should however be considered of being synonymous with each other.
95 Term for describing an agreement between two parties, in this case, two jurisdictions. The term multilateral,
would signify an agreement between more than two parties.
distribution if parent company, among other conditions, is not established in a State within the EEA or in a State with which Sweden has concluded a taxation convention that con-tains a provision on exchange of information. The ECJ has clarified the art. 56(1) ECT of being clear and unconditional, which gives a direct effect for the claimer, and with no im-plementation requirement, leading to a relevant rule in the domestic law. The court has ruled the Swedish tax authorities to not be able to use the Directive 77/799/EEC with a third country, but referred to the exchange of information clause in the bilateral tax agree-ment between the countries and to interpret it on a domestic level as the ECJ is not com-petent to interpret it itself. The outcome of this case shows both the relevance of the free movement of capital, with limitation to Directives, but also that the ECJ is using Model conventions and that its clause of exchange of information could supplement the lack of EC Directives. More of this will hence be discussed in chapter 4.
3.5.1.1 Free Movement of Capital and Portfolio Investments
As art. 56 ECT is applicable for the free movement of capital the question arises whether portfolio investments by a resident of one MS in shares in a corporation, with a permanent establishment in another MS, and the returns on these investments can be qualified as movement of capital.
One of the earliest cases related to a pure ruling in the area of direct taxation and with re-spect to the free movement of capital is the case of Verkooijen97. Mr. Verkooijen who was
a resident of the Netherlands, was refused exemption from income tax for share Dividends from a foreign resident company: established in Belgium. According to Dutch law, 1000 NLG per individual was exempt, if the source country for the Dividends was the Nether-lands.
As the ECT was not during the process in force, the Directive 88/361/EEC et al was used, to implement the establishing of the free movement of capital by art 67 EC. As the court didn’t find any guidance of a definition of capital in the ECT, it sought for guidance in the Annex I of the Directive.98
97 C- 35/98 – Verkooijen. 98 Ibid, para. 20-21.
The ECJ founded that the Dividends and the returns was governed by the Directive and receipted as ‘presupposes participation in new or existing undertakings’.99
The court had to be clearer with the definition as the company paying the Dividends was resident in another MS. A clearer definition of the Dividends came by linking them to the ‘acquisition ... of foreign securities dealt in on a stock exchange’ and was thus ‘indissociable from a capital movement.’100 The outcome showed a connection between: Dividends and returns and the
free movement of capital101, as well as its position within the area of direct taxation as ‘al-though direct taxation falls within [...] competence, the MS’s must none the less exercise that competence consistently with community law’.102
3.5.1.2 Free Movement of Capital in Relation to other Fundamental Freedoms As the free movement of capital is a part of the internal market it is co-existing with other fundamental freedoms, but how would the legal value be of the free movement of capital in a conflict with another free movement?
In the year 2006 did the ECJ give a controversial judgement in relation to the question: The company Fidium Finanz103, resident in Switzerland, wished to offer credit via their website to residents in Germany. According to German law did a prohibition lay on grant-ing credits as the company was not havgrant-ing a permanent establishment in the territory of Germany. Fidium Finanz turned to the ECJ as it considered the situation to be in breach of art. 56 ECT. The court found both the free movement of capital and the free movement of services to be applicable in the case. Due to the applicable articles, only the article 56 estab-lishing the free movement of capital was considered to extend the fundamental freedom to jurisdictions not being MS. The court decided that the case must be treated with accor-dance to the rules of free movement of services as the movement of capital should be
99 para. 27-30. 100 Ibid. 101 para. 30.
102 C- 279/93 – Schumacker, para. 21. 103 C- 452/04 – Fidium Finanz, para 16.
sidered as ‘an inevitable consequence of the restriction imposed on the provision of services’.104 The
deci-sion shows that in conflict with other freedoms then the free movement of capital has to surrender. Fidium Finanz did not win the case as it was not entitled to have any ECT rights.
The case has got huge critics as the court did not judge in the given question if the prohibi-tion was fair due to art. 56 ECT, instead it answered which treaty was most affected, and by only focusing on that freedom, exluding the other which also seems strange as only the free movement of capital appears in the ECT between MS and non-MS. Finally has the critics been pointed of the lack, from the ECJ, of considerating art. 57(1) ECT:
‘The provisions of Article 56 [the free movement of capital] shall be without prejudice to the application to third countries of any restrictions which exist on 31st of December 93 under national or Community law
adopted in respect of the movement of capital to or from non-member countries involving direct investment--including in real estate--establishment, the provision of financial services or the admission of securities to capital markets’.
4 Taxation of International Portfolio Holding
4.1
Portfolio Holders
105Different forms of a portfolio holding exist as different tax rules106 and consequently
dif-ferent tax treatment occurs, depending on who is the tax subject and which jurisdictions are involved. The reader should not be ignorant of this as it is highly relevant for financial decision-making and market behaviour how the personal income and corporate income tax systems are regulated.107
104 Ibid, para. 48-49.
105 The word investor is also used in this paper which is synonymous to portfolio holder. 106 For instance personal income vs. corporate income.
4.1.1 Individual
The holder of a portfolio is a natural person who has legal capacity. A natural person can be subject to among other taxes: personal capital tax, specificaly to a shareholder level taxa-tion, instead of a corporate taxation.
A portfolio is established when person A, who owns less than 10 % shares directly in com-pany Y. The requirement for the holder is that (s)he must be a natural person who is a tax-payer and subject of personal income tax.
An alternative would be if person A owns shares in an investment fund, which then pur-chases shares in company Y. In general, it is common that investment funds are established as partnerships.108 In many jurisdictions is a partnership considered to be a transparent entity,
which is not subject to strict rules and are therefore more flexible than other companies.109
The profit from such a company is often taxed among the partners, and the partners them-selves can be liable for the tax based on their property and family circumstances.110
A person who chooses to have the holding via an invetstment fund, would be considered as a holder as (s)he invests and owns assets which are in the portfolio. The positive apect of having a holding via an investment fund can be a possibility to reduce taxation of Divi-dends, conversion of income from a progressive to nominal tax, Dividend averaging, ad-vanced banking facilities such as bank secrecy, and reducing Capital Gains tax among oth-ers.111
4.1.2 Entity
The tax subject for a portfolio income could also be a company. Company X could own the limited number of 10 % shares in company Y. As company X is a taxpayer, it is subject to corporate income tax.
108 p. 218 Schaffner.
109 About partnerships, see for instance more about Schaffner or Barenfeld. 110 p. 218 Schaffner.
To observe is that in the given examples, is company Y considered to be a tax subject in a jurisdiction, but it doesn’t thereby mean it also is a legal entity. A jurisdiction could for in-stance treat a partnership to be liable to tax despite not having the definition as a legal en-tity.
4.2 Internal Approach
As the issue of double taxation occurs, it is possible for a country to give a relief for juridi-cal double taxation by avoiding, or atleast reducing, the tax by making a more fair taxation of the income of the portfolio holder. This internal approach is made by a jurisdiction’s chosen unilateral methods which are considered to be a part of anti-avoidance rules. Those rules exist as countries hope to reduce double taxation. On the flipside of the coin, coun-tries do also hope to eliminate double non-taxation which is seen as unfair to other inves-tors as a tax which should be paid but is not, violates the concept of neutrality.
The rules leads tax authorities to keep an eye on the domestic and world-wite tax revenues. If they would not be aware of it, tax avoidance would accur. To prevent this phenomenon, jurisdictions have implemented laws regulating anti-tax-avoidance. For instance laws on CFC112, Transfer Pricing and Thin capitalisation. In this paper do the mentioned rules fall out of the scope, but another possibility to regulate this phenomenon is by double tax trea-ties.113
4.2.1 The Unilateral Methods
Unilateral methods are set up to give a relief from the effects of juridical double taxation on the basis of domestic legislation for its residents. It is a unilateral method as a conse-quence of not having any treaty on double taxation with another country that is claiming a right to tax. The methods are correlated to the mentioned concepts of neutrality.114
112 Shortening for Controlled Foreign Corporation. 113 p. 5 Rohatgi (2005).
Most of the Capital exporting countries have passed the unilateral methods of anti-avoidance rules and the two first methods, which are presented below, are used by most of the OECD countries, as they theoretically could solve the issue of double taxation.115
4.2.1.1 Foreign Tax Credit Method
Foreign-source income earned by residents can be taxed by the home country116 with a credit given for withholding and corporate income taxes levied by the host country.117 The
amount of the foreign tax credit can be subject to one or more limitations, referred to as a foreign tax credit limitation.118 The method takes one out of two forms, labelled as full credit
and ordinary credit.
With the previous form, the home country allows a deduction from its domestic tax of the amount equal to the tax paid in the other State and later taxing the amount that the foreign tax do not tax. The later form, gives a maximum deduction which is restricted to the ap-propriate proportion of its own tax.119 The ordinary credit method is intended to apply also for a State which follows the Exemption method but to give a credit some modification can be relevant.120
An example of the forms are set in the table 1.1
Ordinary Credit Full Credit
Foreign taxable income 100 € 100 €
- Foreign tax of 30 % -30 € -30 €
- Domestic 35 % world-wide tax
-5 € [35-30] 0 €
= Total tax burden 35 € 30 €
= After tax result 65 € 70 €
Table 1.1
115 p. 8 Mintz (1992). 116 Country of Residence. 117 p. 8 Mintz (1992).
118 para. 73 OECD Commentary.
119 para. 57 OECD Commentary and p. 178 Molenaar. 120 para. 58 OECD Commentary.
For the countries using the credit method, the full tax credit method gives the taxpayer the best result as (s)he will keep more money. It also seems to be having a close connection to the mentioned concept of CEN as the total tax burden after the full tax credit is equal to the tax that would be due if the income were earned in the home country only.121
Policymakers use this method to encourage cross-boarder trading.122 Further, can countries using the credit method, choose to not refund taxes if their taxpayers pay foreign taxes at a rate higher than the domestic rate.123 US is for instance a country using the credit method.124
According to Rohatgi125 are the advantages with the credit method such as:
• It is capital export neutral, i.e. it treats all taxpayers in the residence State on the same tax basis:
• It allows the deduction of foreign losses of permanent establishment in the home country:
• It discourages the transfer of assets or income to low-tax countries or tax havens: and
• It is easy to apply since the tax authority giving the tax credit, computes the amount under its own laws and does not have to consider the foreing tax system.
Rohatgi has also provided disadvantages such as:
• The taxpayer always pays the greater of foreign and domestic taxes: • It could lead to excess foreign tax credits that may not be useful:
• It eliminates the tax relief and incentives given in the source State, unless the resi-dence State spares the tax. In other words doesn’t it eliminate by itself double taxa-tion:
• It makes the export of capital less attractive: and • It is complicated and can be time-consuming.
121 p. 178 Molenaar. 122 p. 228 Graetz (2004). 123_http://goliath.ecnext.com/coms2/gi_0199-2147645/Relief-from-international-double-taxation.html (2008-11-12). 124 art. 23 US Model. 125 p. 71 Rohatgi (2005).
