Chapter 3

International taxation issues

Contents
• What is International taxation?
• Who should tax foreign source income?
Residence or Source country?
• Global and territorial systems of taxation
• Avoiding double taxation
• Taxation and Multinational Enterprises

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 Who should tax foreign source income?

Residence or Source country?

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 What is International taxation?
• International taxation –imposing taxes on taxable activities
abroad by a person or company subject to taxes;
• International taxation generally refers to the tax treatment of
cross-national transactions.
• may include:
– Sales between companies in different countries;
– Individuals travel from one country to the other for
business or any other purpose;
– Generation of income in one country as a result of
investments made by individuals or corporations of another
country; or
– Services rendered by residents of one country to persons in
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another country etc. 3
• International taxation deals with the taxation of income
originated in different countries;

• Countries involved in international taxation are termed as

source and residence countries;

• The country where the income is generated is the Source

Country (state) ;

• The country where the taxpayer resides is the Residence

Country (state);
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Residence rules:
•Countries have specific rules pertaining to the determination
of the residence of individuals or a company;

•Individuals’ residence – number of days /months supplemented by

other requirements;

• France 180 days;

• Germany 6 months;
• USA 122 days;
• Ethiopia 183 days (and other requirements like has a domicile within
Ethiopia….etc

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• Companies residency rules usually consider:
– Where the headquarter is,
– Where the ownership is,
– Where the effective (central) management is etc.

• Countries have specific rules pertaining to the determination

of the resident of a company;

• For example UK company residency rules:

– if it is incorporated in the UK or,
– if not incorporated in the UK, if its central management and control is
exercised in the UK.

• Ethiopia company residency rules:

– If it is incorporated in the Ethiopia;
– Has principal office in Ethiopia;
– Effective management in Ethiopia;
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 Who should tax foreign source income?
Residence or Source country?

• Both countries have the sovereign right to

impose tax;

• Every country has the right to tax income

accruing, arising or received in it, on
account of the activity carried on in its
territory.

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Residence and Source based taxation
Residence based taxation:
•All incomes (both foreign & domestic source incomes) are
taxable in the country of residence only;

•No tax in Source countries;

•Foreign Source income is exempted in the country of source;

•Likely to give advantage to developed countries at the cost of

developing countries;
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Source based taxation:

•Foreign source income is taxed in the country of origin

and exempted in the country of residence;

•No taxation on foreign source income in the country of

residence;

•Likely to cause distortions – excessive capital export

•Specifically, excessive capital outflow to countries

where the tax rate is low;
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 Global and territorial systems of taxation
Global system (worldwide) - the total amount of tax payable
should be roughly independent of whether the income is
earned at home or abroad;

•It taxes residents of a country on their worldwide income no

matter in which country it was earned;

Examples of countries using WWI method:

•A resident in the UK or US is liable to tax on worldwide income;
•A resident of Ethiopia is also subject to tax on worldwide income;

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• Territorial system - a citizen (a company) earning income
abroad needs to pay tax only to the host government;

• Territorial taxation – taxes income in the country it is earned;

does not tax foreign source income;

• Any business income earned in a territory is subject to income

tax in that territory, regardless of whether the business is
owned by foreigners.

• Any foreign source income earned by residents are exempted.

• Follows taxing at source approach instead of at destination

• Does not entail double taxation………
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Example:
Mr A a resident in the US earned income of $10,000
from work performed in the UK (in the year 2008). He
also earned $120,000 in the US (same year).

•Home country (country of residence)= USA

•Host country = UK
•Income generated in the home country = $120,000
•Foreign source income = $10,000
•Taxation in the UK (host country)-non-resident
taxation
•Mr A is liable for income tax on $10,000;
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• Taxation in the US (home country) resident
taxation (WWI)
• Residents are taxed based on their worldwide income;
• Worldwide income in the example=
Income in home country + income host country
=$120,000 + $10,000
= $130,000;
• The foreign source income =$10000 is taxed twice
(double taxation of the same base);
• One of the problems in taxation of foreign source
income is the existence of double taxation;

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• Double taxation has effects on the cost of operations
and effectively may act as a hindrance to cross border
activities (investments);

• International taxation regime deals with how

to tax international activities and avoid unfair
treatment of taxpayers (double taxation);

• In international taxation regime, the Source State

(country) is granted the prior right to tax all income
and the residence State (country) has the primary
obligation to prevent double taxation;
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 Avoiding double taxation
• The principle underlying avoidance of double taxation is to
share the revenues between the countries involved;

• Double taxation is usually avoided through a Double Taxation

Avoidance Agreement (DTAA) entered into by two countries
for the avoidance of double taxation on the same income.

• The DTAA eliminates or mitigates the incidence of double

taxation by sharing revenues arising out of international
operations by the two contracting states to the agreement.

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• Double tax treaties (or conventions) are bilateral
agreements between two countries, which allocate
taxing rights over income between those
countries, thereby preventing double taxation of
income. ... Double tax treaty models are generally
used by countries as a starting point when negotiating
bilateral tax treaties.

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 Objectives of a tax treaty
include:
– Prevent double taxation;

– Facilitate cross boarder activities (investment

etc) by removing tax impediments;
– Eliminate tax avoidance;

– Exchange of information; and

– Determine dispute resolution mechanisms.

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 Methods for preventing double taxation
• Three methods of providing relief from double
taxation –
1. Exemption
2. Credit and
3. Deduction methods

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1. Exemption method- the residence country exempts income
that has arisen in the source country;

• Foreign source income is taxed only in the country of origin

(source);

• Income earned abroad is exempted

– Example Netherlands

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2. Credit method -residence country grants credit for taxes
paid by its resident in the source country;

– The tax paid in the source country is credited against the

total tax liability in the resident country;

– Countries using this include the US, Ethiopia etc

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3. Deduction method – resident countries allow residents to
deduct tax paid to a foreign country in respect of foreign
income in the determination of taxable income in the
resident country. ;

• Mostly the credit method is adopted in the DTAA for

providing relief from double taxation;

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 Illustrative data:
• ABC Company is a resident in country A and it has operations in country B as
well.
• Country A is a resident state while country B is a source state;
• During the year ended in Dec. 2016, tax relevant figures were as follows:

• Income derived by ABC Co. in residence Country (A) =$2,000,000

• Income derived by ABC Co. in Source Country (B) = $1,200,000
• Global income of ABC Co. in the residence Country =$3,200,000

• The resident country uses WWI taxation

Tax rates:
• Country A (residence state) up to $1,000,000 tax rate is 25% and more than
$1,000,000 the rate is 35%
• Country B (source state) 20%
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 Tax liability of ABC under different conditions:
1. No attempt to eliminate double taxation:

• ABC Source country (State B) tax liability = $1,200,000 @20% = $240,000

• ABC in Residence country (State A) total taxable income = $3,200,000

• ABC tax liability in residence country = $1,000,000 @25% = $250,000
= 2,200,000 @35% = $770,000
1. Total tax liability of ABC co in the country of residence $1,020,000

2. Worldwide tax paid by ABC company =$240,000 + $1,020,000

= $1,260,000

• Double taxation of income generated in the foreign country

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2. Measures are taken to eliminate double taxation :-

2.1 Exemption method – exempts foreign source income from taxation in the country of residence.

•Tax in the country of origin (source) 1,200,000 @ 20% =$240,000

•Taxable income in the country of residence $2,000,000 as the foreign source income is exempted.

•Tax in the country of residence $1,000,000 @ 25% = $250,000

$1,000,000 @35% = $350,000
•Total tax in the country of residence $600,000
•Worldwide tax paid by ABC company :
= $240,000(paid in country B) + $600,000 (paid in country A)
= 840,000

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• 2.2 Credit method – allows the tax paid in the source country to be credited against the tax
liability in the source country;

• Tax in the country of origin (source) 1,200,000 @ 20% =$240,000

• ABC in Residence country (State A) total taxable income = $3,200,000

• ABC tax liability in residence country = $1,000,000 @25% = $250,000

= 2,200,000 @35% = $770,000
• Total tax liability of ABC co in the country of residence $1,020,000
• Less foreign tax credit (tax paid in source country) 240,000
• Net tax that should be paid in the country of residence $780,000

• ABC’s worldwide tax:

= $240,000(source country) + $780,000 (resident country)
= $1,020,000

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• What if the tax rate in the source country were higher
than maximum tax rate in the residence country?

• Here there is full credit as the tax rate charged by the

source country is lower than the tax rate in the residence
country.

• If the tax rate in the source country were higher the credit
is limited to the amount that would have been paid if the
maximum tax rate in the residence were applied.

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• For example if we change the tax rate in the source country to
40 % instead of 20 %.

• The tax that should have been paid in the source country would
be 1,200,000 @40 = $480,000

• However, the maximum credit the taxpayer can get in the

country of residence would be limited to $1,200,000@ 35% =
$420,000

• Tax liability in the country of residence = $1,020,000

• Less foreign tax credit (max) = 420,000
= $600,000
• ABC’s worldwide tax paid:
=$480,000 (source country) + $600,000(resident country)
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= $1,080,000 30
2.3 Deduction method :
•Under this method the foreign tax is deductible in the
determination of taxable income in the resident country.

•Tax in the country of origin (source) 1,200,000 @ 20%= $240,000

•Taxable income (WWI) in the country of residence = $3,200,000

•Less tax paid on foreign source income 240,000
•Taxable income in the country of residence $2,960,000

•Tax in the country of residence $1,000,000 @ 25%= $250,000

• $1,960,000 @35% = $686,000
•Total tax paid in the country of residence = $936,000

•Worldwide income tax ABC company

= $936,000(tax resident country) + 240,000(source country)
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• The least applied of the three is the deduction method.

• Under the deduction method, which is normally applied by the

country of residence, the foreign tax is treated as a deductible
expense so that the income is taxed net of foreign tax.

• This method is generally the least favorable to the taxpayer. It

is usually used as a unilateral tool in the absence of a tax
treaty.

• International tax arrangements, whether bilateral or

multilateral, normally prevent double taxation through the
credit method or the exemption method.
(UNCTAD, 2000)

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 What are Multinational Enterprises?

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 Multinational enterprises (companies)
• MNE is an entity that conducts business in more than one
jurisdiction;
– Home office in one country-branch in another country
– Parent Company in one country- Subsidiaries in other
countries
– Affiliated companies: Sole agent, Distributor etc
• Multinational corporations are subject to tax in their home
country depending on the specific multinational taxation
system adopted by the home country.
• Multinational corporations are subject to tax in their home
country depending on the specific multinational taxation
system adopted by the home country.
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 Taxation and MNE

•Strategies used by MNE in reducing tax burdens:

1. Affiliates – Subsidiaries
2. Tax havens and Payments to and from foreign
affiliates (transfer price) etc

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 A. Affiliates
Branch and subsidiary
An overseas affiliate of MNC can be organized as a
branch or a subsidiary;
• A foreign branch is not an independently incorporated
firm separate from the parent;
• Branch income becomes part of parent’s income;

• Subsidiary income
• A foreign subsidiary is an affiliate organization of the
MNE that is independently incorporated;
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• In the case of the US for example, a foreign
subsidiary is a company owned by a US corporation
but incorporated abroad and hence a separate
corporation from a legal point of view;

• Taxation of the income from a foreign enterprise can

be deferred if the operation is a subsidiary;

• Profits earned by a subsidiary are included only if

returned (repatriated) to the parent company;

• Thus, for as long as the subsidiary exists, earnings

retained abroad can be kept out of the reach of the
resident country’s tax system;
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 Illustrative data:
Example on the some of the schemes that MNE use to avoid taxes:

•Setting up a group company in a country where the tax rate is lower

•US MNE sets up a company in Honk Kong
•Tax rates US 35%; HK =15%

•US parent: Income originated in the US = $2,000,000

•HK subsidiary: Income originated in HK = $5,000,000

•Under normal circumstances, income generated by a subsidiary is taxable

in the resident country when the income is repatriated. As long as the
income is retained in the country of source no taxation in the residence
country as the subsidiary is legally independent entity.

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1. Tax if no income is repatriated assuming credit method:

•US parent
Income tax = $2,000,000 @ $35% = $700,000

•HK subsidiary
Income tax = $5,000,000 @ 15% = 750,000
•Total tax for the company as a whole = $1450,000

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2. If all subsidiary income is repatriated:

•HK subsidiary: Income tax = $5,000,000 @ 15% = 750,000

•US parent:
•Income by the parent = $2,000,000
•Foreign source income = 5,000,000
•Total taxable income = $7,000,000
•Total tax = $7,000,000@35% = $2,450,000
•Less foreign tax credit = $ 750,000
Tax that should be paid in the US =$1,750,000

•Total tax for the company as a whole

= $750,000 (Hong Kong tax) + $1,750,000 (US tax)
=$2,500,000

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 2. Tax Havens and Transfer pricing

•A tax haven is a jurisdiction which serves as a means

by which firms and individuals resident in other
jurisdictions can reduce the taxes that they would
otherwise be obliged to pay there;

•Most commonly it refers to those countries or

jurisdictions that have a low-tax or no-tax regime or
which offer generous tax incentives.

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Tax havens may be identified by reference to the
following factors:

• No or only nominal taxes (generally or in special

circumstances);

• Laws or administrative practices which prevent the effective

exchange of relevant information with other governments on
taxpayers benefiting from the low or no tax jurisdiction;

• Tax competition – governments compete for taxes;

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A Good example:
•Panama

•Offshore companies incorporated in Panama, and the

owners of the companies, are exempt from any
corporate taxes, withholding taxes, income tax, capital
gains tax, local taxes, and estate or inheritance taxes,
including gift taxes.

•Switzerland, Ireland

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• An important reason for the stiff competitive
pressure in corporate taxation is that multinational
integrated companies can perform ‘tax arbitrage’;

• Tax arbitrage is the act of profiting from differences

in how income or capital gains are taxed.

• They can avoid taxes by transferring ‘profits’ from

high to low tax jurisdictions;

• Through this they can benefit from the good

infrastructure and other locational advantages in
high tax countries and the tax advantages offered in
low tax countries or tax havens;
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• ‘Profit shifting’ happens through various techniques
such as the (legal) manipulation of internal transfer
pricing for products or the skillful choice of financial
structures, especially debt rather than equity
financing;

• In this way multinational companies can book the

profits in low tax countries and their losses in high
taxation countries, without changing their location of
real production;

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• Many empirical studies have investigated whether and
how strongly tax differences between countries
influence decisions on where companies transfer their
‘profits’;

• Despite different approaches, all the studies come to

the same conclusion: the transfer of taxable profits is
very sensitive to taxation;

• Payments to and from foreign affiliates for the purpose

of shifting profit;

• Having foreign affiliates offers transfer price tax

arbitrage strategies (for shifting the profit);
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 Transfer pricing

•The transfer price is the accounting value assigned to

a good or service as it is transferred from one affiliate
to another;

•Transfer pricing refers to the prices that related

parties charge one another for goods and services
passing between them;

•Transfer pricing happens whenever two

companies that are part of the same
multinational group trade with each other.
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Cont’d

•For example, if company ‘X’ manufactures goods and

sells them to its sister company ‘Y’ in another country,
the price at which the sell takes place is known as the
transfer price;

•When a US-based subsidiary of Coca-Cola, for

example, buys something from a French-based
subsidiary of Coca-Cola. When the parties establish a
price for the transaction, this is Transfer pricing.

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Cont’d

•Transfer pricing is not, in itself, illegal or necessarily

abusive.

•What is illegal or abusive is transfer mispricing, also

known as transfer pricing manipulation or abusive
transfer pricing.

•Transfer mispricing includes trade between unrelated

or apparently unrelated parties.

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• These prices can be used to shift profits to
preferential tax regimes or tax havens;

• If, a subsidiary in a high-tax jurisdiction

charges a price below the “true” price (i.e. it
transfers at a price below the actual price),
some of the group's economic profit is shifted to
the low-tax subsidiary;

• Consequently, the assessee is able to escape tax or

mitigate it but at the same time the tax base of high-
tax jurisdiction is eroded;
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• Hence, unless prevented from doing so, corporations
or other related persons engaged in cross border
transactions can escape from paying tax by
manipulating the transfer prices;

• If one country has high taxes, do not recognize

income there- have those affiliates pay high
transfer prices;

• If one country has low taxes, recognize income

there – have those affiliates pay high transfer
price to the co. located in low tax jurisdiction;
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• For example, World Inc. grows a crop in Africa, then
harvests and processes it and transports and sells the
finished product in the United States.

• It has three subsidiaries: Africa Inc. (in Africa), Haven

Inc. (in a zero-tax haven) and USA Inc. (in the U.S.).

• Africa Inc. sells the produce to Haven Inc. at an

artificially low price. So Africa Inc. has artificially
low profits – and therefore an artificially low tax bill
in Africa.

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• Then Haven Inc. sells the product to USA Inc. at a
very high price – almost as high as the final retail
price at which USA Inc. sells the processed product.
So USA Inc. also has artificially low profits, and an
artificially low tax bill in the U.S.

• But Haven Inc. is different: it has bought cheaply

and sold at a very high price, creating very high
artificial profits. Yet it is located in a tax haven – so
it pays no taxes on those profits. A tax bill
disappears.

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• Most countries have transfer pricing rules which regulate
the prices charged by related Companies.

• Most tax systems, including the U.S. transfer pricing rules,

follow the arm’s length principle;

• Under the arm’s length principle – transfer price should be

the price that would have been set if the parties (to the
transaction) were unrelated enterprises acting independently;

• The underlying principle is that the prices charged by related

parties (mostly units of an MNC) to one another should be
consistent with the price that would have been charged if both
parties were unrelated and negotiated at arm's length;

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…………………visit the proclamation for more

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 End of Chapter 3

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 Chapter 4
Taxation and corporate decision making
Points of Discussion

• Taxation and choice of finance

• Taxation and dividend policy
• Taxation and choice of company location
• Involvement in Charities
• Employee Benefit Decisions

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•Taxes have impacts on investment and economic
activities;

•For example, the use of tax policy to attract companies

through low tax rates highlights the role of taxation in
investment, which in turn contributes to economic
growth.

•Governments often consider the use of tax incentives;

•Theoretically, these incentives schemes are believed to

have effect on corporate decision making;
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• Taxation affects the financial policy of firms;

• how much of the capital structure to support by debt,

rather than equity; and

• how much of the earnings to retain for use as internal

equity finance, rather than distributing dividends and
raising new equity in the market.

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 Taxation and choice of finance

•Firms can finance their investments using equity or

debt.
•Equity – internally available to the firm or funds raised
by issuing stock;

•Debt – a firm can raise debt by borrowing from its

shareholders, from financial institutions, or from the
public;

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• All interest paid by a corporation to its lenders is tax-
deductible, generating a tax shield;

– Subject to limit in Ethiopia

• Interest paid to shareholders on loans and advances
shall not be deductible to the “extent that the loan
or advances in respect of which the interest paid
exceeds on average during the tax period four times
the amount of the share capital.
• Dividends are not tax- deductible;
– Distribution of after tax net income
01/24/24 65
• there is an incentive for firms to use debt instead of
equity;
• likely to lead to excessive corporate leverage;

• Empirically, the evidence is mixed:

• Some indicate that higher corporate tax rates are

associated with increased use of debt.

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• Others show that corporations use significant amount
of equity capital;

• There can be significant nontax costs involved with

debt financing.
• Standard Costs of borrowing and risks of financial
distress that liabilities imply.

• Firms fall into financial distress when they have

difficulty making their debt payments.

• Extended periods of financial distress can lead to

bankruptcy.
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 Taxation and dividend policy
• Double taxation is criticized for it leads to high
overall tax rates on corporate income;
• Double taxation - likely to cause economic
distortions:
• Double taxation of dividends encourages
corporations to favour debt financing;
• Taking on more debt, so that the firm’s cash
payments to its investors take the form of interest
payments;
01/24/24 68
• Decisions to retain earnings or distribute dividends;

• Double taxation encourages corporations to repurchase shares

rather than pay out dividends; Tg=30% & Td=10% in Ethiopia.

• Repurchasing shares would result in a reduced capital gains tax

rate;

• So, as an investor, sale your shares if you need the money

• Firms make cash payments to shareholders by repurchasing their

own shares;
01/24/24 69
Taxation and choice of company location

• Low-tax jurisdictions also exist within countries;

• Examples include special economic zones in China, low-tax

states and enterprise zones in the United States;

• Subsidies of land and other facilities in Ethiopia

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• Companies try to use tax havens in their choice of investment
location;

• For example, U.S. companies make extensive use of foreign

tax havens in their decision of where to locate their
investment;

• As of 1999, nearly 60 percent of U.S. firms with significant

foreign operations had an affiliate presence in tax-haven
countries;

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 Involvement in Charities
• Taxation influences firms involvement in charities

– Tax deductible donation policies

• In Ethiopia, no more than 10% of taxable income, including:

– Donations in response to state of emergency declared by

government

01/24/24 72
 Employee Benefit Decisions
• Limiting tax free and other benefits:

– Transportation allowances

– Pension contributions

– Representation allowances

– Interest for loans from owners

01/24/24 73
 End of Chapter 4

01/24/24 74
 Chapter 5
Tax avoidance and evasion

Points of Discussion
• Meaning
• Factors Causing Tax Evasion
• Tax Planning

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• Tax avoidance - an attempt to reduce tax liability by
legal means, for example, by exploiting loopholes;

• Legal exploitation of the tax regime to one’s own

advantage;

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• Tax evasion - attempting to reduce tax
liability illegally (by breaking laws);

• Tax evasion - intentional misrepresentation or

hiding of the true state of taxpayers’ affairs ;

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• Tax evasion may be through suppression of income or
exaggeration of expenditures;

• Includes taxpayers that deliberately understate their income;

over claim deductions, credits; fail to record returns; or do not
keep the required records etc (McKerchar 2002, p. 27)

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 Factors Causing Tax Evasion
• Theoretically, there are a number of factors causing tax evasion:

• high tax rates- first and foremost reason for evasion which
makes the evasion attractive and profitable

• Complexity of tax laws- demanding lots of time and cost to

comply with

• low probability of audit & detection-inadequacy of power and

lack of experienced personnel in the tax authority

• Lack of publicity- lack of public information about the person’s

return .

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 • Low penalty rate- nominal penalty or no penalty

• Low level of education-lack of awareness of taxpayers

• Corrupt practices- the general environmental practices

• Peers’ evasion decision- a sense of equity … others are

doing it why not me

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 Tax planning

•Systematic analysis of differing tax options aimed at the

minimization of tax liability in current and future tax periods;

•Tax planning is a way by which you arrange your financial affairs

in such a manner that without breaking up any law you take full
advantage of all Exemptions, Deductions, Rebate and Reliefs
allowed by law so that your tax liability will be reduced.

•Government provides deductions, exemptions, reliefs or rebate for

the benefits of economy and society. Like if you made donation to
Scientific research , then it is good for Society and economy too.
01/24/24 81
 – mitigate tax liability by:

• Obtaining deductions;

• Use exclusions

• Postpone income recognition;

• Accelerate losses and deductions;

• Change tax jurisdictions – to those that have preferential

treatment;

• Spreading/shifting income among related taxpayers

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Features of tax planning :

•Tax planning is legal;

•Consider tax effects before transactions are finalized;

•Pay close attention to the structural and transactional categories

established by the government;

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 Objectives of Tax Planning
• Claim Deductions
• It will reduce your tax liability and you have to pay less tax,
• Minimize the war between Tax Payer and Tax Administrator, Tax
payer wants to pay less tax and Tax Administrator wants to extract
most of the tax, by using Tax Planning this war is minimized as tax
payer is using all legal ways to reduce tax liability,
• Makes Investments :- By tax planning, a Tax payer will invest his
money in some good funds which will result in productive returns
for tax payer and transfer money to government for investment too.
• Helps in growth of economy,
• Makes society grow,
• Money saved by you will result in investment which will result in
employment generation.

01/24/24 84
Basics of tax planning

•Deduct: is a claim to reduce your taxable income.

•Defer: A deferral strategy is to try to push having to pay tax now into
future years. Deferring tax means you might eliminate the tax this year
but you will eventually have to pay the tax down the road.

• Divide: Often called income splitting, dividing taxes implies the

ability to take an income and spread it among a number of different
taxpayers.

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The End 85