Income itself does not have a geographical location. It is a quantity, calculated by adding and subtracting various other quantities in accordance with certain accounting rules. By long-standing convention, however, income is assigned a geographical location by reference to the location of the assets and activities that are used to generate the income. When all of those assets and activities are located in one State, that State may be considered to be the unconditional source of income. For example, wages paid to an employee stationed in a State that represents compensation exclusively for work performed in that State would have a source exclusively in that State.
However, when some of the assets or activities generating income are located in more than one state, the source of the income is less clear. For example, business profits derived from the manufacture of goods in State A and their sale in State B have a significant relationship to State A and to State B. In these circumstances, some rules for determining sources are needed. Those source rules might apportion the income between the two claimant States, or they may assign it to one State exclusively.
State practice of charging tax
Basing the tax on the taxpayer’s overall capacity to pay, without reference to the source of income, is consistent with most theories of distributive justice. Whatever the theory, a State cannot tax the worldwide income of its residents unless in practice it has the power to do so. A State typically has some degree of power to compel tax payments from its residents, but only if it has reliable information about the amount of income they have earned. Bilateral tax treaties containing appropriate exchange of information provisions or a multilateral agreement on the exchange of information for tax purposes may assist a State in determining the foreign source income of its residents. A bilateral or multilateral treaty with an assistance-in-collection provision may also be helpful to a State in collecting taxes due with respect to foreign-source income.
The reach of a State’s residence jurisdiction depends on how a taxpayer’s residency is determined. Physical presence in a State for an extended period is an important indicator of residence. Some States also determine the residency of an individual by reference to a variety of other indicators of allegiance to the State, such as the location of the individual’s abode, his family, and his fiscal interests. In other States, physical presence in the State 183 days of the year is enough to establish residence for that year. Conflicts in residency rules can result in an individual being a dual resident, that is, a resident of two different States.
The same issues arise in respect of legal entities. A legal entity can be considered a resident in the country of its incorporation, place of its head office, or based on other criteria – such as place of effective management or control. Tax treaties generally do an excellent job at resolving problems of double taxation resulting from conflicting residence rules – using the tie-breaker rules in Article 4 paragraphs 2 and 3. 5 of the double tax treaty.
When income is derived within a State by a resident of that State, both the source principle and the residence principle can be invoked to support a tax on that income. A State can invoke only the source principle to tax income derived within its territorial boundaries by a non-resident. It can invoke only the residence principle to tax income derived by a resident from activities conducted outside the State’s territorial boundaries. Most States utilize both the residence principle and the source principle. All States utilize the source principle.
A few States tax on the basis of the source principle alone (so-called territorial system). The number of States using a territorial system has diminished because countries have recognized that the failure to tax residents on income derived from foreign activities undermines the fairness of the tax system and provides residents with a tax incentive to invest abroad. Such an incentive is almost certainly contrary to the national interests of a State in need of capital for domestic investment. Nevertheless, if only a tiny percentage of the population of a State derives any foreign source income, the residence principle may have little practical importance to that state.
States that invoke only the source principle are typically concerned about the ability of their tax department to determine the amount of foreign source income derived by their residents. In some cases, an exemption for foreign source income can complicate tax administration, due to legal disputes that may arise over the source of particular items of income or to the difficulties the tax administration may encounter in determining whether a deduction claimed by a taxpayer properly relates to domestic or foreign income.
In some cases, a State exercising only source jurisdiction may be tempted to adopt source rules that may conflict with the source rules of other countries in order to tax income that does not present them with significant enforcement problems. They may be inclined, for example, to treat the income of government employees earned abroad as a domestic source of income.
A few States consider nationality as establishing a sufficient relationship between the taxpayer and the taxing State to justify taxation on worldwide income. Because it is based on the connection of the tax subject to the taxing State, this principle is best understood as a variation on the residence principle. The overwhelming majority of citizens of a State are also residents of that State. As a result, residence jurisdiction and nationality jurisdiction overlap considerably.
The United States of America is the only State where tax jurisdiction based on nationality is important, although a few other States, including Bulgaria, Mexico, and the Philippines, have used citizenship as a basis for taxation in the past. The United States of America generally does not tax its citizens on foreign earnings below a high threshold amount if they have established a foreign residence. Many countries take an individual’s citizenship into account in determining whether that person is a resident. Tax treaties, including Article 4.2.c of the United Nations Model Double Taxation Convention between Developed and Developing Countries, use citizenship as a tie-breaker in resolving problems of dual residency.
The jurisdictional principle based on the tax object (source, situs) and tax subject (residence, nationality) were developed initially for individuals in the context of the personal income tax. States also invoke those principles, at least by analogy, in asserting the right to tax juridical persons or other entities, such as corporations and trusts. All States invoke the source principle in taxing corporations and other taxable legal entities. The many States also invoke an adapted version of the residence or nationality principle to tax certain corporations and other legal entities on their worldwide income.
Some States determine the residence or nationality of a corporation based on its place of incorporation. The other States determine the residence of a corporation by reference to its place of management. As a practical matter, most States using a place of management test employ some objective standard, such as the place where the board of directors meets, to determine the place of management. Otherwise, the place of management would be indeterminate in many important situations. Some States use both a place-of-incorporation test and a place-of-management test. A corporation that is subject to tax on its worldwide income may be able to avoid taxation on foreign source income by creating an affiliated foreign corporation and arranging for that affiliated corporation to earn the foreign-source income it otherwise would have earned.
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