International Taxation

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KEY CONCEPTS

International taxation. Avoidance of double taxation. Cross-border transactions. OECD and UN Model Conventions. Digital economy. Permanent Establishment. Tax base erosion. Profit shifting. BEPS. Controlled foreign companies. Pillars 1 and 2.

THE CONCEPT OF INTERNATIONAL TAXATION

The concept of international taxation as a component of the state’s foreign trade policy emerged in response to the development of international trade and the opportunity for economic entities to receive income in different countries.

Every state has the right to tax its residents because taxes are a matter of sovereign right. However, when two governments tax the same person or property, there can be a problem with interpretation.

The concept has a long history and covers the tax aspects of cross-border transactions. Thus, the term “international taxation” has been used in the same sense as “cross-border taxation.”

“A traveling Assyrian merchant who traded with royal merchandise provided a letter to the foreign authorities sent by Aplahanda (king of Karkamiš) to Yasmah-Addu (King of Mari) which stated: ‘Say to Yasmah-Addu: thus speaks Aplahanda, your brother. This transport is mine; so do not bother my servitors with a tax story’.

This is the first evidence in the Mesopotamian history of the tax cooperation of kings, showing that taxation was already an obstacle to the free movement of goods and persons who traded and traveled between different kingdoms. This tax, called “Miksum”, was applicable to goods in transit, whether international or local, and not on what individuals pass off as their own needs.”

Sadowsky, Marilyne, The History of International Tax Law.^[1]

In modern times the term “international taxation” appeared to describe the fundamental structure for international taxation of income announced in the 1928 League of Nations Model Treaty.^[2]

The International Chamber of Commerce and the newly established League of Nations commissioned the “Report on Double Taxation” in 1923 to study the problem of double taxation. The context was the sharp increase of income tax rates during World War I and the fear that tariff barriers and a retreat from globalization would restrict cross-border investment^[3].

Edwin R. A. Seligman was one of the four economists who authored the report, along with Professors Bruins, Einaudi, and Sir Josiah Stamp played a significant role in the preparation of the report.

The report was a significant milestone in the development of international tax law and helped to establish the principles of international taxation that are still in use today.

International taxation now is understood as the application of direct taxes that are levied on income and capital. The broader concept of international taxation also includes indirect taxes and customs-tariff regulation and applies in the sphere of international economic (cross-border) activity.

International tax law means laws that stem from domestic sources and international sources, that refer to taxation in cross-border situations (International Tax Law by Peter Hongler, 2021).^[5]

RULES ON INTERNATIONAL TAXATION

Over time, most states have entered double tax treaties (DTTs). These agreements are largely based on the Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income and Capital^[6] and the United Nations (UN) Model Convention for the Avoidance of Double Taxation between Developed and Developing Countries^[7].

DTTs provide mechanisms to prevent or eliminate double taxation that occurs when the same income or capital is subject to taxation in two or more states. They define rules for the allocation of tax jurisdiction between states and establish procedures for the exchange of information and the resolution of tax disputes between states.

The OECD and UN Model Conventions are the basis for the development of national tax treaties between states. They contain common principles and standards that help states develop treaties to prevent double taxation and ensure the taxation of international income and capital in a tax-efficient and fair manner.

The main difference between the OECD Model Convention and the UN Model Convention is the approach to the taxation of income and capital. The UN Model Convention generally adheres to the broader taxing rights of the country where the source of income is located (the so-called “source country”). The OECD approach, as presented in the OECD Model Convention, is based on the principle of taxation in the country of residence of the recipient of income.

PREMISES FOR THE REVISION OF ESTABLISHED RULES

Throughout history, countries developed international tax rules to regulate the taxation of income and capital in cross-border transactions. However, over time, multinational enterprises (MNEs) began exploiting differences in tax laws between countries to reduce their tax obligations or avoid paying taxes altogether.

An example of such tax optimization is the deliberate selection by holding companies of jurisdictions that offer low tax rates or exemptions on capital outflows, such as dividends, interest, or royalties. Some of these jurisdictions include the Netherlands, Cyprus, Denmark, Luxembourg, Irland, the UAE, and other countries. As a result of using such tax schemes, source countries with weak tax administration suffer from reduced tax revenues.

In January 2017, the OECD estimated that profit shifting mechanisms were responsible for annual tax losses ranging from approximately $100 billion to $240 billion^[8].

In June 2018, an investigation led by Gabriel Zucman and others^[9] revised this estimate closer to $200 billion annually.

The rapid development of the digital economy has become a significant factor necessitating a reassessment of international tax rules. Previously, conducting business in another country required a physical presence of company representatives, which granted the country the right to tax the company’s profits based on the criteria of a “permanent establishment.”

However, with the emergence of the digital economy, companies now can actively engage in economic activities in other countries by transacting with their consumers online, without physical or tax presence in those countries. The traditional concept of a “permanent establishment” does not allow the country where the primary value is created to tax even a portion of the profits derived from this “digital presence.”

This has led to the need for reviewing tax rules and developing new approaches to consider the unique characteristics of the digital economy and ensure fairer taxation. Many countries and international organizations are currently actively working on the development and implementation of international tax reforms to ensure adequate taxation in the digital economy and prevent tax avoidance.

ACTION PLAN TO COMBAT BASE EROSION AND PROFIT SHIFTING (BEPS)

The OECD has long been seeking a solution to the issue and in February 2013, it published the report “Addressing Base Erosion and Profit Shifting,”^[11] which outlined the problems of international taxation, including those discussed above. Subsequently, the OECD developed and adopted the Action Plan on Base Erosion and Profit Shifting (BEPS).^[12]

The BEPS Action Plan consists of 15 actions that provide governments with domestic and international rules and tools to address tax avoidance issues. Its aim is to ensure that profits are taxed in the country where economic activities generating the profits and value creation take place. The BEPS plan aims to prevent tax avoidance and ensure fairer and more effective taxation in an international context.^[13]

The BEPS plan includes the following actions or measures:

BEPS 2.0 PLAN

Currently, there is a high priority placed on solving tax issues related to the globalization of the digital economy. In this context, the Organization for Economic Cooperation and Development (OECD) in collaboration with the Group of Twenty (G20) countries has developed a new plan called BEPS 2.0, which consists of two key components:^[14]

• Pillar One (Nexus and Profit Allocation): This component aims to address the challenges of taxation in the digital age by reallocating taxing rights between countries. It focuses on ensuring that businesses pay taxes in the jurisdictions where they have significant consumer markets and generate value, even if they do not have a physical presence there.
• Pillar Two (Global Minimum Tax): This component aims to establish a global minimum corporate tax rate of 15% for companies with revenue above €750 million and create a top-up tax for certain profits in jurisdictions below the minimum tax rate to prevent multinational enterprises from shifting profits to low-tax jurisdictions. It includes the development of rules to ensure that profits are subject to a minimum level of taxation, regardless of where they are earned.

Approximately 140 countries and jurisdictions have joined this new plan and are obligated to review their national tax legislation in accordance with the new reform.

Let us now examine in more detail the key rules of these two BEPS components.

PILLAR ONE. NEXUS AND PROFIT ALLOCATION

Pillar One brings changes to the allocation of profits by establishing a connection between the profits generated and the business activities carried out in a specific jurisdiction. It aims to expand the taxing rights of “consumer” jurisdictions where businesses engage in sustained economic activities and have a presence, including digital activities.

Initially, this concept was planned to apply only to companies providing automated digital services and/or consumer-facing businesses. However, it was later decided to extend the new rules to all companies meeting certain criteria, except for the extractive industries and regulated financial services.

Key elements of Pillar One include:

• Amount A
• Amount B
• Tax certainty

Amount A

Pillar One Amount A rules apply to the biggest and most profitable MNEs and allocate parts of their profits to the countries where they sell their products and provide their services (the market countries).

This component regulates the reallocation of “residual” profits between MNEs and the jurisdictions where their consumers are located. If the “residual” profit exceeds 10% of the income derived in the consumer jurisdiction, then 25% of that profit is subject to taxation in the corresponding country, proportionate to the revenue generated there.

The “Amount A” element applies in the following cases:

• MNEs with a global turnover exceeding EUR 20 billion (possibly lowered to EUR 10 billion in the future) and a profitability threshold above 10% (i.e., the ratio of pre-tax profit to revenue).
• Jurisdictions where MNEs operate have the right to tax a portion of the profits only if the income derived from their activities in that jurisdiction exceeds EUR 1 million (with a lower threshold of EUR 250,000 for countries with GDP below EUR 40 billion).

The implementation of “Amount A” requires adherence to the Multilateral Convention, which will regulate the international taxation of MNEs, and making the necessary changes to the domestic legislation of countries. Thus, global changes to existing tax treaties are not required. The Multilateral Convention eliminates the taxation of digital services in countries and obliges countries not to introduce such taxes in the future.

Amount B

Amount B simplifies the existing transfer pricing rules for all taxpayers. It is focused on the application of transfer pricing rules to so called baseline marketing and distribution activities, likely the most frequent fact patterns that MNEs encounter in the jurisdictions where they operate.

While de minimis retail sales are allowed, the primary focus of “Amount B” is on the wholesale distribution of goods, including commissionaires and sales agents. It establishes new principles for determining remuneration for basic marketing and distribution functions related to the presence in the market of the jurisdiction where the distributor operates.

In cases where the distributor performs minimal functions and assumes insignificant risks in the transaction, their remuneration will be determined based on a fixed profitability according to established calculations, rather than following existing transfer pricing rules. This allows jurisdictions to obtain a corresponding share of the profits from the distributors’ activities within their territory.

Tax Certainty

This element proposes an enhanced mechanism for preventing and resolving disputes between countries regarding the application of “Amount A” and “Amount B”. This mechanism aims to provide a more efficient and transparent process, reduce potential disagreements, and improve cooperation between tax administrations.

The mechanism includes the development of standard procedures and guiding principles for dispute resolution, and provides for the use of alternative dispute resolution mechanisms such as international arbitration procedures or mediation.

PILLAR TWO. GLOBAL MINIMUM TAX

Pillar Two aims to counteract the business structuring strategies of MNEs using low-tax jurisdictions and to compensate the host countries for the lost revenues.^[15]

The main component of this reform is the Global Anti-Base Erosion (GloBE) rules, which include:

1. The Income Inclusion Rule.
2. The Undertaxed Payments Rule, which serves as an alternative.

Rules (1) and (2) establish a minimum level of tax burden on MNCs. They introduce a minimum corporate tax rate on income, set at 15% for MNCs with annual income exceeding 750 million euros. These rules aim to bridge the gap between tax rates in different jurisdictions and ensure fair taxation of MNC profits.

In the context of international taxation, many multinational corporations (MNCs) abuse the rules of Double Taxation Agreements (DTAs) to transfer capital and erode the taxable base. They utilize various types of intra-group payments, such as royalties, interest, marketing, agency, and consulting services, to reduce the tax base in the country where income is generated.

To combat these practices, the Subject to Tax Rule (3) complements the Global Anti-Base Erosion (GloBE) rules. This rule targets MNCs that use intra-group payments to shift profits from the source country to jurisdictions where these payments are either not taxed or subject to low tax rates. The objective of the rule is to protect the tax base of source countries, particularly those with limited tax administration capabilities.

The Subject to Tax Rule applies to specific types of payments between related parties that pose the highest risk of base erosion and profit shifting. These categories of payments include:

• Interest and royalties.
• Franchise fees or payments for the use of intangible assets.
• Insurance or reinsurance premiums.
• Guarantee fees, brokerage, or financial commissions.
• Rental payments or payments for the use of movable property.
• Payments for marketing, procurement, agency, or other intermediary services.

According to the Subject to Tax Rule, jurisdictions where these payments occur have the right to tax the gross amount of these payments received by related companies until the globally agreed minimum tax rate is reached. This rule allows for the control and minimization of base erosion, ensuring that source countries can tax the relevant payments and reducing opportunities for profit shifting through intra-group operations.

CONCLUSION

Establishing rules in the field of international taxation is a complex and multifaceted process. It involves analyzing the tax systems of different countries, their interactions, and considering the peculiarities of modern international economic relations.

While serving as the basis for international tax agreements for a long time, the model conventions of the OECD and the UN no longer fully correspond to the new processes and schemes that have emerged in the modern economy. As a result, tax rules have been revised and new approaches to taxing income have been developed, with a focus on taxation in the country of consumption.

The BEPS and BEPS 2.0 plans are important steps towards more fair and efficient taxation, promoting the development of international economic relations and ensuring stability in the global economy. They aim to prevent base erosion and profit shifting.

[1] Cited in Sadowsky, Marilyne, The History of International Tax Law (March 16, 2021). OUP Handbook of International Tax Law (F. Haase, G. Kofler eds., Oxford University Press 2021 Forthcoming), Available at SSRN: https://ssrn.com/abstract=3853172. Accessed: July 19, 2023.

[2] Michael J. Graetz & Michael M. O’Hear, The “Original Intent” of U.S. International Taxation, 46 Duke L. J. 1021 (1997). URL: https://scholarship.law.columbia.edu/faculty_scholarship/389. Accessed: July 19, 2023.

[3] Avi-Yonah, Reuven S., The 1923 Report and the International Tax Revolution (February 21, 2023). Available at SSRN: https://ssrn.com/abstract=4365398 or http://dx.doi.org/10.2139/ssrn.4365398. Accessed: July 19, 2023.

[4] Image by Unknown author. Unknown author (https://commons.wikimedia.org/wiki/File:Edwin_RA_Seligman_portrait.jpg), „Edwin RA Seligman portrait,” marked as public domain, more details on Wikimedia Commons: https://commons.wikimedia.org/wiki/Template:PD-1923

[5] Cited in What is International Tax Law? (2023). The University of Melbourne Library. URL: https://unimelb.libguides.com/int_tax_law. Accessed: July 19, 2023.

[6] OECD (2019), Model Tax Convention on Income and on Capital 2017 (Full Version), OECD Publishing, Paris, https://doi.org/10.1787/g2g972ee-en. Accessed: July 19, 2023.

[7] UN (2021), Model Double Taxation Convention between Developed and Developing Countries. URL: https://financing.desa.un.org/un-model-convention. Accessed: July 19, 2023

[8] “BEPS Project Background Brief” (PDF). OECD. January 2017. p. 9. URL: https://www.oecd.org/tax/beps/background-brief-inclusive-framework-for-beps-implementation.pdf. Accessed: July 19, 2023.

[9] Gabriel Zucman; Thomas Torslov; Ludvig Wier (June 2018). “The Missing Profits of Nations.” National Bureau of Economic Research, Working Papers. p. 31. Appendix Table 2: Tax Havens. URL: http://gabriel-zucman.eu/missingprofits/. Accessed: July 19, 2023.

[10] Image by librairie mollat (https://commons.wikimedia.org/wiki/File:(Gabriel_Zucman)_La_richesse_cachée_des_nations,_enquête_sur_les_paradis_fiscaux_(cropped).jpg), „(Gabriel Zucman) La richesse cachée des nations, enquête sur les paradis fiscaux (cropped),” https://creativecommons.org/licenses/by/3.0/legalcode

[11] OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris. URL: https://doi.org/10.1787/9789264192744-en. Accessed: July 19, 2023.

[12] OECD (2020), Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. URL: https://doi.org/10.1787/beba0634-en. Accessed: July 19, 2023.

[13] OECD, BEPS Actions. URL: https://www.oecd.org/tax/beps/beps-actions/. Accessed: July 19, 2023.

[14] OECD (2020), Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, URL: https://doi.org/10.1787/beba0634-en. Accessed: July 19, 2023.

[15] OECD (2020), Tax Challenges Arising from Digitalisation – Report on Pillar One Blueprint: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, URL: https://doi.org/10.1787/beba0634-en. Accessed: July 19, 2023.