International Taxation Rules on International Companies - Essay Example

International Taxation Rules on International Companies Many developed and developing countries have been party to various political and economic conventions, organizations, protocols, and agreements, specifically designed to enhance trade and economic development among member states. Besides helping nations to settle their disputes amicably without necessarily resulting to war like it happened in World Wars I and II, these organizations and treaties have been key in ensuring that international trading and economic standards are maintained for the benefit of all nations (Rawal, 2006). Perhaps one of such organizations that have been instrumental in ensuring fair economic play within Europe and its allies is the Organization for Economic Cooperation and Development. After the devastating effects of the World War II, a number of developed countries came together under the auspices of the Organization for European Economic Cooperation (OEEC) to help in the administration of the Marshal Plan for the rebuilding of Europe. The OEEC was later rearranged into the Organization for Economic Cooperation and Development (OECD) in 1961. Today, the OECD is made up of thirty countries that accept the principals of free market economy and representative democracy (Owens, 2008). Most OECD countries are developed countries, with high-income countries. Some of its members include France, United Kingdom, United States, Denmark, Finland, Spain, Sweden, Italy, Japan, among others. The functions of the OECD are multifaceted. But for the purposes of this discussion, it is only imperative to mention that, OECD functions as an intergovernmental organization which aims at coordinating economic development of members as well as non-member nations through trade liberalization, multilateral trade, and economic reform. The organization also covers economic and scientific research, technology transfer, international terrorism, and economic and statistical information (OECD, 2007). Tax Rules and Taxation of International companies As much as the OECD would want to come up with proper legislation and mechanism for international taxation policy, it found out that some of its definitions caught certain features of member countries' tax systems. For example, most developed nations have zero or low taxes for certain types of groups. As such, the organization has found itself leaning more on international taxation rules in its operations. This is because many corporations may have interests in several countries that employ different tax regimes (Doenberg & Hinnekens, 1998). A good example would be the Multinational corporations, which must employ the services of an international tax specialist to decrease the global tax liabilities. Tax laws from different countries around the world affect companies and individuals with assets and income in more than one nation differently. Tax laws vary in different nations as to what income is taxable and how it is measured, who or which entity is taxable, when deductions are allowed and income is taxed, what deductions are allowed from the taxable income and the tax rates. These variations, if not well controlled may bring a scenario where the same income of an international company is taxed by different countries (Larkins, 2004). This is better known as double taxation. As such, there is need for international tax planning to take care of the loopholes occasioned by the above named variations among countries. How then must international companies be taxed rationally The concept of international tax planning and law has gained considerable attention from the perspective of tax authorities as well as from the taxpayers. The OECD has played an active role in the creation of international tax rules to help businesses move away from double taxation, intractable disputes, and uncertainty (Owens, 2008). According to Mr. Jeffrey Owens, a director of OECD in tax policy administration, improper tax rules can discourage international activity, discourage investment, and bring conflicts among nations as to the appropriate tax treatment of a multinational business and between governments and taxpayers. This will impede global development. As such, various international tax rules have been developed, especially by OECD to deal with international companies. Below I attempt to discuss some of the rules. Transfer pricing guidelines A key issue concerning international corporations is the "allocation of the overall income arising from the transactions between the various taxing jurisdictions involved" (Owens, 2004). It is known that international companies that produce and distribute services and goods make use of their parent companies and subsidiaries located in different tax jurisdictions (countries). International companies would naturally wish to calculate their tax burdens in such a manner as to concentrate tax payments in lower tax regimes. Through internal accounting, these tax guidelines can be used by multinational firms to shift profits among subsidiaries therefore lessening their overall tax burden, or in some cases avoiding to get taxed in some jurisdictions altogether (Kaufman, 1998). In international taxation law, transfer pricing guidelines are addressed by both the treaty law as well as the domestic tax legislation. In the OECD Model treaty, article 9 provides for the right of contracting countries to adjust the profits transferable to an associated subsidiary by means of pricing, which should not use the arms length rule (Doernberg & Hinnekens, 1998). The arms length rule treats each member of the multinational corporation as a separate entity for taxation purposes. Article 7 of the same treaty provides for a direct or indirect method of profit allocation between subsidiaries of an international company, requiring separate accounts for the permanent establishment, and goes on to impose the arms length rule to relations between permanent subsidiaries and head office (Larkins, 2004). Advance pricing agreement This international tax law allows the governments and tax payers involved to reach taxation agreements in principle on the suitable taxation procedures to be applied to particular cases before tax transactions can take place (Owens, 2004). The international corporation must submit to the relevant tax authorities the financial information that would be necessary in determining the precise nature of the underlying transactions. The tax authorities afterwards use the transfer pricing guidelines discussed above to agree on the suitable methodology to apply to the case (Thuronyi, 1998). In international taxation law, the advance pricing agreement simply formulates a basic framework through which the tax transactions of particular international companies will be handled and analyzed (Rawal, 2006). It does not address all the finer details as to how the transaction would be taxed. This international tax law has greatly reduced the chances of double taxation and cultivated deep trust between the parties involved. Through this method, all tax jurisdictions involved are left satisfied about their proportion of tax revenues that are likely to be generated from these transactions. Source of income rules The foundation of the US international tax system could be found in the source of income rules. The same income can be taxed twice due to overlapping international tax rules. It is international practice to impose taxation on the basis of source (Larkins, 2004). Source of income rules applies to income made by international corporations arising within the geographic borders of the nation that is levying the tax. Every country in the world that imposes an income tax does it on the basis of the source of that income (Doenberg & Hinnekens, 1998). According to Kaufman (1998), an issue that is closely associated with the source of income is the splitting up of the profits of an international corporation among the nations in which the corporation conducts business. Most nations to date have followed the general rule which treats each member of the international corporation as a separate entity for taxation purposes. This arms length principle generally requires individual subsidiaries of a multinational group to decide their incomes as if transactions within the corporation took place under prevailing market conditions. Under this rule, the price paid within a tax transaction between the subsidiaries of an international group should have been the amount payable in a transaction between unrelated entities transacting at arms length. This principle has been credited with distributing the profits of a multinational among various tax jurisdictions in which the group conducts its business, while at the same time avoiding the prospects of being taxed for the same income by more than one tax jurisdiction (Larkins, 2004). Rules on taxation of permanent residents Taxation of permanent establishments constitutes a vital part of international taxation law. According to Rawal (2006), the OECD has infact published some discussion drafts on the issue of attribution of profits to permanent establishments. The international taxation law has come up with modalities of attributing profits of an entity amongst the various activities that are conducted by the corporation itself. The organization has also come up with modalities of attributing profits in the case of tax transactions between the permanent establishments (subsidiaries) and the head office. In the OECD circles, one of the most practically complex and conceptually difficult issue in international taxation is the attribution of profits to a permanent establishment (PE). Permanent establishment is used in international tax law to determine the right of a nation to tax the profits of an entity of the other contracting nation under the tax treaties (OECD, 2008). A contracting nation cannot in any way tax the profits of an international corporation of another contracting nation unless the corporation conducts its business through a permanent establishment that is situated in the latter's nation. This is as far as the OECD model Tax convention goes. OECD Member countries and tax havens Consequently, all the above international tax laws that have been ratified by the OECD will affect the friends' plans on establishing their company in a tax haven so as to avoid payment of tax. In fact, the OECD is very clear on tax havens. A tax haven consists of a country where certain applicable taxes are not levied at all or are levied at much discounted rates. Due to these tax breaks, firms and individuals find it appealing to locate in such countries with lower tax tariffs (Larkins, 2004). This has often created a situation of tax competition among nations, a scenario that has not been supported by OECD to date. In tax-haven countries, there exists a composite tax structure that has been deliberately established to exploit or take advantage of a worldwide demand for occasions to engage in tax avoidance (Kaufman, 1998). The OECD has since 1998 led a campaign against what it perceives as harmful tax practices, directed at the activities of these tax havens. Its efforts have been met with mixed reactions since it principally accepts the policies of member countries that tend to encourage tax competition among countries. There are also those countries which argue that a country's tax policy is an issue of supreme entitlement and therefore should not be dictated upon by any organization. Such countries include Monaco, Andorra, and Liechtenstein, and have earned the wrath of the OECD by being blacklisted as uncooperative tax havens (Kaufman, 1998). Both Andorra and Monaco do not levy Personal Income Tax. Switzerland is presently been considered as a possible addition to the list of uncooperative tax havens due to its policies that encourage tax fraud. The OECD has identified several benchmarks used to consider whether a jurisdiction or nation is a tax haven. First is the availability or non-availability of nominal charges. Known tax havens impose nominal or no taxes at all in special or general circumstances. These countries are therefore used by non-residents as conduits of escaping high taxes in their own countries. The second benchmark is the protection of personal financial information. Countries that are perceived as tax havens have administrative practices and laws under which individuals and businesses benefit from strict rules against scrutiny by foreign tax authorities (Larkins, 2004). The third benchmark used by OECD is lack of transparency in the operation of the legal, legislative, and administrative provisions. There should be a consistent and open administration of law. Information needed to determine a taxpayer's situation must be made available to foreign tax authorities. It would be difficult for other tax authorities to apply their laws effectively if there is lack of transparency from one country. Negotiated tax rates, secret rulings, and other questionable tax practices that fail to apply law consistently and openly are examples of lack of transparency (Rawal, 2006). References Doenberg, R.L., & Hinnekens, L. Electronic Commerce and International Taxation. Kluwer Law International. 1998. Retrieved 24 Nov. 2008, from http://books.google.co.ke/booksid=aNXapzr1_2MC&pg=PA202&lpg=PA202&dq=international+taxation+rules+:+Transfer+pricing+guidelines&source=bl&ots=fQejIx9p_2&sig=_GREPiVTnFZ-pQZ9j7kZQwa1B6I&hl=en&sa=X&oi=book_result&resnum=1&ct=result#PPA204,M1 Kaufman, N.H. Fairness and Taxation of International Income. 1998. Retrieved 24 Nov. 2008, from http://findarticles.com/p/articles/mi_qa3791/is_/ai_n8761729 Larkins, E.R. International applications of U.S. Income Tax Law: Inbound and Outbound Transactions. John Wiley & Sons Inc. 2004. Retrieved 24 Nov. 2008, from http://books.google.co.ke/booksid=_Dp5Ku1TsZMC&pg=PA49&lpg=PA49&dq=International+tax+law++source+of+income+rules&source=bl&ots=6ZOT97spyW&sig=UwsZgADUpnI27SmpAVLl6C-RXKc&hl=en&sa=X&oi=book_result&resnum=5&ct=result Organization for Economic Cooperation and Development (OECD). OECD Launches Consultations on Attributing Profits for Tax Purposes to Permanent Establishments. 2008. Retrieved 24 Nov. 2008, from http://www.oecd.org/document/2/0,3343,en_2649_33753_2081986_1_1_1_1,00.html Organization for Economic cooperation and Development (OECD) 2007. Retrieved 24 Nov. 2008, from http://www.businessdictionary.com/definition/Organization-for-Economic-Cooperation-and-Development-OECD.html Owens, J. Resolving International Tax disputes: The Role of OECD. 2008. Retrieved 24 Nov. 2008, from http://www.oecdobserver.org/news/fullstory.php/aid/1290/Resolving_international_tax_disputes:_The_role_of_the_OECD.html Rawal, R. The Taxation of Permanent Establishments: An International Perspective. Spiramus Press Ltd. 2006. Retrieved 24 Nov. 2008, from http://books.google.co.ke/booksid=9mqDPIGkMMkC&pg=PR5&lpg=PR5&dq=International+tax+law++attribution+of+profits+to+a+permanent+establishment&source=web&ots=yAYID4mKRv&sig=uzZoMehVKktQXRPKWnJ4agPtKPM&hl=en&sa=X&oi=book_result&resnum=5&ct=result#PPR13,M1 Thuronyi, V. Tax Law Design and Drafting. International monetary Fund. 1998. Retrieved 24 Nov. 2008, from http://books.google.co.ke/booksid=19mdVW1W1zgC&pg=PA808&lpg=PA808&dq=International+tax+law++Advance+pricing+agreement&source=web&ots=gVRhNflkA2&sig=b6vnUzzKNkaDvYAFcBKYs5eGKRU&hl=en&sa=X&oi=book_result&resnum=3&ct=result Read More