The Present and the Future of Territorial Tax Countries
How is the source of income determined from a tax perspective?
We often find a number of clients that interpret that income is sourced where the monies for goods and services are paid i.e. the location of the clients. Following this approach, a company that is tax resident in a jurisdiction with a territorial tax system would pay no tax on the revenues arising from foreign clients.
The above does not generally apply. Although the definition of what constitutes foreign-source income varies depending on the jurisdiction, generally, the source of the income refers to the place where the activities that generate such income are carried on, regardless of the place where the clients or payers are located.
The scope of such foreign activities, and whether income arising from such foreign activities is taxable, may also vary across different territorial tax jurisdictions.
Certain territorial tax jurisdictions have a more flexible approach as to what level of commercial substance of foreign activities would give rise to foreign-source income, and as to whether such foreign-source income is subject to tax locally; other jurisdictions are stricter – for instance if certain income is considered foreign-source income and thus non-taxable income, then it should be taxed elsewhere, in the place where it is sourced, and proof of this should be provided.
In this article, we aim at providing an understanding of certain concepts related to the definition of foreign-sourced income, reviewing the key aspects and notable differences between the largest business centers whose tax system is based on the principle of territoriality, as well as looking at the latest international tax trends and developments on territorial tax systems. This article does not intend to be a comprehensive review and is not legal or tax advice of any kind.
Foreign-Source Active Income from Permanent Establishments
As we previously mentioned, foreign-source income is generally income derived from business activities carried out outside of the country where a given company is a tax resident.
A company carrying on business activities in a foreign country may be deemed to have a permanent establishment (PE) in this foreign country. A PE is usually constituted when a company has a stable and ongoing presence in a given country generating revenue from such establishment.
Most jurisdictions follow the OECD Model Tax Convention for defining a PE. The OECD’s criteria provide for three types of PEs:
- A fixed place of business
- Construction or project
- An agency
Generally speaking, a fixed place of business is usually interpreted as a facility that is used by a company to do business which has some degree of permanence. This could be a branch office, a factory, the place of management or a mine or warehouse with certain exceptions.
Facilities for storage, display or delivery of goods, for the purposes of maintaining stock or for the purpose of having another company process to process such goods, are generally excluded from the definition of permanent establishment.
A construction or project permanent establishment usually refers to a building site or construction or installation project that lasts a certain period of time.
Agents may include directors, attorney-in-fact, authorized signatories, employees, dependent contractors exclusively working for a given company or others under the control of the principal.
Double-tax agreements between jurisdictions or local tax laws may provide for additional cases. For instance, in certain jurisdictions, a local internet server may constitute a permanent establishment.
Income generated by a permanent establishment is taxed locally – in the jurisdiction where it is established. As most countries tax companies on their worldwide income, double-tax agreements prevent double-taxation events to occur. Mos treaties generally exempt a company from being taxed on income derived from a permanent establishment located in a ‘treaty’ country.
However, in the absence of a tax treaty, these two countries could have the right to tax such permanent establishment income and situations of double taxation could occur. Most countries provide for tax credits for foreign tax paid, although these need to be claimed, and could be cumbersome to obtain.
Countries with territorial tax systems solve that issue by granting an exemption or directly considering non-taxable income such income arising from a foreign-source, from a permanent establishment abroad – effectively avoiding double taxation, regardless of whether a tax treaty is in place or not.
However, one should also look at whether such foreign-source income arising from a permanent establishment is taxed when repatriated to the headquarters and received locally, and whether exemptions are in place for certain classes of income.
Foreign-Source Active Income without Permanent Establishment
There are a number of situations where a company may be deriving income from foreign sources without having a permanent establishment.
For instance, a company may physically provide services in another country, without this activity constituting a permanent establishment, due to the lack of a fixed place of business.
Such income may be considered local-source income in the country where the services are physically provided and may be subject to withholding tax. The same income may also be subject to taxes in the country where the company is fiscally domiciled if a worldwide taxation system applies.
In the same way as with permanent establishments, double-taxation agreements may provide for an exemption from such withholding tax or a reduced rate. In the absence of a treaty, a tax credit on foreign-source service income tax paid may be available.
However, territorial tax countries generally do not tax such service income arising from services performed on foreign soil. However, such services must be physically provided abroad – if the service is performed for a foreign client but locally (e.g. online services), service fees would usually be treated as local-source income in the company’s country of residence, as the activity that generated such income would have been conducted locally.
When it comes to trading goods and commodities, determining the source of income is more complex, and several aspects come into place, which is interpreted differently across jurisdictions. A combination of the place where the goods or commodities are bought and sold, and where the contracts are negotiated and executed (with a broad meaning of execution) may have implications when determining the source of the income.
For instance, if a company buys and sells goods or commodities within the same foreign country, that may constitute local-source income in such country and therefore, be subject to taxes.
If a company negotiates sales and purchase contracts and executes such contracts in a foreign jurisdiction, income arising from such contracts could be deemed local-source income. If such contracts are concluded via electronic means, that would generally be considered local-source income in the country where the company operates and is tax resident.
If a company negotiates and executes the sales and purchase contracts overseas, but goods traded are manufactured locally (where it is tax resident), income from the sale could be considered local-source income, regardless of whether the contracts are negotiated overseas with foreign clients.
As we have seen there are a number of facts to assess to determine the source of income from international trading profits. Furthermore, each territorial tax jurisdiction has its own set of definitions, interpretations, and jurisprudence. Therefore, each specific case should be analyzed separately.
Passive income is generally defined as earnings that are derived from holding or selling assets, whether fixed or mobile, without the active involvement of the person holding the title of such assets.
Typical passive income streams include dividends, interests, royalties, rental income and capital gains from the sale of assets.
In territorial tax countries, dividends from foreign sources, e.g. dividends from foreign subsidiaries, portfolio companies, etc., are generally deemed to be of offshore nature, and therefore exempt from local tax.
Certain jurisdictions consider foreign dividends non-taxable income, and others provide exemptions from taxes based on the fulfillment of certain requirements, such as the underlying dividend-paying company not carrying out business activities locally, or being subject to a certain level of tax, among others.
Interest income from foreign bank deposits and/or foreign bonds is also generally considered foreign-source. However, in certain territorial tax countries, foreign interest income derived from loan contracts may be taxed if the paying company uses such funds for local activities, or the contracts are concluded locally, or lending constitutes the main business activity of the company.
When it comes to royalties, the situation may be of added complexity. Royalty income is derived from licensing or allowing the use of certain intellectual property rights. The resources allocated to the development of such intellectual property may have generated tax-deductible expenses locally. This may create a mismatch whereby expenditures have been used to reduce local tax payable, but passive income generated from such expenditures be exempt from tax.
Furthermore, the royalty-paying company may be using such IP rights locally in the jurisdiction where the IP holding is tax resident.
Therefore, certain jurisdictions put in place certain measures and requirements to obtain a tax exemption on such foreign royalty income. For instance, foreign royalty income whose expenditures have been tax-deductible, or foreign royalty income derived from IP rights used locally, may be taxed locally.
It is important to note that most countries levy withholding taxes on dividends, interests and royalties. Withholding tax refers to income tax that is withheld (and deposited to the relevant tax office) by the paying company on behalf of the payee. This means that even if a territorial tax country does not charge tax on foreign income, such income may be subject to tax in the country where the payer is located.
However, double-tax agreements (DTA) generally reduce (or even exempt) withholding taxes on transactions between contracting countries.
Foreign rental income are earnings derived from a real property located overseas, a physical asset, and therefore is usually considered foreign-source income and not taxed in territorial tax countries. Rental income is generally taxed where the property is physically located.
For the same reason, capital gains from the sale of an overseas property would generally be exempt from local taxes.
Capital gains from the sale of securities and other financial assets could be deemed as local-source income, given that assets that derive their value from contractual claims are generally deemed to be located where the holder of the title is resident. One would also need to look at where the negotiations, conclusions and contracts for the sale of such assets take place.
Nonetheless, most territorial tax countries provide for an exemption from capital gains taxes on the sale of securities (whether local or foreign).
There is an exception to the above in certain countries: if the capital gains arise from listed securities in foreign exchanges, those may be taxed in the country where the securities exchange is located, and deemed foreign-source income in the country where the holder is tax resident.
Likewise, the source of income of gains from the sale of other intangible assets such as intellectual property is generally the place where the company is resident, regardless of whether the intangible asset is registered for protection in foreign countries (e.g. trademarks, patents, designs, utility models, etc).
Territorial Tax Jurisdictions
Each territorial tax country has a different approach when it comes to assessing the source of income, determining what constitutes taxable income, and whether exemptions from income taxes are granted to certain income streams derived from foreign countries. Certain countries provide blanket exemptions on foreign-source income, and others require such income to meet certain conditions, as well as the level of proof required by a given tax authority.
Furthermore, certain countries apply a territorial tax regime for corporate tax purposes, but not for personal income tax purposes, and others the opposite.
We have summarized below the territorial corporate tax regimes from the largest international business and financial centers.
Hong Kong has one of the largest corporate registries when it comes to non-resident owned companies, second to BVI. Besides its large financial infrastructure, freeport, and being the main commercial and financial conduit to and from China – one of the fundamental aspects of why Hong Kong has attracted such a large number of foreign players is its tax regime.
Hong Kong taxes profits that arise in or are derived from a trade, profession or business carried on in Hong Kong i.e. on a territorial basis. The standard profits tax rate is 16.5%, although a reduced tax rate of 8.25% applies to the first HKD 2,000,000 in profits. Capital gains derived from the sale of securities and dividend income are generally exempt from taxation.
Profits that do not arise in or are derived from Hong Kong and/or from a company that is not carrying on a trade, profession or business in Hong Kong are not taxed in Hong Kong.
Although when assessing the source of profits, the IRD looks at all operational and commercial facts of the company, the key aspect is where the income-generating activities take place. Income-generating activities are specific activities that produce income.
For instance, for a service company, the income-generating activity may be the specific service fulfillment and to a lesser extent, the related sales and marketing activities. Other company activities that are not directly connected to the income, such as personnel training or accounting, are not relevant.
If the service company renders such services from within Hong Kong, regardless of whether those are provided to a foreign client or via electronic means, profits arising from such services would be taxable in Hong Kong. If the services are rendered to a non-Hong Kong customer physically outside Hong Kong or by a foreign agent, or outsourced to a foreign service provider – profits arising from such services may be exempt from tax.
For trading companies, the main income-generating activities would generally be the negotiation, conclusion and execution of contracts.
If sales or purchase agreements (whether written or oral) are negotiated or concluded or executed in Hong Kong (the person is located in Hong Kong), trading profits arising from such transactions would likely be deemed from a Hong Kong source, and therefore, taxed in Hong Kong.
Generally, if the supplier or customer is a Hong Kong person, profits would be deemed from local-source. Much in the same way, a company manufacturing goods in Hong Kong would likely be taxed on profits arising from the sale of such goods, regardless of whether the sales contracts are effected overseas. If the goods are partly manufactured overseas, apportionment may be available, and the company could pay only tax on a certain percentage of profits.
Other factors may also need to be assessed. The place from where the company conducts its marketing and sales activities or the place where the orders and goods are processed may also be relevant for determining the source of the trading profits.
Then, there are general aspects to take into account that apply to all companies, regardless of their activities. For instance, if the company is managed from Hong Kong, and/or has its main place of business and operational activities in Hong Kong, it would likely be taxed in Hong Kong if it does not have a registered business presence overseas to which the profits could be attributed.
Having such business presence overseas has become more relevant lately, as we will see below.
For a company to benefit from a foreign-source income tax exemption, it should file with the IRD a tax computation claiming the offshore tax exemption together with the profits tax return and the auditor’s report. The IRD will proceed with an investigation, and if satisfactory, will approve the application and issue a ‘tax exemption’ letter. This process may take more than 6 months.
If the company only generates offshore profits, the tax exemption may be granted for a determined period of time subject to the activities of the company and the source of its profits remaining unchanged – which will need to be outlined in its annual audit report. If the company accrues both offshore and local-source income, the tax exemption might need to be claimed every year.
The IRD may randomly select a series of transactions of the company, and inquire about further details. The Hong Kong company claiming the offshore tax exemption will need to provide supporting documentation. The initial presumption from the IRD is that a Hong Kong company carries on business locally and therefore derives local-source profits – the foreign-source of such profits shall be proven.
This supporting documentation may include detailed descriptions and memos of meetings with customers and suppliers overseas, copies of passport visa stamps, flight tickets or boarding passes to shipping documents, purchase and sales orders, and even proof of business presence overseas such as permanent establishment registration documents (e.g. branch offices), or lately, proof that such profits are subject to tax or have been taxed overseas.
If the IRD is not satisfied with the documentary evidence provided by the company, the offshore profits tax exemption claim will be rejected.
The Tax office is taking a strict approach lately, with a significantly increasing number of claims rejected, and intensive investigation which leads to longer turnaround times and a substantial increase in accounting and audit costs.
As discussed above, the main purpose of a territorial tax system is to avoid double taxation in the absence of tax treaties. When profits are derived from foreign activities, income arising from such activities may be taxable income in the foreign jurisdiction, subject to its tax law.
However, companies may ‘abuse’ or ‘take advantage’ of certain structures that lead to a ‘double non-taxation’ situation, where profits are taxed neither in the country of tax residency of the company booking the profits nor in the country where the real activities that generate the income take place.
This practice is being heavily criticized and targeted by international agencies and organizations such as the OECD and the EU. We will discuss this in more detail later.
Following the latest developments in international tax trends, Hong Kong has been no exception to this, and therefore, the IRD is placing stricter controls on companies that are claiming offshore income tax exemptions, in order to safeguard its position as a reputed international financial and business center, and avoid being blacklisted.
Furthermore, mechanisms for the exchange of information are put in place, whereby the IRD could report to and exchange information with the countries’ authorities where a given Hong Kong company claims that profits are sourced from – and whether such profits have been declared and/or taxed in that country.
All in all, companies should carefully assess whether they have sufficient basis to claim for an offshore income tax exemption and whether it is worth going through it – considering the risks that the application may be rejected and the accounting and audit costs related to preparing such application, and following up with the ongoing investigation and inquiries from the tax office.
Note that if the offshore tax claim takes more than one year, and is finally rejected, the company may also incur penalties and interest due to the underpayment of tax due.
Therefore, a prudent and effective approach is registering a permanent establishment overseas. The Hong Kong company may seek to set up offices in certain strategic jurisdictions, for instance, Labuan in Asia, or Malta or Cyprus in Europe. Income derived from these permanent establishments would be taxed locally at low tax rates, and by proving tax registration and liability, it is more likely the IRD to grant a tax exemption on such income.
Singapore is another international financial and business hub in East Asia. Singapore has been the jurisdiction of choice for a number of companies doing business in the region to set up their regional headquarters, especially lately, given the political uncertainty and turmoil affecting Hong Kong.
Like Hong Kong, Singapore has a relatively low tax regime that applies the principle of territoriality. Unlike Hong Kong, Singapore has traditionally been much stricter when it comes to providing tax benefits on foreign-source income.
Singapore corporate income tax is levied on all income accruing in or derived from Singapore and all foreign-sourced income remitted or deemed remitted to Singapore.
The headline corporate tax rate is 17%, although various partial exemptions apply to the first SGD 200,000 profits. Capital gains from the sale of securities are generally exempt from tax if it does not constitute the ordinary business activity of the company.
Foreign-source income is defined by the Inland Revenue Authority of Singapore (IRAS) as profits that arise from a trade or business carried on outside of Singapore – mainly foreign dividends, foreign branch profits, and foreign service fees. Income from foreign property or interests may also qualify as foreign-sourced income.
Dividends distributed by a foreign company to a Singaporean shareholder would be considered foreign-source income.
When it comes to trading, income would be considered foreign-sourced as long as it is derived from a foreign branch i.e. a foreign permanent establishment whose income is subject to taxes locally.
Service fees could be deemed of a foreign source if they are derived from a fixed place of operation overseas. Namely, a place of management, an office or some floor space where employees provide the services.
This fixed place of operations should be permanent, available on an ongoing basis, and is used to carry out its income-generating activities rather than auxiliary activities. This ‘fixed place of operations’ would likely be considered a permanent establishment in a foreign country.
Therefore, a Singaporean tax resident company would not generally be able to avoid tax on their foreign trading or service income if such income is not taxed elsewhere. ‘Double non-taxation’ on service and trading income is uncommon for Singaporean companies. For foreign-source income to be not taxed in Singapore, it should be subject to taxes elsewhere.
Furthermore, companies in Singapore are tax resident in Singapore if their place of effective management (e.g. board meetings) is situated in Singapore. However, if a Singapore company does not have a registered corporate headquarters overseas, for corporate tax purposes, IRAS may consider the company to be managed from Singapore and its income to be locally sourced income. Contrary to common belief, it is generally not possible to operate with a Singapore company as an “offshore company”.
We have established what may constitute foreign-source income exempt from Singaporean taxes. However, as previously mentioned, if such foreign-source income is remitted to Singapore or deemed remitted to Singapore, it is taxable in Singapore.
The above means that even if qualifying as foreign-source income, the corporate tax applies to such income if it is remitted or received in a Singaporean bank account of the company, or is used to repay a debt incurred in respect of a trade or business carried on in Singapore; or applied to purchase any movable property, which is brought into Singapore.
However, certain tax exemptions on foreign-sourced dividends, foreign branch profits and foreign-sourced service fees that are brought to or received in Singapore by a resident company may apply, if the following conditions are met:
- ‘Subject to tax’ condition;
- ‘Foreign headline tax rate of at least 15%’ condition; and
- ‘Beneficial tax exemption’ condition
The subject to tax condition is straightforward – foreign income must have been subject to tax in the foreign country of source. In certain cases, IRAS might request audited accounts of the paying company (dividends), tax return or withholding tax return (branch profits and service fees).
If the foreign income is exempt from tax in the foreign jurisdiction due to tax incentives granted for substantive business activities carried out in that jurisdiction, the ‘subject to tax’ condition may still be met. In that case, a copy of the tax incentive certificate or approval letter might be requested by IRAS upon review of the tax return.
The ‘foreign headline tax rate of at least 15%’ condition refers to the requirement that the foreign country’s highest corporate tax rate is at least 15%. For instance, foreign-sourced income from a tax neutral jurisdiction remitted to Singapore will be taxable in Singapore.
Much in the same way as with the previous condition, if income has been taxed at lower rates due to a tax incentive (which must be proven), this condition may still be met if the standard corporate tax rate of the country is at least 15%.
Last, the ‘beneficial tax exemption’ condition is met if IRAS considers that the tax exemption would be beneficial to the taxpayer.
Expenses incurred related to exempted foreign-sourced income received in Singapore cannot be used for deduction against any taxable income.
Note that Singapore has mechanisms to avoid double taxation when foreign tax is paid and local tax is due on the same income. Singapore has a broad network of double tax agreements, which generally provide for a tax credit for foreign tax paid, otherwise a unilateral tax credit may be given in respect of foreign tax on all foreign-sourced income.
Panama has traditionally been a jurisdiction of choice for setting up ‘offshore companies’ due to its tax system based on the territoriality principle – especially in the shipping industry as a ‘flag of convenience’ jurisdiction.
In Panama, both residents and non-residents are only taxed on their Panamanian-source income. Generally, for determining taxable income in Panama, the place of tax residency of the company is not relevant; rather the source of the income.
When a nonresident company produces Panamanian-source income, tax is generally withheld at the source. When a resident company produces Panamanian-source income, it must file tax returns and pay tax on such income.
Taxable income in Panama is defined as income produced within the territory of Panama, regardless of the place where the income is received. As we will see, Panama has a broader approach than Hong Kong and Singapore.
Panamanian companies that have a place of business in Panama or accrue local-source income need to obtain a “Notice of Operation”.
Companies that obtain a Notice of Operation (onshore companies) are generally expected to submit annual accounts and tax returns, and pay taxes on their taxable income (local-source income), whereas ‘offshore companies’ without Notice of Operation and only deriving foreign-source income are exempt from most reporting requirements.
The Notice of Operation itself does not create a tax liability to the company; taxes will still be imposed by applying the territorial principle. However, it may create a tax liability for the company shareholders. Dividend payments to foreign shareholders from companies holding an Operations’ Notice and producing foreign-sourced income or export income may be subject to a 5% withholding tax (10% is the regular rate).
From a source of income perspective, income from sales of goods that do not enter Panamanian territory (bought and sold overseas) is generally deemed foreign-sourced income and not subject to taxes, regardless of whether sales and purchase contracts or transactions are concluded in Panama or managed by a local office in Panama. Income from goods sourced and exported from Panama is generally subject to taxes if the company is not situated in a Special Economic Zone.
Service fees are considered offshore income if the services are not performed within Panama to Panamanian customers. If the services are performed to overseas customers from a Panamanian office, service fees may also be exempt from taxes, as long as the services provided are not related to the generation of Panamanian source income by the foreign client.
Dividends received and capital gains from the sale of securities are also considered offshore income as long as the underlying company’s income is not of Panamanian source, regardless of whether it is a Panama-incorporated company or a foreign-incorporated company.
Interest income is also considered foreign-sourced and thus exempt from taxes as long as the borrowing company is outside of Panama. Royalties derived from IP rights not used in Panama are also considered non-taxable income.
All in all, Panama has a flexible territorial tax system where income arising from a broader class of transactions with foreign clients can be considered foreign-sourced income, and thus, exempted from tax.
However, Panama has been no exception to the clampdown on ‘harmful tax regimes’ by the Forum on Harmful Tax Practices (FHTP) and the EU Code of Conduct Group (COCG).
Economic Substance requirements have been put in place for accessing tax concessions under the Multinational Headquarters Regime and the Pacific Special Economic Zone, among others. Furthermore, the COCG is currently reviewing the territorial tax system of Panama, which could lead to tax legislative change requests from the EU.
We have been discussing throughout the last year how most jurisdictions were adapting their corporate and tax legislation following the ‘advice’ of the FHTP and the COCG.
A number of offshore jurisdictions had international business company (IBC) legislation providing for different tax treatment for resident-owned and nonresident-owned companies.
IBCs were exempted from tax, whereas domestic companies were subject to high corporate taxes (25-35% on worldwide income). IBCs were de jure or de facto prohibited to do business locally and to deal with residents.
This was the case of Nevis, Belize, Saint Vincent and The Grenadines, Saint Lucia, Curacao, Antigua, Dominica, Seychelles, among others.
The FHTP and the EU forced these jurisdictions to abolish ring-fencing features and tax benefits – providing residents access to international business structures, and abolishing blanket tax exemptions.
In order to save their corporate registrations’ industry, a number of these jurisdictions, such as Seychelles, Belize or Saint Lucia opted to implement a territorial tax system.
Each regime had its own nuances. For instance, the territorial tax provisions under the Belize Income and Business Tax Act of Belize provided a vague definition of what constituted foreign-source income – which was considered harmful by the EU.
In order to avoid being listed as a non-cooperative jurisdiction for tax purposes’ (‘EU Blacklist’), the Belize Income and Business Tax Act was further amended last December 2019, abolishing the tax exemption on foreign-source income. Belize IBCs are now subject to tax on their worldwide income.
Authorities from jurisdictions such as Nevis or Saint Vincent announced their intentions to establish a territorial tax system. Given the feedback from the EU, these jurisdictions may face challenges to amending their tax legislation in a way that could keep their offshore industry alive, while at the same time complying with the EU requirements.
Furthermore, the above has led the EU to focus not only on these new territorial tax regimes but also on existing ones. The EU Code of Conduct Group is currently conducting a review on the territorial tax regimes from large corporate and financial centers to conclude whether they have harmful elements.
The Future of Territorial Tax Regimes
As discussed above, one of the EU Code of Conduct Group’s focus is foreign-source income exemption regimes.
In order to provide guidance to relevant jurisdictions, the COCG has set new criteria and issued guidelines on what they understand should be a ‘non-harmful’ territorial tax regime.
The main concern of the COCG are territorial tax regimes that create situations of double-non taxation, where income is not taxed either in the ‘territorial tax’ country and in the country of source.
According to the COCG, such regimes provide for an overly broad definition of foreign-source income without any conditions or safeguards, as well as the absence of a definition of nexus compliant with the permanent establishment definition, following the OECD Model Tax Convention on Double Taxation Treaties.
As per the COCG criteria, tax exemptions on foreign-source passive income can only be in place under certain conditions. The recipient company should have economic substance or a real activity in the jurisdiction where it is resident to avoid aggressive tax arrangements, such as group companies shifting profits using royalty streams to the intellectual property holding companies, or interest payments to group financing companies.
Therefore, COCG mandates that economic substance requirements and anti-abuse rules should be implemented, in order to prevent abusive tax structuring arrangements.
The COCG also noticed that tax exemptions on foreign-source active income could lead to non-double taxation situations and that such foreign-source active income should be derived from a foreign permanent establishment according to OECD standards.
The EU approach is that if foreign-source active income is exempt from taxation, income should be taxed elsewhere, where the income is sourced. Countries should have the proper mechanisms to exchange tax information to avoid aggressive tax avoidance, or straight tax evasion situations.
If companies are claiming that certain income is from foreign activities, they should prove that they have reported this economic presence and income in the foreign jurisdiction – in order to determine the proper allocation of profits between jurisdictions and the right to tax.
The COCG is currently assessing whether the territorial tax systems of the largest countries with international financial centers have harmful features. These include those reviewed today – Singapore, Hong Kong, and Panama – but also other jurisdictions such as Malaysia, Costa Rica or Uruguay.
There are already tangible results on this international tax trend and guidelines on ‘tax good governance practices’. As discussed before, the IRD in Hong Kong is becoming stricter when it comes to granting exemptions and is increasingly requesting proof of tax paid overseas, and exchanging information with overseas tax authorities.
The Bottom Line
Territorial tax and the source of income are terms that are sometimes misunderstood by some.
The source of income is generally the country where the activities and operations that produce the income take place – not the country where the client or payer is located or where the funds are paid or received.
Therefore, territorial tax systems are generally meant for companies with economic presence in various jurisdictions, to avoid double taxation – avoiding tax in the country of tax residency when the activity that gives rise to the income takes place overseas.
However, when a company has a regular place of business overseas, this generally constitutes a permanent establishment and needs to be registered, e.g. as a branch and pay taxes locally on income derived from this presence.
Flexible tax regimes that applied the territorial principle have traditionally allowed companies to exploit non-double taxation opportunities.
However, the international tax landscape is going through major changes; the OECD’s FHTP and the EU’s COCG are forcing jurisdictions to close tax loopholes and enhance anti-tax avoidance policies.
It is expected that the relevant territorial tax jurisdictions will follow guidelines from the EU and the OECD, and introduce these ‘tax good governance’ practices and provisions in their legislation, placing stricter conditions on companies to access tax exemptions.
Economic substance for groups’ service, financing and IP holding companies is becoming a global standard.
Companies deriving active income will need to prove their economic presence overseas by way of registration of permanent establishment, and that such foreign-source income has been taxed.
A number of mechanisms for exchange of information are in place, and an increasing number of countries are signing up for those bilateral and multilateral instruments for the exchange of fiscal data.
Legally exploiting loopholes and tax mismatches between territorial tax countries and other countries is becoming harder. Rules are tightening.
In current times, tax structuring should not only consider purely tax aspects but be a combination of commercial, operational, financial and tax strategies.
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