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Executive Summary

Two concerns that frequently arise when business and investors derive income from a foreign country are: (i) the potential for double taxation, and (ii) the impact of transfer pricing rules.

Double taxation occurs when a business or investor is taxed in both its country of residence and the country in which it invests or operates. To minimise the impact of double taxation, states enter into bilateral tax treaties that determine whether the host state, the residence state or both will be entitled to tax income that a non-resident derives from the host state. Among other issues, double taxation treaties generally resolve which state may tax: (i) business operations in the host state, (ii) capital gains from the sale of host state assets, and (iii) dividends derived from host state companies.

Many states impose transfer pricing rules which apply to commonly-controlled business entities (such as a parent company and its subsidiaries) that are part of a multinational group. Transfer pricing rules seek to prevent the arbitrary shifting of profits from one group member to another to reduce the group’s overall international tax burden. The rules compare intra-group prices to the “arm’s length” prices that would be charged if unrelated parties were engaged in the same transaction.

1.0 Double Taxation Treaties

1.1 Introduction

One of the main concerns of an investor considering overseas operations is whether its income will be subject to double taxation — taxation by both its country of residence and the country in which it will operate.

Countries may tax their citizens and residents on: (i) income sourced in the country of residence, (ii) worldwide income (as in the United States), or (iii) a combination of both. Countries generally tax non-residents on income that is sourced to that country. In most commercial and industrial nations the source of an item of income is based on the economic origin of the income — usually the place where income-producing activity is conducted (e.g., services are sourced to the country in which they are performed, and dividends are sourced to the country in which the paying corporation is organised). The host state generally has primary taxing rights over domestically sourced income and the residence state has residual taxing rights.

To avoid double taxation, states use bilateral conventions or tax treaties that restrict their source-based taxing rights in exchange for enhancing their residence-based taxing rights. International organisations, such as the Organisation for Economic Co-operation and Development (OECD) and the United Nations (UN), have developed model treaties.¹

There are several provisions common to most income tax treaties that have particular relevance for investors. These include provisions addressing permanent establishment, capital gains and dividends.²

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1.2 Permanent Establishment

The concept of permanent establishment is critical to the determination of the taxation rights of the host state. Nearly all tax treaties, including the Model Tax Conventions published by the OECD³ and the UN,⁴ contain a provision governing when a resident of the other treaty state will be deemed to have a permanent establishment in the host state.

Under most treaties the host state may only tax the business profits of an enterprise or resident of the other state if: (i) the enterprise or resident is carrying on business through a permanent establishment maintained in the host state, and (ii) the business profits are attributable to that permanent establishment.

• Article 5.1 of the OECD Model Tax Convention⁵ sets forth the general rule that a “permanent establishment” is a “fixed place of business through which the business of an enterprise is wholly or partly carried on.”
• Article 5.2 of the OECD Model Tax Convention provides a list of examples each of which constitutes a permanent establishment: (a) a place of management; (b) a branch; (c) an office; (d) a factory; (e) a workshop; and (f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
• Article 5.3 of the OECD Model Tax Convention supplements the general rule of permanent establishments by defining a permanent establishment to also include “[a] building site or construction or installation project” which lasts “more than twelve months” (the “construction site rule”).⁶

Treaties generally exempt certain preparatory or auxiliary activities from the definition of “permanent establishment.”

Investors should consider their level of activities in a host state and the potential risk of taxation that may result from activities that are broad enough to rise to the level of a permanent establishment.

Governments should be vigilant against attempts by investors to structure their operations in the state to artificially avoid the creation of a permanent establishment.

1.3 Capital Gains

Capital gains are the profits realised from the sale or exchange of a capital asset. Generally, gains from the sale of property are only taxable in the state of residence, unless the gains are from the sale of: (i) real property,⁸ or (ii) movable property forming part of the business property of a permanent establishment.

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Investors contemplating business operations in a host state should consider exit scenarios when structuring their investment. If it appears likely that their activities in the host state will give rise to a permanent establishment, investors should consider whether conducting operations through a host state subsidiary may be preferable.

An investor seeking to avoid host country taxation from the disposition of a host state company that derives more than 50% of its value from immovable property may be able to do so by investing in the host state company through a foreign holding company. When the investor wishes to exit its investment, it can sell its shares in the holding company. Gains from such a sale generally will not be subject to host country tax. However, a purchaser may discount the price it is willing to pay for the foreign company to reflect the built-in tax liability in the host company investment.

1.4 Dividends

“A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock or other property.”⁹

Generally, dividends paid by a company that is a resident of one state to a resident of the other state may be taxed in that other state. However, most double taxation treaties also contain a provision permitting the state in which the company resides to impose tax on dividends paid to residents of the other state. These provisions usually limit the amount of tax the host state may impose — e.g., under the OECD Model, the host state may tax dividends at a 5% rate if the resident of the other state is a company and certain ownership conditions are met, and at a 15% rate in all other cases.

To the extent possible, businesses and investors that plan to acquire interests in a host state corporation should structure their investment through a jurisdiction that has a double taxation treaty with the host state providing for favourable tax rates on dividends. Note, however, many treaties contain provisions designed to limit “treaty shopping.”

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2.0 Transfer Pricing

Transfer pricing is a key issue in international taxation. Transfer pricing refers to the pricing of transactions between commonly-controlled (or affiliated) entities (e.g., a holding company and its subsidiaries) that are part of a multinational group. Such groups may engage in arrangements, including loans, transfers of tangible or intangible property, and controlled service transactions, that artificially shift profits from one group member to another in order to reduce the overall international tax burden. For example, a group member located in a high-tax jurisdiction may make an above-market interest or royalty payment to an affiliate in a low-tax jurisdiction, thereby allowing the high-tax member to take an excessive deduction and shifting the taxable profits to the low-tax member.

Most countries have developed a set of rules that require multinational group members to price transactions with affiliates as if the parties to the transaction were independent enterprises operating at arm’s length (the so-called “arm’s length principle”). These rules may also provide guidance as to the methods that may be used to determine the arm’s length price.

Multinational group members in different states that undertake substantial transactions with each other should commission a Transfer Pricing Study to ensure that the terms of the transactions are the same as would be present in transactions between unrelated parties dealing at arm’s length. The Transfer Pricing Study can be used to support the group members’ tax positions should they be audited by the tax authority in their jurisdiction. Additionally, in some jurisdictions (such as the United States), a Transfer Pricing Study is required to avoid significant penalties, should the tax authority determine that the terms of the transaction are not arm’s length.

2.1 Transfer Pricing Methodology

2.1.1 OECD Approach

The OECD generally requires multinational group members to price transactions with affiliates using the “comparable uncontrolled transaction” method.¹⁰ Under this method, transactions within the group must be priced by reference to similar but uncontrolled transactions in comparable circumstances. An uncontrolled transaction is one between a group member and an independent enterprise or one between two independent enterprises. This analysis starts by determining whether the two transactions are similar (using a set of comparability criteria), then focuses on the nature of the transactions between the related parties, and on whether the conditions thereof differ from the conditions that would be obtained in comparable uncontrolled transactions.¹¹

2.1.2 US Approach

The United States requires multinational group members to price transactions with affiliates using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result (the “best method” rule). Under the best method rule, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others. In determining which of two or more available methods provides the most reliable measure of an arm’s length result, the two primary factors to take into account are the degree of comparability between the controlled transaction and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis.¹²

2.2 Transfer Pricing Documentation Requirements and Information Reporting

Tax authorities often have difficulty obtaining adequate information to apply transfer pricing rules. Recently, the OECD has led a comprehensive effort on transfer pricing issues called the Base Erosion and Profit Shifting (BEPS) Action Plan.¹³ The BEPS Action Plan focuses on developing standards that ensure that the allocation of profits is aligned with the economic activity that produced the profits; in other words, profits

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are generally taxed where the economic activity that produced them took place. As part of that effort (Action 13), the OECD articulated a standardised approach to transfer pricing documentation that would require multinational groups to submit a country-by-country report to the relevant tax authorities.

The country-by-country report is intended to contain all information on the global allocation of the multinational group’s income and taxes paid. The OECD has released a model template country-by-country report that requires a multinational group to provide: (i) an allocation of its aggregate income, taxes and other financial and business information by tax jurisdiction, and (ii) a list of all of its constituent entities including each entity’s tax jurisdiction, place of organisation or incorporation and main business activity.

Most countries have adopted country-by-country reporting in their local legislation.

Notes

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