The main connecting factors which are commonly used by States to establish jurisdiction to tax the profits of multinational enterprises are “residence” and “source”, which are linked to concepts of “nationality” and “territoriality” used in public international law.
Notions of residence and source are recognized by both OECD and UN and are reflected in their tax treaty models.
Under residence approach, a state imposes its taxing rights of legal entity or individual based on its relation to the person who derives income.
Under source principle, a state assess legal entity or individual to tax based on its relation to assets that generate income.
All the states use source principle to levy taxes on income generated within state’s territory. Some states invoke residence/nationality principle and thus tax their citizens and residential companies on their worldwide income (the USA, Russia, Finland, etc.). Some states adopted only territorial principle (Hong Kong SAR, Singapore, Malaysia, Panama, Costa Rica, etc.). However, and most of states utilize both principles.
State practice in determining place of residence comprises two main tests: place of incorporation (state under which legislation company was registered – the USA, France, etc.) and place of effective management (place from there company is actually managed and controlled). Most states utilize both place-of-incorporation and place-of-residence tests (the UK, the Netherlands, etc.)
The question is more difficult when it concerns dual residence entities, since they have chance to manipulate their tax residence and claim benefits under treaties (highlighted in Action 6 of BEPS Project). According to the US Model Treaty Article 4 (4), dual residence entities can not use benefits, however the next article states that the residence can be determined by mutually agreed procedures for not individuals and not companies.
As for the OECD Treaty Model, it previous version had a POEM (place of effective management) clause which could serve as tie-breaker. However, in 2017 update it was replaced by recommendation to resolve issue with help of mutually agreed procedures (Article 4 (3)).
Article 3 of OECD Treaty Model points out that pension funds shall be regarded as resident of state where they have been incorporated.
Income itself does not have source, it is just a quantity calculated according to certain accounting rules. Generally, income is considered to have geographical location of assets or activities which generated this income. To determine the source of income can be difficult since assets located in different countries may participate in generation of income. Then special rules are required to determine source of income.
For purposes of determination the source of income, it is classified as business income and investment income. As for the first type of income, determining factor can be existence of permanent establishment, and in case of investment income, “pay rule” or “use rule” is applied. Double taxation can be a result of various circumstances. In terms of judicial double taxation, the most often reasons are the following conflicts.
Source-source conflict, when both states assess persons for taxation based on source of income principle. The most effective instrument of elimination is a DTA which allocates taxation rights between states (Articles 5 and 7). Also, if agreed by contacting states, sourcing rules can apply.
Residence-residence conflict, when one or more states use their own definitions of residency, and thus impose taxes on the same persons on their worldwide income. The DTA, and agreed tie- breaker rules are the most effective instrument to solve the conflict.
Source-residence conflict, when different states want to tax the same income based on their principles of taxation. Under the most DTAs, the source states receives right for taxation, and residence state shall provide a relief either by tax exemption, or be tax credit (Articles 23A and 23 B of OECD Treaty Model).
As for court practice, the case of Perrin v HMRC (2014) can be mentioned where source of investment income was determined based on multifactorial analysis.
The key objective of states entering into DTA is to promote trade between them by eliminating mentioned conflicts and to combat fiscal evasion.