Great article! This seems like a valuable avenue for people with the relevant skills.
I’m interested in your observation that poorer countries tend to prefer a source country-based tax, while wealthier countries lean toward a consumer country-based tax. However, it seems paradoxical that OECD countries, which hold stronger influence over international tax law, have led us to a predominantly source country-based tax system. Could you comment on why think this is the case?
I’ve been interested in the idea of a consumer country-based tax ever since I worked on a film with Thomas Piketty, which loosely covered his Capital in the 21st Century. If I understood his view correctly, a consumer country-based tax could potentially help eliminate tax havens because companies can’t control where their consumers are in the same way they can control where their offices are based.
Hi James, thanks for your comment. A couple of points in response:
OECD Model and residence-based taxation
I disagree that the OECD Model has led to a predominantly source country-based tax system. Quite the opposite — relative to the UN Model, the OECD Model favors residence-based taxation.
In broad terms, under the OECD Model, residence States have taxing rights over an enterprise’s business profits (Article 7) unless the DTA provides otherwise. The key exceptions are:
Article 5 (Permanent Establishment (PE)). To the extent those business profits are attributable to a PE in another State, the residence State gives up taxing rights over those profits. While virtually all countries agree with this general principle, source States and residence States have different negotiating positions on this, with source States preferring a broad definition of “PE” and residence States preferring a narrow definition. You can see this by comparing the OECD Model’s relatively narrow PE definition and the UN Model’s broader definition.
This is what I meant when I said above that “taxing rights are primarily based on physical presence”. The concept of a PE has historically been based on physical presence. Over the years, the definition has broadened to include things like dependent agents but not all of those changes will be fully picked up by States that favor residence taxation.
Article 6 (Immovable property—i.e. land and natural resources). Apart from the PE Article, this is probably the main article giving a broad taxing right to source states. It is a longstanding and widely accepted principle that source States have primary taxing rights over immovable property.
Articles 10 and 11 (Dividends and Interest). Under the OECD Model, residence States give up some taxing rights over dividends and interest income, but they limit the source States’ rights to apply withholding tax to some fixed percentage of the dividend or interest (e.g. 10% on the gross interest payment). The exact rates will be key issues in any treaty negotiation. Residence States tend to seek lower rates; source States tend to want higher rates.
Article 12 (Royalties). This is an important difference between the UN and OECD Models. The OECD Model does not provide for any source State withholding tax on royalties. The UN Model does provide for source State taxation but leaves the rate to be determined in bilateral negotiations. The lack of source taxation on royalties can lead to double-non-taxation because if the residence State doesn’t tax foreign-sourced royalties, the royalty income escapes taxation altogether. So this creates an incentive for multinationals to shift their intellectual property to countries that won’t tax foreign-sourced royalties (or only tax them lightly). (I should note that, despite the OECD Model, many OECD countries do agree to some source taxation on royalties in their DTAs. But that will be decided in bilateral treaty negotiations.)
Article 13 (Capital gains). Residence States get taxing rights with some limited exceptions such as if the property is immovable property or part of a PE in the other State. Put simply, this means residence States get sole taxing rights over capital gains from most share sales.
Just to clarify, when I say poorer/developing countries tend to prefer source country taxation, that is a simplification and generalisation. There are some developed countries like Canada that favor strong source taxing rights (I think this is because of its heavy reliance on natural resources and possibly because so many more US businesses operate in Canada than the other way around—but this is speculation on my part).
Consumer-country based taxes
I haven’t read Piketty’s book but I generally like the idea of ‘destination-based taxes’ which are those based on the destination/location of consumers like you describe. Consumption/sales taxes tend to be destination-based whereas income taxes tend to be ‘origin-based’.
My understanding is quite a lot of academics and economists like destination-based taxes, particularly the ‘destination-based cash flow tax’ and some prominent economists have written some detailed papers on it (see e.g. Auerbach et al, 2017). In 2016, the US Republican Party even included a proposal for it, but that did not go ahead.
I am broadly sympathetic to the idea but I have not looked at it in detail and it’s not my area of expertise. I might look into it more at some point in the future, especially if the idea gains traction in the US (I suspect it would be hard for other countries to implement it unilaterally).
Hope that is helpful and happy to clarify if there’s anything I haven’t explained well. I’ll also flick you a PM.
Thanks, I think I may have used the wrong term “source”-based, meaning “origin” or “residence”-based. I was meaning that generally a company is taxed in the country where their offices are, not where their consumers are.
Great article! This seems like a valuable avenue for people with the relevant skills.
I’m interested in your observation that poorer countries tend to prefer a source country-based tax, while wealthier countries lean toward a consumer country-based tax. However, it seems paradoxical that OECD countries, which hold stronger influence over international tax law, have led us to a predominantly source country-based tax system. Could you comment on why think this is the case?
I’ve been interested in the idea of a consumer country-based tax ever since I worked on a film with Thomas Piketty, which loosely covered his Capital in the 21st Century. If I understood his view correctly, a consumer country-based tax could potentially help eliminate tax havens because companies can’t control where their consumers are in the same way they can control where their offices are based.
I’d love to hear your insights about this.
Hi James, thanks for your comment. A couple of points in response:
OECD Model and residence-based taxation
I disagree that the OECD Model has led to a predominantly source country-based tax system. Quite the opposite — relative to the UN Model, the OECD Model favors residence-based taxation.
In broad terms, under the OECD Model, residence States have taxing rights over an enterprise’s business profits (Article 7) unless the DTA provides otherwise. The key exceptions are:
Article 5 (Permanent Establishment (PE)). To the extent those business profits are attributable to a PE in another State, the residence State gives up taxing rights over those profits. While virtually all countries agree with this general principle, source States and residence States have different negotiating positions on this, with source States preferring a broad definition of “PE” and residence States preferring a narrow definition. You can see this by comparing the OECD Model’s relatively narrow PE definition and the UN Model’s broader definition.
This is what I meant when I said above that “taxing rights are primarily based on physical presence”. The concept of a PE has historically been based on physical presence. Over the years, the definition has broadened to include things like dependent agents but not all of those changes will be fully picked up by States that favor residence taxation.
Article 6 (Immovable property—i.e. land and natural resources). Apart from the PE Article, this is probably the main article giving a broad taxing right to source states. It is a longstanding and widely accepted principle that source States have primary taxing rights over immovable property.
Articles 10 and 11 (Dividends and Interest). Under the OECD Model, residence States give up some taxing rights over dividends and interest income, but they limit the source States’ rights to apply withholding tax to some fixed percentage of the dividend or interest (e.g. 10% on the gross interest payment). The exact rates will be key issues in any treaty negotiation. Residence States tend to seek lower rates; source States tend to want higher rates.
Article 12 (Royalties). This is an important difference between the UN and OECD Models. The OECD Model does not provide for any source State withholding tax on royalties. The UN Model does provide for source State taxation but leaves the rate to be determined in bilateral negotiations. The lack of source taxation on royalties can lead to double-non-taxation because if the residence State doesn’t tax foreign-sourced royalties, the royalty income escapes taxation altogether. So this creates an incentive for multinationals to shift their intellectual property to countries that won’t tax foreign-sourced royalties (or only tax them lightly). (I should note that, despite the OECD Model, many OECD countries do agree to some source taxation on royalties in their DTAs. But that will be decided in bilateral treaty negotiations.)
Article 13 (Capital gains). Residence States get taxing rights with some limited exceptions such as if the property is immovable property or part of a PE in the other State. Put simply, this means residence States get sole taxing rights over capital gains from most share sales.
Just to clarify, when I say poorer/developing countries tend to prefer source country taxation, that is a simplification and generalisation. There are some developed countries like Canada that favor strong source taxing rights (I think this is because of its heavy reliance on natural resources and possibly because so many more US businesses operate in Canada than the other way around—but this is speculation on my part).
Consumer-country based taxes
I haven’t read Piketty’s book but I generally like the idea of ‘destination-based taxes’ which are those based on the destination/location of consumers like you describe. Consumption/sales taxes tend to be destination-based whereas income taxes tend to be ‘origin-based’.
My understanding is quite a lot of academics and economists like destination-based taxes, particularly the ‘destination-based cash flow tax’ and some prominent economists have written some detailed papers on it (see e.g. Auerbach et al, 2017). In 2016, the US Republican Party even included a proposal for it, but that did not go ahead.
I am broadly sympathetic to the idea but I have not looked at it in detail and it’s not my area of expertise. I might look into it more at some point in the future, especially if the idea gains traction in the US (I suspect it would be hard for other countries to implement it unilaterally).
Hope that is helpful and happy to clarify if there’s anything I haven’t explained well. I’ll also flick you a PM.
Thanks, I think I may have used the wrong term “source”-based, meaning “origin” or “residence”-based. I was meaning that generally a company is taxed in the country where their offices are, not where their consumers are.