Determination of tax residence of entities and double taxation

Determination of tax residence of entities and double taxation

If an entity is identified to be tax resident in a particular country, then that country has the right to tax it on its income. However, it may also be taxed in another country according to the source principle. Some countries tax companies based on residence principle and some tax based on source principle. However, a combination of both principles is very popular especially in circumstances where residence is deemed.

The concept of residence and source were justified in the writings of George Van Schanz (1892), who wrote about “persons” being economically tied to a community and suggested that everyone who benefits from the community share the responsibilities by paying taxes whether they have benefited from being residents or having business activities in that country.

There are two approaches to determining the residence of companies for tax purposes namely, the legal approach and economic approach.

Legal approach

The legal approach is based on where the company is incorporated or domiciled. Zambia among other countries uses the incorporation test. This means that an entity registered in Zambia is tax resident in Zambia, therefore taxable in Zambia.

Economic approach

The economic approach, also known as the commercial approach takes different forms and the approach is subjective. The approach uses the place of effective management (POEM) test. The test looks at where the decisions are made. The residence of individuals making the decisions is not relevant but rather the location of those people when those decisions are made. Zambia also uses this test.

There are instances where an entity is identified as a tax resident in two different countries, for example, where the company is incorporated in one country which uses the incorporation test but decisions are made in another country which uses the POEM test. This gives rise to double taxation. The term double taxation refers to being exposed to tax more than once on the same profit or income. There are two types of double taxation namely, economic double taxation and juridical double taxation.

Economic double taxation

Economic double taxation refers to a situation where the same income is taxed twice but in different hands. For example, after being subject to corporate tax, when the post-tax profits are distributed to shareholders, the shareholders are taxed also on the dividends they receive.

Juridical double taxation

Juridical double taxation arise because of jurisdictional conflict in the rules that are used for tax purposes. It occurs where more than one country attempts to tax the same income.

There are different situations which result in double taxation and these have been unpacked as:

     i.        Residence/residence

This happens when two countries classify the entity as resident for tax purposes in both countries. It is usually a result of different tests used by different countries to determine residence. An entity can be tax resident in one country based on incorporation test and also be resident in another country using the POEM test.

   ii.        Residence/Source

This happens when an entity resident in one country is taxed on its worldwide income using residence principle but also taxed on the same income from a source in another country based on the source principle. An example is, dividends received from a foreign subsidiary are brought into taxation by the receiving country but would have been subjected to withholding tax in the source country.

 iii.        Single/transparent entities

This happens when an entity is viewed differently for tax purposes by more than one country. An entity can be classified as transparent entity in one country and a single/opaque entity in another country. This is very popular in the United States of America and they use the “check the box” rule, which allows a US taxpayer whether an entity is to be regarded as transparent or opaque for US tax purposes, regardless of the actuality.

In all this, a relief is available to eliminate the effects of double taxation. The Organisation for Economic Cooperation and Development (OECD) as well as the United Nations (UN) developed a model double taxation convention (MTC) which may be used to eliminate double taxation. Countries may refer to the MTC when making their own double taxation agreements. It is important to note that Zambia follows the OECD and UN MTC.

In case of disputes between two or more countries on tax residence of companies, the dispute should be resolved through Mutual Agreement Procedure (MAP). The MAP is a means through which competent authorities consult to resolve disputes regarding the application of double taxation conventions. The MAP article in double taxation conventions allows competent authorities to interact with the intent to resolve international tax disputes situations where the same profits have been taxed in two jurisdictions.

NB: THIS ARTICLE WAS PREVIOUSLY PUBLISHED BY HLB ZAMBIA IN ITS MONTHLY TAX FLASH FOR MARCH 2022.

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More articles by Nyasha Nigel Machiri, BSc, ACCA, AZICA, AICTA,RTAcc, ADIT

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