International Taxation: A Business Owner’s Essential Guide

July 28, 2023 By Israel Padilla

If you run a business that operates across borders, you need to know about international taxation. International taxation is the study of how different countries tax the income and assets of businesses and individuals. In this article, we will outline the main topics that you should be aware of as a business owner, such as:

– The concept of tax residency and how it affects your tax obligations
– The difference between source-based and residence-based taxation and how to avoid double taxation
– The types of taxes that you may encounter in different jurisdictions, such as corporate income tax, withholding tax, value-added tax, and customs duties
– The benefits and challenges of using tax treaties, tax havens, and transfer pricing to optimize your tax strategy
– The current trends and developments in international tax law and policy, such as the OECD’s Base Erosion and Profit Shifting (BEPS) project and the digital services tax

By the end of this article, you will have a better understanding of the complexities and opportunities of international taxation for businesses. You will also learn some practical tips and best practices to help you comply with the tax rules and regulations of the countries where you operate.

Tax Residency Explained

Tax residency is a concept that determines which country has the right to tax your income and assets. It is not the same as your citizenship or your physical location. Depending on the rules of each country, you may be considered a tax resident of more than one country at the same time, or of no country at all. This can have a significant impact on your tax obligations, especially if you are a business owner or an investor who operates across borders.

For example, if you are a tax resident of Country A, but you earn income from Country B, you may have to pay taxes in both countries on the same income. This can result in double taxation, which can reduce your profits and cash flow. To avoid this, some countries have tax treaties with each other, which provide rules to allocate taxing rights and avoid or reduce double taxation. However, not all countries have tax treaties with each other, and some tax treaties may not cover all types of income or situations.

To illustrate this, let’s say you are a tax resident of Mexico, but you own a company in Canada that makes $100,000 in profits. According to the tax treaty between Mexico and Canada, Canada has the right to tax your business income at a rate of 15%, which means you have to pay $15,000 in taxes to Canada. However, Mexico also has the right to tax your worldwide income at a rate of 30%, which means you have to pay $30,000 in taxes to Mexico. This means you are paying $45,000 in total taxes on your $100,000 income, which is a 45% effective tax rate.

Fortunately, the tax treaty between Mexico and Canada also provides a mechanism to avoid double taxation. Under this mechanism, Mexico will give you a credit for the taxes you paid to Canada, up to the amount of taxes that Mexico would charge on the same income. In this case, Mexico will give you a credit of $15,000, which means you only have to pay $15,000 in taxes to Mexico. This reduces your total taxes to $30,000, which is a 30% effective tax rate.

Therefore, it is important to understand the tax residency rules of the countries where you live, work, invest or do business. This can help you plan your tax affairs more efficiently and avoid any unpleasant surprises or penalties from the tax authorities.

Navigating Source-based and Residence-based Taxation

One of the challenges that businesses face when operating internationally is how to deal with different tax systems. There are two main approaches to taxing cross-border income: source-based and residence-based taxation. Source-based taxation means that the income is taxed in the country where it is generated, regardless of where the business is located. Residence-based taxation means that the income is taxed in the country where the business is located, regardless of where it is generated.

Both approaches have advantages and disadvantages, but they can also create problems of double taxation, which occurs when the same income is taxed twice by different countries. To avoid this, countries often sign bilateral or multilateral tax treaties that establish rules for allocating taxing rights and providing relief from double taxation. For example, a tax treaty may specify that certain types of income are only taxable in the source country, or that the residence country will give credit for the taxes paid in the source country.

To illustrate this, let’s consider a numerical example. Suppose that a US-based company sells goods to customers in France and earns $100,000 in income from this activity. If France has a source-based tax system and imposes a 20% tax rate on foreign businesses, the company will have to pay $20,000 in tax to France. If the US has a residence-based tax system and imposes a 35% tax rate on worldwide income, the company will also have to pay $35,000 of tax to the US. This means that the company will face a total tax burden of $55,000, or 55% of its income.

However, if there is a tax treaty between France and the US that follows the OECD model, the situation may be different. The treaty may stipulate that France can only tax 5% of the income as a withholding tax and that the US will give a foreign tax credit for the taxes paid to France. In this case, the company will pay $5,000 of tax to France and $30,000 of tax to the US (35% of $100,000 minus $5,000), resulting in a total tax burden of $35,000, or 35% of its income.

So Many Types of Taxes

One of the challenges of doing business internationally is dealing with different types of taxes in different jurisdictions. Some of the common taxes that you may encounter are:

– Corporate income tax: This is the tax that a company pays on its profits, usually based on the location of its headquarters or permanent establishment. The tax rate and rules vary by country, and some countries may offer tax incentives or exemptions for certain activities or industries. For example, according to the NBER, the US corporate income tax rate was reduced from 35% to 21% in 2017, while Ireland has a low corporate income tax rate of 12.5%.

– Withholding tax: This is the tax that a company pays when it makes payments to foreign entities, such as dividends, interest, royalties, or fees. The tax rate and rules depend on the source country and the type of payment and may be reduced or eliminated by tax treaties between countries. For example, according to Wikipedia, the US imposes a 30% withholding tax on dividends paid to foreign shareholders, unless a lower treaty rate applies.

– Value-added tax (VAT): This is the tax that a company pays on the value added to goods and services at each stage of production and distribution. The tax rate and rules vary by country and by type of goods and services, and some countries may exempt or zero-rate certain items. For example, according to the Tax Foundation, the EU has a harmonized VAT system with a standard rate of 15%, but member states can apply reduced rates or exemptions for certain categories.

Tax Treaties to the Rescue

Tax treaties are agreements between two countries that help avoid double taxation of income and promote cooperation on tax matters. They are pretty useful for businesses that operate across borders, but they also come with some challenges. Let me explain.

One of the benefits of tax treaties is that they can reduce the tax burden on cross-border income by lowering the withholding tax rates on dividends, interest and royalties. For example, if a company in Germany pays dividends to a shareholder in the US, the German tax authority may withhold 25% of the dividend as tax. But if there is a tax treaty between Germany and the US that reduces the withholding tax rate to 15%, the shareholder will pay less tax in Germany and may also claim a foreign tax credit in the US.

Another benefit of tax treaties is that they can prevent double taxation of business profits by allocating the taxing rights between the source country (where the income is earned) and the residence country (where the taxpayer is based). This is done by using rules to determine whether a business has a permanent establishment (PE) in the source country, which is a taxable presence. If there is no PE, the source country cannot tax the business profits. If there is a PE, the source country can only tax the profits attributable to the PE. For example, if a company in Luxembourg lends money to its subsidiary in the US to finance an acquisition, the interest income may be taxed in both countries. But if there is a tax treaty between Luxembourg and the US that defines what constitutes a PE, the Luxembourg company may not have a PE in the US if it does not have a fixed place of business or an agent there. In that case, the US cannot tax the interest income and only Luxembourg can.

However, tax treaties also pose some challenges for businesses. One of them is that they are not uniform and may differ in their scope, definitions, provisions and interpretations. This means that businesses have to deal with complex and sometimes conflicting rules when they operate in multiple jurisdictions. For example, some tax treaties may have a broader definition of PE than others, or some may have special provisions for certain types of income or activities. Businesses have to be aware of these differences and plan accordingly.

Another challenge of tax treaties is that they are subject to changes and updates, which may affect the existing or planned transactions of businesses. For example, some countries may renegotiate or terminate their tax treaties to protect their tax base or to align with international standards. Some countries may also introduce domestic anti-abuse rules or measures that override or limit the benefits of tax treaties. Businesses have to monitor these developments and adjust their strategies accordingly.

Is There Such a Thing as a Tax Haven?

Tax havens are countries that offer low or no taxes to foreign businesses and individuals who want to save money on their tax bills. Some of the benefits of using tax havens are:

– You can keep more of your income and profits without paying high taxes to your home country.
– You can enjoy more privacy and secrecy, as some tax havens do not share information with foreign tax authorities.
– You can diversify your assets and reduce your exposure to political and economic risks in your home country.

However, there are also some challenges and drawbacks of using tax havens, such as:

– You may face legal and ethical issues, as some tax havens are associated with tax evasion, money laundering, and other illegal activities.
– You may incur additional costs and fees, such as setting up and maintaining offshore entities, hiring lawyers and accountants, and complying with local regulations.
– You may damage your reputation and credibility, as some tax havens are blacklisted or criticized by international organizations and governments.

For some people though, the benefits are worth every drawback.

To illustrate how tax havens work, let’s look at a numerical example. Suppose you are a U.S. citizen who owns a company that makes $10 million in profits per year. If you pay the U.S. corporate tax rate of 21%, you will owe $2.1 million in taxes. However, if you set up a subsidiary in the Cayman Islands, which has no corporate tax, you can shift your profits there and pay zero taxes. This way, you can save $2.1 million in taxes per year by using a tax haven.

Another Way to Pay Less: Transfer Pricing

One of the ways that multinational corporations can optimize their tax strategy is by using transfer pricing. Transfer pricing is when different parts of the same company charge each other for goods or services they provide. For example, if a company has a subsidiary in Mexico that makes software and another subsidiary in Canada that sells the software, the Mexican subsidiary can charge the Canadian subsidiary a price for the software. This price is called the transfer price.

Why does this matter for taxes? Well, because different countries have different tax rates and rules, the transfer price can affect how much profit each subsidiary reports and how much tax it pays. If the Mexican subsidiary charges a high transfer price, it will report more profit and pay more tax in Mexico, but the Canadian subsidiary will report less profit and pay less tax in Canada. On the other hand, if the Mexican subsidiary charges a low transfer price, it will report less profit and pay less tax in Mexico, but the Canadian subsidiary will report more profit and pay more tax in Canada.

So, if a company wants to minimize its overall tax bill, it might try to set the transfer price in a way that shifts profit from high-tax countries to low-tax countries. This is called transfer pricing optimization or tax planning. Of course, this is not so easy to do, because tax authorities in different countries might not agree with the transfer price and challenge it. They might think that the transfer price is not based on market prices or arm’s length principles, which means that it is not what independent parties would charge each other for the same goods or services.

To avoid disputes and penalties, companies need to follow the transfer pricing rules and regulations of each country they operate in, and document how they set their transfer prices. They also need to consider other factors besides taxes, such as operational efficiency, performance evaluation, and risk management. Transfer pricing is not just about saving taxes, but also about aligning the incentives and goals of different parts of the company.

To illustrate how transfer pricing works, let’s look at a numerical example. Suppose that Company A has two subsidiaries: Subsidiary B in Brazil and Subsidiary C in Canada. Subsidiary B produces widgets and sells them to Subsidiary C for $100 each. Subsidiary C then sells them to customers for $150 each. The cost of production for Subsidiary B is $50 per widget, and the selling and administrative expenses for Subsidiary C are $25 per widget. The tax rate in Brazil is 25%, and the tax rate in Canada is 15%.

Entity	Revenue p/unit	Cost p/unit	Profit p/unit	Tax Rate	Tax p/unit	Net Income p/unit
Subsidiary B	$100	$50	$50	25%	$12.5	$37.5
Subsidiary C	$150	$125	$25	15%	$3.75	$21.25

If Subsidiary B sells 100 widgets to Subsidiary C then we have this result:

Entity	Profit	Tax	Profit After Tax
Subsidiary B	$5,000	$1,250	$3,750
Subsidiary C	$2,500	$375	$2,125
Company A	N/A		$5,875

Now suppose that Subsidiary B decides to decrease its transfer price from $100 to $80 per widget. This means that it will charge Subsidiary C less for the same widgets. How will this affect the profits and taxes of each subsidiary and the company as a whole?

Entity	Revenue p/unit	Cost p/unit	Profit p/unit	Tax Rate	Tax p/unit	Net Income p/unit
Subsidiary B	$80	$50	$30	25%	$7.5	$22.5
Subsidiary C	$150	$105	$45	15%	$6.75	$38.25

If Subsidiary B sells 100 widgets to Subsidiary C at $80 each, then its profit before tax is:

Entity	Profit	Tax	Profit After Tax
Subsidiary B	$3,000	$750	$2,250
Subsidiary C	$4,500	$675	$3,825
Company A	N/A		$6,075

As you can see, by decreasing the transfer price, Subsidiary B has decreased its profit after tax, but Subsidiary C has increased its profit after tax. The total profit after tax for Company A has also increased, from $5,875 to $6,075. This is because the lower transfer price has shifted profit from a high-tax country (Brazil) to a low-tax country (Canada), resulting in a lower overall tax expense for the company.

This example is simplified for illustration purposes. In reality, transfer pricing is a complex and dynamic process that requires careful planning and analysis.

This is the Future: BEPS and DST

One of the major initiatives in international tax law and policy is the OECD’s Base Erosion and Profit Shifting (BEPS) project. This is a set of 15 actions that aim to prevent multinational companies from avoiding taxes by shifting their profits to low-tax or no-tax jurisdictions. The BEPS project covers issues such as transfer pricing, digital economy, treaty abuse, hybrid mismatch arrangements, and harmful tax practices. The OECD estimates that BEPS could cost governments up to $240 billion in lost revenue each year.

Another hot topic in international taxation is the digital services tax (DST). This is a tax that some countries have introduced or proposed to impose on the revenues of certain digital companies that operate in their markets, such as online platforms, social media, e-commerce, and streaming services. The rationale behind the DST is that these companies create value from the users and data in the countries where they operate, but they do not pay enough corporate income tax there because they have little or no physical presence. The DST rates vary from 2% to 7.5% depending on the country.

Now, let me give you a numerical example of how these two developments could affect a hypothetical multinational company called ABC Inc. ABC Inc. is a US-based company that provides online advertising services to customers around the world. It has subsidiaries in Ireland, France, and India. In 2020, it had the following financial results (in millions of US dollars):

Country	Revenue	Cost	Profit	Corporate Tax Rate	Corporate Tax Paid
US	500	300	200	21%	42
Ireland	400	100	300	12.5%	37.5
France	100	50	50	28%	14
India	50	30	20	25%	5
Total	1050	480	570		98.5

ABC Inc.’s effective tax rate (ETR) is calculated as follows:

ETR = Corporate Tax Paid / Profit
ETR = 98.5 / 570
ETR = 17.3%

Now, suppose that the OECD’s BEPS project is fully implemented and that France and India impose a DST of 3% on ABC Inc.’s revenue in their markets. How would this affect ABC Inc.’s tax situation?

First, under the BEPS project, ABC Inc. would have to report its profits in each country according to the economic substance and value creation of its activities there, rather than using artificial arrangements or loopholes to shift them to low-tax jurisdictions. This means that ABC Inc. would have to allocate more of its profits to the US, France, and India, where it has more customers and users, and less to Ireland, where it has a low-tax subsidiary but little economic activity. Let’s assume that the profit allocation changes as follows (in millions of US dollars):

Country	Revenue	Cost	Profit
US	500	300	250
Ireland	400	100	200
France	100	50	70
India	50	30	30
Total	1050	480	550

Second, under the DST regime, ABC Inc. would have to pay an additional tax of **3%** on its revenue in France and India. This means that ABC Inc.’s DST liability would be as follows (in millions of US dollars):

Country	Revenue	DST Rate	DST Paid
US	500	N/A	N/A
Ireland	400	N/A	N/A
France	100	3%	3
India	50	3%	1.5
Total	150		4.5

Third, ABC Inc.’s corporate tax liability would change according to the new profit allocation and the existing tax rates in each country. This means that ABC Inc.’s corporate tax liability would be as follows (in millions of US dollars):

Country	Profit	Corporate Tax Rate	Corporate Tax Paid
US	250	21%	52.5
Ireland	200	12.5%	25
France	70	28%	19.6
India	30	25%	7.5
Total	550		104.6

Finally, ABC Inc.’s effective tax rate would be calculated as follows:

ETR = (Corporate Tax Paid + DST Paid) / Profit
ETR = (104.6 + 4.5) / 550
ETR = 19.8%

As you can see, the implementation of the BEPS project and the DST would increase ABC Inc.’s effective tax rate from **17.3%** to **19.8%**, which means that it would pay more taxes overall and have less after-tax profits.

I hope this example helped you understand the current trends and developments in international tax law and policy, and how they could affect multinational businesses like ABC Inc.