The Hon’ble Mumbai Branch of ITAT ( The ITAT Mumbai) in the case of Ashapura Minichem Limited VS Assistant Director of Income Tax Mumbai has analyzed the various concepts / principle of determining the taxation of income prevailing worldwide. The observation of the ITAT Mumbai has come in a time when the Govt. is ready to table the direct tax code in the forthcoming monsoon session where in also the concept has been discussed in detailed in the discussion paper. Through this article my endeavor is to elaborate the different taxation systems prevailing and their advantages and disadvantages and understand the taxation principle followed by India currently and in proposed Direct tax Code.
A- Territorial based taxation system.
A territorial tax system is a tax system that taxes only income which are accrued and received to a tax resident within the borders of a specific territory (usually a country). This is also called the residence based taxation. For country that predominantly uses territory based tax system, any foreign income that is earned outside by it’s residents out of its borders is not taxed in that country. These countries treat such income earned but it’s resident as “foreign income” hence keep out of the scope of total income for taxation in their country. Countries those have considered Territorial tax systems include France, Belgium, Hong Kong and the Netherlands and all the tax heavens such as Bermuda, Bahamas, Isle of man, Cyprus, British Virgin islands, Mauritius etc. It is worth noting that except certain tax heaven all the countries adopting the resident that although these countries primarily adopt a territorial based tax system, they have adopted certain exceptions to stop tax abuses.
The territory based taxation method is simpler to understand, easier to administer and considered pro free markets and boost business as the business has opportunity to pay taxes only on the income earned in those territory. Though this system has been considered disadvantageous as it allows the taxpayer to use the territory for tax evasions.
B - Worldwide / residence base tax systems.
The major feature of a Worldwide Tax System / residence base tax system is that residents and entities are taxed on any income that is earned within its borders and in addition, income that is earned throughout the world. The natural persons or individuals are taxable in the country or tax jurisdiction in which they establish their residence or domicile, regardless of the source of income. In the case of non-natural persons such as companies or firms, the place of incorporation or the place where control or management is exercised is deemed to be the place of residence.
In this kind system of taxation, the ability to pay off taxes by residents of that country is fully measured by their global income. Therefore, the principle of residence-based taxation of income envisages the taxation of global or worldwide income. The worldwide tax system improve the tax neutrality of investment decisions as the resident of one country irrespective of it’s investment location has to pay taxes in the country of it’s residence. It promotes economic efficiency since the decision on the location of the investment remains unaffected by the tax rate. It is neutral to capital export.
The residents are allowed credit for foreign taxes against the tax liability in the country of residence , however in many cases double taxation can in fact occur. The examples of countries who predominantly employs a worldwide tax system is United States. The main disadvantages of this system are
· Worldwide / residence base tax systems require a large bureaucracy to administer and enforce tax laws.
· Following a worldwide tax system / residence base tax system can be extremely complicated and confusing for tax payers.
· Reduces revenues in poor developing countries, who rely heavily on source based taxation, and leans in favour of the rich developed countries where investors reside.
· Residence based taxation is much easier to evade or avoid, by channeling international investments through tax havens.
C - Source Base tax System
The another system of taxation is Source Base taxation of income . In this system, the taxes are levied in the country in which the source of income is. The "residence" base taxation system does not work well in the case of developing countries which attract substantial foreign investments from the residents of other countries who posses capital and invest in other countries. These countries where the investment opportunity exists, provide the residents of other countries an opportunity to earn / generate income. There is a view that the country which provides the opportunity and facilities to generate income or profits should also have the right to tax the same.
This view forms the underlying basis of the principle of source-based taxation of income. This principle is invariably applied to non-residents in a country and envisages the taxation of only such income which is sourced in that country. What is source of income is not defined anywhere. The practices in various countries vary as to the nature and extent of the source rules. Generally, countries use geographical boundaries, types of income or a mixture of both to determine the extent to which they will seek to tax income sourced in their jurisdiction.
The Pure source based taxation enables foreign investors to play one country against another or others in order to obtain the lowest source based tax rate leading to reduction in rate of tax by such countries resulting in erosion of revenue base. It also adds complication in form of determining the source of income and issues relating to transfer pricing.
D- Mixed principal of taxation.
From the above it can be seen that the in practice, staying with pure application of either principles has its own pros and corns. So a mix of residence and source based direct taxation has emerged as a necessity to tap the benefits of both the systems. Under this category the Residence base taxation is applied for nationals (including non-natural persons) residing in the country and the source base taxation for income earned within the country by non-residents.
The degree of mixes between source base or residence base depends on each taxing jurisdiction's perception of the relative importance of a number of factors, notably the volume of foreign investment that is attracted, the revenue implications, the domestic administrative capabilities, and the degree of cooperation that can be expected from competing jurisdictions. Most is the taxing jurisdictions, developing or developed, have followed the mixed system of taxing Income.
E -The system of taxation followed in India
India, being a developing country, currently follows the mixed system of taxation of income. Section 5 of The Income Tax Act 1961 defines the scope of taxation of income which provides that a resident is liable to tax in India for his worldwide income. A person who is a resident but not ordinary resident is taxable in India except for income which accrue and arise to him outside India if such source of income is controlled from India. The non residents are taxes only in respect of all his income which either received or deemed to be received by him in India and accrue and arise to him in India or deemed to accrue and arise in India.
Under the newly proposed Direct tax Code also residence based taxation is applied for residents and source based taxation for non-residents. A resident in India will be liable to tax in India on his world-wide income However, a non-resident in India will be liable to tax in India only in respect of accruals and receipts in India (including deemed accruals and receipts). The concept of resident but not ordinary resident has been done away with under DTC in order to align the Indian tax with the internally accepted practice. Lets hope that intent is followed post introduction of DTC.