Concept of Residence vs. Concept of Source


Since the 20th century the increased cross border trade and investments has led to flow of man, money and machines between countries. Cross border transactions resulted in to income streams from various countries and with that the dilemma which country should tax the income. To benefit their exchequer, many countries started with aggressive income tax, which punished the tax payer. To provide remedy for the tax payer so that the flow of capital and funds does not stop, countries enter in Double Taxation Avoidance Agreement (DTAA).

International Taxation revolves around two premises:

  • Concept of Residence
  • Concept of Source
Concept of Residence V. Concept of Source

Concept of Residence

In this principle, the country taxes the individual or entity based on the residential status of the tax payer. Residential status of the individual is different from the citizenship. Every countries tax law provides the basis on which the individual could be classified as residential to that country for that year. It has to be tested every year.

In case of the income taxation, where the person is regarded as a resident for tax purposes, the country may tax the income of that person regardless of where the income has the sources. Most countries tax their residents on their world wide income (example : India) and some countries tax income derived by their residents from sources in these countries ( example: Panama, Costa Rica)

Some countries also tax based on the Citizenship i.e. Citizenship based taxation.  It is the most draconian form of all and is only used by Eritrea and the United States.

Difference in tax laws of different countries for determining residence for the tax purposes mean that individuals and legal entities that have links in more than one countries will get taxed on their global income in multiple countries. Tax treaties try to address such issues by providing tie breaker rules that allocate tax residence to only one country for the purposes of the application of the provisions of a tax treaty.

Concept of Source

Tax is also imposed by many countries if it is considered to have its sources therein regardeless of whether that income is derived by a resident or a non-resident. Similarly capital taxes are levided with respect to property situated in a country regardless of the residence of the owner of the property. There are no clear rules for determining the source, but it is generally applied where the income has a relevant nexus with the country. For instance, a natural resource utilised for income is located in that country  or where the assets that generates income is located in that country.

Few countries have statutory rules for determining the source of income for tax purposes. These rules provide exhaustive list of all categories of income that be treated as source. Others do not have statutory source rules and rely on general purpose source rules which is applied to the cases as and when required.

Sometimes a transaction can trigger sources at multiple countries, for example:

Mr A resident of Irelandà pays Royalty to Mr B of China à for IP registered in India.

In the given cases, Ireland will claim as Source as it is paying the amount, India will Claim the source as IP is registered in India.

Types of Issues on Double Taxation.

Double Taxation  can tax varied forms and can occur in different situations. DTAA seeks to reduce the double taxation in number of ways. Following are the different types of double Taxation:

Residence – Residence juridical double taxation

Double taxation in this scenario occurs when a person is classified as resident for tax purposes in two countries. It is dealt with Tie Breaker rules mentioned under Article 4 of the UN Model. These rules deem the person to be a resident of only one of the countries for the purposes of the treaty. And for the purpose of the application of the treaty by the two treaty countries one country taxes the person on a source basis only with relied from double taxation being provided by the other country .

Source – Residence juridical double taxation

Double taxation in this scenario occurs when an income is taxed at the country where it arises (source) and also the country in which the person deriving the income is resident (residence). It is dealt in various ways under the treaty by limiting the rights to either source or residence for some income or taxing the income in both treaty partner countries and resident country to provide the tax credit or relief for tax paid in source countries.

Source- Source juridical double taxation.

Double taxation in this scenario occurs when an income is claimed to be sourced in more than one country, i.e. in the country from the income arises and the country of residence of the person paying for it. Such cases are commonly found for dividend, royalty, interest, etc. and tax treaties exclusively deals with the same.

Economical double taxation

Such instances occur when the same income is taxed in more than one country in the hands of different tax payers only in certain circumstances.  It could occur in case of treatment of entities are fiscally transparent, transfer pricing adjustments etc. Those are dealt in DTAA under Transparent entity provisions and Article 25 “ Mutual Agreement Procedure”.

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