State of source: a guide to the taxation principle. The rules are deriving from the principle of taxation of income in the source State—problems of double taxation of income and international treaties.
Income taxation under the source state principle provides for the taxation of income arising from sources located in that jurisdiction. This principle applies to income from real estate, dividends, interest and royalties. Usually, the source state taxation principle integrates with the worldwide taxation of income-generating possible phenomena of double taxation of income.
When it comes to income produced abroad by a tax resident in our country, we know that the general rule of taxation, established by Article 2 of Presidential Decree no. 917/86 is the worldwide taxation principle (so-called “worldwide taxation principle”). On the basis of this provision, all income received, including foreign ones, must be subject to taxation in Italy.
It is essentially one of the key provisions of our tax system. However, in some cases, it can be applied alongside the principle of income taxation in the source state.
The classic case is that which derives from the rental income of a property held abroad by an Italian person. In this case, these fees are subject to taxation abroad, according to the principle of taxation in the source country, but also in Italy by virtue of the principle of taxation on a worldwide basis. When we are faced with situations like this, we have to solve the problem (double legal taxation), through remedies that are usually: exemption or credit for foreign taxes.
In this article, I want to analyze in which particular cases the taxation in the source State is applied and how this must be harmonized with the general criterion of world taxation of income.
The principle of taxation of income in the source state
According to the principle of taxation in the source state, a state is subject to taxation that income which originates from sources located in its jurisdiction. This, regardless of whether such income is attributable to resident or non-resident individuals.
With reference to non-resident subjects, in order to apply the principle of taxation in the source State, national laws must identify the domestic sources of income that constitute the tax base for non-resident subjects.
The law must also establish the rules that determine the amount of income that is considered to derive within the jurisdiction of that state. The categories of income attributable to non-residents generally taxable in the source state are identified below.
Which income categories are subject to unlimited taxation in the source state?
This method of taxation of income in the source state generally applies if the latter derive from:
-Real estate properties, located in the source state, which have been provided for income;
-Profits realized by a permanent establishment of a company located in the source State;
-Remuneration deriving from employment contracts in the private sector for the activity carried out in the source State (according to tax treaties, generally applied only if the recipient is present in the state for more than 183 within a period of 12 months ).
The assessment of taxation in the state of the unlimited source is made on a declaratory basis, or with the presentation of a tax return: gross income, net of deductions and other deductions, is taxed by applying the normal tax rates for individuals physical or legal. The non-resident, the natural or legal person, is personally responsible for the tax to be paid.
The problem, in the case of unlimited application of taxation in the source State, may be the fact that the criteria that establish the tax obligation (the rules of the source) are not or are insufficiently established.
For example, only a few states provide for a definition of a permanent establishment according to internal law (the concept is generally defined in the context of tax treaties). Furthermore, if there is a definition, they may vary from state to state, or there may be discrepancies or inconsistencies between internal rules and the rules of other states.
Which income categories are subject to limited taxation in the source state?
Limited taxation in the source state generally occurs in the case of applying a withholding tax to:
-Dividends paid by a company resident in the source state to a non-resident parent company or to a series of non-resident investor shareholders (obviously the profits made by the company are fully taxable in the source state since the subsidiary company is resident in that state). For example, in Italy, the withholding tax applicable to dividends is 26%.
-Interest paid by a company resident in the source state to a non-resident parent company;
-Royalties paid by a company resident in the source state to a non-resident parent company.
In the case of Italy, the withholding tax applicable to interest is 12.5% or 26%, and in the case of royalties, the withholding tax is 22.5%. In some cases, the withholding tax can also be applied to emoluments paid to members of the Board of Directors of non-resident companies.
Generally, taxation in the state of limited source is applied through withholding tax. The person who distributes dividends and pays interest or royalties (i.e. the company or a bank) must operate the withholding, generally, applying it to the gross amount of income. The tax burden, however, is borne by the foreign recipient.
Allocation of income
Once an income attributable to non-resident persons has been classified within the categories of taxable income in the source State, it is necessary to establish the rules that determine the taxable part that is to be considered attributable to the state of the source itself. These rules, known as “income allocation”, can lead to significant discrepancies between states, as well as double taxation.
This occurs, for example, if a state considers a share of income attributable to a permanent establishment, while the other state does not recognize this attribution. Other distortions can be caused by differences in the deductibility of particular types of expenses. It should also be emphasized that the application of taxation at source must not be confused with the territorial system.
Pay rule and use rule rules
Income that is taxable in the recipient’s state of residence (i.e. based on the principle of worldwide income taxation) may also be taxed in the source state, based on the source of income definition rules established in that state.
It is important to determine within what limits and under what conditions, according to internal rules or bilateral rules or a combination of the latter two, the income is presumed to derive from that state and, therefore, can be subject to limited taxation. The rules of the source are not always the rules that define the jurisdiction to which the right to tax is recognized.
The source issue may also be relevant if the source State does not have taxation powers. For example, in many states, the application of source rules to income received by residents also has the function of clarifying whether these specific incomes are to be considered domestic or foreign source income for the purposes of applying the double taxation treaties. Generally, internal laws establish distinct rules for each individual income category.
Compensation from employment, emoluments and other types of payments must be classified according to a certain income category and, only subsequently, will it be established which source rules will apply in relation to that income category.
Source income rules
The rules of the source of an internal nature are generally of three types:
The presumption that an income derives from a State if it is paid by a resident of that State (pay rule); the pay rule is present in many states;
The presumption that the income originates in the state in which the assets are located, to which the payment of a price for its use (for example, the right to use a patent) is attributable (use-rule); this rule applies, for example, in the United States of America;
A combination of the rules mentioned in the previous points. For example, it can be established that an income does not derive from a State if the goods from which the price is deducted are used outside the state itself, although the payment is made by a person resident in that state.
Withholding taxes can be applied to a wide range of payments, including dividends, interest, royalties (including, at times, lease payments), fees for technical assistance or services, management fees and consultancy fees. In fact, any type of payment could be subject to withholding tax.
When received by a company, these items of income normally acquire the characteristic of business income for the recipient. However, this does not prevent the source State, in a transnational context, from reclassifying this income in a different category for tax purposes (unless the recipient has a permanent establishment in the source State to which the income in question is allocated).
For a non-resident company to be subject to tax or a withholding tax to it, a certain source of income must be located or presumed to be in the source state. The criteria for identifying the source, based on the internal rules of the States, are as follows:
According to the rules established by most states, the source of dividends is the place of residence of the company distributing the dividends (pay rule).
In the United States it is also relevant to determine where the distributing company has formed its profits. If a US company, in the three years prior to the distribution of dividends, earned at least 80% of its income from foreign sources, only the portion of dividends attributable to income formed in the United States is subject to withholding tax on dividends of 30%.
Conversely, a non-US company with 25% or more of its income actually related to a US business or business formed in the last three years prior to the distribution of dividends to non-US shareholders is subject to 30% US withholding tax. if the dividend is attributable to income from US trade or economic activity.
The most commonly applicable source criterion is the place of residence of the interest payer.
Other criteria may be those of the state where the loan from which the interest is paid is used, the place where the interest is paid, or the place where the lender can deduct the interest expense paid (or from the profits of a building organization).
The most common criterion is that of the place of residence of the person who pays the royalties.
Another important criterion is that relating to the state in which the rights or immovable property from which the payments of royalties or rents derive (for example, the United States of America) are used.
A further criterion is that of the state in which the payer can deduct the royalty payments, or where the royalties are paid (for example in France).
Similar rules, regarding source recognition, may apply to fees for technical assistance, services and professional advice. These types of income paid to non-resident companies are, for example, taxable in a number of Asian states (India, Malaysia, Pakistan) and Latin America (Argentina and Brazil) when paid to non-resident individuals.
This generally entails major problems in practical application: since according to most treaties, withholding taxes cannot be applied to this type of income unless the treaty contains special clauses, the source states try to safeguard their tax rights, assimilating this type of payment, for the purposes of the treaty, to royalties.
Although this practice is not compatible, for example, with the treaties entered into in accordance with the OECD model, it is generally extremely difficult to convince the tax authorities of these states to waive the application of such withholding taxes.
Implications of the source principle
Some further implications deriving from the application of the source principle are the following:
The principle of taxation in the source state is important not only in order to determine the extent of the tax obligation of non-resident individuals. In fact, the principle is also applied by the state of residence of the taxpayer to apply the methods to eliminate double taxation. This can result in double taxation in the event that the state of residence does not recognize the rights of the other state to tax certain income if it claims that, according to the internal rules of the state of residence, there is no source of income in the other state;
The application of taxation in the source state is of particular importance in determining whether a state can apply a withholding tax. For example, there may be a case in which it is necessary to determine whether the interest due for a loan used by a permanent establishment of a foreign company is subject to reduced withholding tax pursuant to a tax treaty concluded by the state in which the permanent establishment is located. . It is important to clarify this and other similar issues, bearing in mind that a permanent establishment in general is not a subject to which the benefits of tax treaties can be recognized.
In order for it to be possible to affirm the existence of a tax obligation of a non-resident taxpayer for income from domestic sources, it is necessary that the sources of income taxable in that state are explicitly identified by the laws or regulations of that state. This implies that sources of income that have not been individual as such cannot entail any taxation on a non-resident person.
A typical example of planning based on the source of income discrepancy is the treatment of capital gains arising from the sale of a UK property by a non-UK resident.
Such capital gains are not taxable in the UK to the extent that the real estate is not part of a UK-based company. This is because such capital gains are not recognized by UK law as a source of taxable income for a non-resident person. In the event that the owner of a property is resident in a state that recognizes the exemption for income from foreign sources, as an internal measure for the elimination of double taxation, in this case, the final result would be the absence of taxation both in the state of the source (United Kingdom) and in the state of residence of the seller.
This fact depends on the application of measures against double taxation in the country of residence of the recipient, or by replacing the exemption method with the credit method.
Tax authorities tend to avoid such an extensive interpretation of source rules. Therefore, careful planning is necessary not only in relation to the tax obligation in the source State but also in the state of the taxpayer’s residence with reference to the methods of eliminating double taxation.