Extending the borders of taxation

MODERN-DAY tax systems have moved a long way from those of medieval states where state assets had long been a source of government revenue. Rome had a sixth of its income from state-owned land while Athens and Renaissance Genoa had their own silver and alum mines respectively.

Most of the great European monarchies possessed large royal domains which gave them for a while their principal source of revenue. In many instances, when these royal domains did not raise enough revenue, the crown had to turn to direct taxation through parliamentary acts. Indeed, it has been said that the crown’s lack of independent means was the main reason for the growth of parliamentary power in the late 16th and 17th centuries.

Today, sovereign states adopt sophisticated tax systems to impose tax on those who come within their reach. Thus, most countries adopt either a worldwide or territorial basis of taxation, although within a particular country, the method of taxing individuals may be different from that applying to companies.

The worldwide basis: Under the worldwide basis of taxation, residents of a country are taxed on income or capital gains regardless of where they arise. In other words, even if income or gains arise outside the country where the individual resides, tax will be imposed on the individual who is entitled to the income or gain.

Countries which have a worldwide system include the United Kingdom, the United States, Germany, Italy and Japan. Malaysia adopted the worldwide basis for some years in the 1970s but has since retained it only for resident banks and insurance companies.

Territorial basis: Under the territorial basis of taxation, residents of a country are taxed on income or capital gains arising within its borders. Income or gains, which arise outside, are not taxed.

Malaysia currently adopts the territorial system and so does Hong Kong, Bolivia, Ecuador and Zambia to name but a few.

Plus remittances: Countries which adopt the territorial basis may also tax its residents on income or gains arising outside the country but only if these are brought back (remitted) into the country.

Malaysia has in recent years abandoned the remittance basis of tax. Countries with this system include Singapore, Thailand, Ghana and Israel.        

Residence: It is usual for taxes on income or gains to be levied on individuals or companies who are residents of the particular country under each tax system that is adopted.

While specific rules for the determination of tax residence of individuals may vary, the residence status of companies is based on where their management and control are exercised. This rule is generally adopted by countries with common law traditions.

Source basis: Non-residents of a country are taxed on the income or gains arising within that country’s borders, whether the tax system is a territorial or worldwide one. Thus, any real estate income (rents) from real estate located in a country will be taxed in the country even if the owner is not a resident there.

Citizenship: The application of citizenship criteria as a basis for taxation is very unusual but the notable exception is the United States. A US national is subject to US tax on his/her worldwide income wherever he/she resides. The way to avoid taxes for a US national is to shed his or her citizenship and not just to relocate.

The Vodafone case: The recent tax dispute involving Vodafone, the UK-based global mobile giant, is an issue where the Indian tax department sought to extend its jurisdiction outside India. The case involved Vodafone buying the shares of a Cayman Islands company, which in turn owns an Indian subsidiary, Hutch Essar India, which has extensive telecommunications operations in India.

The Cayman company’s shares were purchased from Hutchinson Whampoa, a Hong Kong-based company.

Vodafone is now faced with a tax bill issued by the Indian tax department of some US$1.7bil being tax on the capital gains on the sale of the Cayman company’s shares. Although the gains were made by Hutchinson Whampoa, Vodafone is being charged because it had failed to withhold taxes from the amount payable to the seller.

The Indian tax department’s case is based on the fact that the Cayman company held an interest in an Indian capital asset i.e. the shares in Hutch Essar India and the transaction involved the transfer of ownership in an Indian capital asset. The fact that the buyer and seller in this instant were both non-resident entities did not alter the tax officials’ view.

The Bombay High Court in a decision delivered in recent weeks ruled against Vodafone which gave notice of appeal to the Supreme Court in India.

There is no doubt that the court decision, if not reversed, will have wide ramifications. It is not without precedent though as tax authorities globally have also become more aggressive in the taxation of offshore entities.

A similar situation could well arise in Malaysia. If say, the shares of a Hong Kong company, which owned shares in a Malaysian “real property company,” were sold to another non-resident entity, could the relevant tax rules under the Real Property Gains Tax Act (which imposes real property gains tax on the gains made on the disposal of shares held in a real property company) be interpreted or widened to produce the same outcome as in Vodafone?

● Kang Beng Hoe is an executive director of Taxand Malaysia Sdn Bhd.

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