REPORT OF THE UNITED NATIONS SECOND INTERREGIONAL TRAINING WORKSHOP ON INTERNATIONAL TAXATION HELD IN BEIJING FROM 23 to 27 APRIL 2001*

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1 1 REPORT OF THE UNITED NATIONS SECOND INTERREGIONAL TRAINING WORKSHOP ON INTERNATIONAL TAXATION HELD IN BEIJING FROM 23 to 27 APRIL 2001* I. OPENING OF THE WORKSHOP 518. The Second Interregional Training Workshop on International Taxation was opened on behalf of the Government of People=s republic of China by the Honourable Mr Hao Zhaochang, Deputy Minister of the State Administration of Taxation, who emphasised the role of taxation and mobilization of financial resources in the process of economic development, particularly in the context of opening of the national economy in the face of globalization. There was need to improve tax administration in bringing about economic reforms. The growth of the GDP of 8% in the first quarter of 2001 and the total national tax collection of US $235 billion in 2000 were significant achievements which were responsible for improving the living standards of large sections of population in the People=s Republic of China. He thanked the Secretary-General of the United Nations for holding the Second Interregional Training Workshop on International Taxation and the Meeting of the Steering Committee of the Ad Hoc Group of Experts on International Cooperation in Tax Matters in Beijing, the capital of People=s Republic of China Mr Abdel Hamid Bouab, Officer-in-Charge, Public Finance and Private Sector Development Branch, Division for Public Economics and Public Administration, Department of Economic and Social Affairs made a statement on behalf of the Department and thanked the Government of People=s Republic of China for the provision of necessary infrastructure for holding the Training Workshop and the meeting of the Steering Committee and for its generous hospitality. He observed that the Training Workshop was being organized in pursuance of the United Nations commitment to assist developing countries and economies in transition to strengthen the institutional capacity and upgrade the technical skills of tax administrators which will enable them to face the challenges of the New Millennium as well as the advent of economic globalization Messrs Abdel Hamid Bouab and Antonio Hugo Figueroa were appointed Co-Chairmen of the Training Workshop and Mr Suresh Shende, as Secretary. Senior tax administrators from 19 developing countries and economies in transition and from State Administration of Taxation of People=s Republic of China participated in the Training Workshop. The list of participants is contained in Annex The Training Workshop had three agenda items : a) Fundamentals of International Taxation and Negotiation of Bilateral Tax Treaties between Developed and Developing Countries; * The original text of this paper, prepared by the United Nations Secretariat, was issued as ST/SG/AC.8/2001/L.7.

2 2 b) Tax Treatment of New Financial Instruments and Globalization of Capital Markets; c) Taxation of Electronic Commerce The meeting of the Steering Committee of the Ad Hoc Group of Experts on International Cooperation in Tax Matters was also held in Beijing from 23 to 27 April Mr Victor Thuronyi, Senior Counsel (Taxation), IMF and Prof Michael J. McIntyre, Wayne State University, Michigan, USA acted as Resource Persons for the Training Workshop and the Steering Committee, who along with the members of the Steering Committee addressed the participants on the following subjects: a) Mr. Mayer Gabay: The Significance of Bilateral Tax Treaties between Developed and Developing Countries b) Mr. Antonio Hugo Figueroa: 1. The Negotiation of Comprehensive Tax Agreements 2. Taxation of Electronic Commerce c) Mr. John Evans Atta Mills: The Negotiation of Bilateral Tax Treaties between Developed and Developing Countries d) Mr. Noureddine Bensouda: Negotiation of Bilateral Tax Treaties between Developed and Developing Countries e) Mr. Victor Thuronyi: New Financial Instruments f) Mr. Pieter J. Vogelaar: E-Commerce and the Concept of Permanent Establishment: View of the Netherlands Ministry of Finance g) Professor Michael J. McIntyre: 1. Fundamentals of International Taxation and the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries 2. Taxation of Electronic Commerce 523. The Second Interregional Training Workshop on International Taxation was held in the context of the advent of economic globalization since the 1990s which had resulted in progressive integration of world economies, faster and more sustained economic growth, higher living standards and increased employment opportunities. However, it had also engendered growing tax competition in developing countries and economies in transition which threatened to reduce tax revenues. There was need to enhance mobilization of financial resources through "widening of the tax base", extensive tax reforms, improvement in effectiveness and efficiency of tax administration and combatting tax evasion and preventing tax avoidance The speakers at the Training Workshop outlined the effects of growth in international trade and increase in capital movements across national boundaries on national tax systems. Bilateral tax treaties are the most obvious international aspect of a country=s tax system. International double taxation arises when the income earned by a taxpayer is subjected to tax by more than one tax jurisdiction. Tax treaties did not only have the technical aspect of adjusting the two tax systems and avoidance of double taxation, but also to promote economic growth by

3 3 removing barriers to cross-border trade and investment, which could be considered as a positive goal. The United Nations has recognized that foreign investment, properly integrated into the political, economic and social priorities of developing countries and economies in transition can make a positive contribution to their economic and social development. It was also emphasised that the United Nations as also its predecessor the League of Nations since early 1920s has taken steps for avoidance of double taxation. In the context of the changes in international economic, financial and fiscal environment, the Ad Hoc Group of Experts on International Cooperation in Tax Matters has recently revised and updated the United Nations Model Double Taxation Convention between Developed and Developing Countries (earlier published in 1980) which is currently being printed and steps have been taken to revise and update the Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries (earlier published in 1979) A primary goal of any tax system is to raise revenue to finance government spending programmes. Raising revenues, as a goal does not explain per se why a personal income tax is preferred over other tax mechanisms, such as a sales tax, nor does it explain very much about the design of particular features of an income tax system. The three specific goals of an income tax system are fairness, efficiency and administrative economy. Despite its general lack of explanatory power, the revenue goal does explain some of the rules applicable to foreigners. Any government is in competition with foreign governments for tax revenue from trans-national income. That competition is regulated by a general agreement of countries to defer, in the case of a conflict between residence jurisdiction and source jurisdiction, to the country of source. To implement that general agreement, many countries have entered into bilateral tax treaties with other countries that require them to give their residents a credit in many circumstances for the income tax paid in the other country with respect to income derived in such other country. Some countries seek to prevent double taxation by exempting their nationals from tax on their foreign source income. The exemption may not extend to income through a tax haven jurisdiction All international tax agreements that limit the taxing powers of sovereign states rest on the following three pillars: first, a country can exercise residence jurisdiction only over its own residents and nationals; second, a country can tax income under its source jurisdiction only if that income has some nexus with that country; third, the country of residence must yield primary jurisdiction to tax to the country of source. Many commentators have suggested that the efficient taxation of resident taxpayers (including citizens and domestic corporations) would be advanced by implementing the principle of "capital export neutrality" which signifies that a country should design its tax laws so that they are neutral as to whether investment is made domestically or abroad. Ordinarily, in a market economy, investors will tend to maximize the social rate of return on their capital if they are free to make their investments without regard to tax consequences To achieve the goal of economic efficiency in taxing foreigners, a government should seek to obtain some reasonable degree of tax parity between its own citizens and foreigners. Efficiency would suffer if the tax burdens on foreigners are too high because such burdens would discourage foreigners from engaging in productive economic activity within the territorial jurisdiction of the host country, while a too low tax burden on foreigners would give them an

4 4 unwarranted competitive advantage over domestic taxpayers. Of course, there is very little possibility of establishing full parity between foreign and domestic taxpayers because foreign taxpayers are not taxable by the host country on their income derived from foreign operations. The withholding rules applicable to non-resident taxpayers are the most obvious example of international rules developed primarily to achieve administrative economy. Withholding at source is the most effective administrative technique yet developed for assessing and collecting income taxes. To facilitate assessment and collection of tax on the investment income of foreign persons at the source, many governments generally impose a flat-rate tax of, say, 30 per cent on gross investment income, without allowance for deductions properly allocable to such income. Obviously this regime is inconsistent with traditional fairness criteria and is not mandated by economic efficiency concerns During the last decade, global financial markets and intermediaries have faced several costly and contagious crises, accompanied by volatility in foreign exchange markets, debt crises in emerging markets and banking sector problems in several countries. These events have been the result of improper macro-economic policies and management control failures as also due to the transformation and restructuring of international finance. These changes include the increase in competition accompanying the liberalization of the financial sector in major countries, integration of capital markets, the development of new financial techniques and instruments and the growth of the emerging markets The objective underlying the lectures on International Tax Aspects of New Financial Instruments was to acquaint the participants with the new financial instruments that are in existence and to discuss the tax problems that they pose, with particular emphasis on cross-border transactions. One of the focus of the Ad Hoc group of Experts on International Cooperation in Tax Matters is the development and application of United Nations Model Convention and the new financial instruments pose challenges in this respect. It was common knowledge that derivatives and ancillary innovative financial instruments pose immense challenges to the tax systems. Tax policy makers and administrators have to be constantly vigilant in spotting and responding to the use of these instruments which would otherwise avoid or inappropriately reduce taxes. Most countries have been in the process of developing their domestic rules for financial assets and derivatives. But it was important that the rules for various types of instruments are as consistent as possible In many of the developing countries and economies in transition, new financial instruments may play a relatively greater role in international transactions than in domestic transactions. Financial markets in many of these countries are generally not as highly developed as in industrialized countries and correspondingly, these instruments are not as frequently used as in the industrialized countries in which the use of new financial instruments is much more widespread in some countries than in others. In addition, new financial instruments should pose relatively less of a problem domestically for non-industrialized countries rather than in industrialized countries for two reasons. First, many industrialized countries make distinctions in taxation according to the character of income, in particular, taxing capital gains at more favourable rates compared with other income. In the case of corporate income tax, however, most

5 5 of the non-industrialized countries do not make distinction between capital gains and other income, taxing all the income of a corporation as business income. To the extent that there is no distinction between capital gains and ordinary income, new financial instruments pose less of a problem, because there is no need for special rules to determine the character of income. Second, the reason why the new financial instruments may pose less of a problem domestically is that rules for taxation of business enterprises typically are based on accounting rules, which tend to be more flexible and may provide a basis for dealing with these instruments in such a way that there is not a significant threat to erosion of the tax base from use of such instruments. By contrast, countries which formulate their tax rules independent of accounting rules, it is necessary to provide detailed rules for the taxation of financial instruments so that taxpayers cannot use them to avoid taxation. Hence, at least in the near future, new financial instruments should be relatively easy to deal with in most developing countries and economies in transition By contrast, international context may be more problematic. First, accounting norms will not help in this area, because rules for withholding must be based on norms specified in the tax laws. Second, the area of withholding is one where legal form makes a difference. Withholding applies only to specified types of payments. For example, some countries impose withholding tax on dividends, but not on interest or capital gains. Or they may impose withholding tax on interest and dividends, but not on other contractual payments. Because the payments under new financial instruments can take forms that are different from the forms of payment traditionally subject to withholding tax, difficulties in terms of the legislative definitions of payments subject to withholding tax can arise. Third, withholding presents a tax policy concern, because the amount of payments under some financial instruments may not be closely correlated with the amount of income actually earned. This is the case of swap payments. There is a risk that if a withholding obligation is imposed, taxpayers will simply will not enter into the type of transaction subject to withholding, because the withholding would be out of proportion to the amount of income involved. This risks denying to domestic companies the risk-shifting benefits that new financial instruments can provide Finally, in the international context tax treaties present an important constraint on countries= freedom of action. Treaties present two main problems in this context for developing countries and economies in transition. First, the effect of existing treaties is generally to preclude taxation in many cases. Second, the application of tax treaties may present difficult legal issues of construction because new financial instruments do not fit neatly into the categories contemplated by treaties Taxation of electronic commerce was a subject which has generated considerable interest among world tax administrators since electronic commerce has affected almost every segment of economic activities, various issues connected with the subject are still in the process of evolution and no firm conclusions have yet crystallized. There was common ground that taxation of electronic commerce should seek to be technology neutral, the rules should ensure certainty and transparency, the tax rules should not result in either double taxation or unintentional non-taxation and lastly, the tax rules should be efficient, so as to keep the compliance costs of business and administration costs of government, minimum compatible with effective tax

6 6 administration The representative of the Netherlands concentrated on the recent OECD report concerning the application of the current Permanent Establishment (PE) definition to electronic commerce. This report provides with a detailed analysis of the current criteria for establishing a PE, as they apply to e-commerce. An important consideration is that the report adheres to the so-called "neutrality principle" as stated in the Ottawa Framework Conditions of the OECD (1998), i.e. the criteria applicable to e-commerce should in principle be the same criteria that apply to traditional business activities, in order to avoid distortion of competition Another important preliminary notion is that this OECD report deals only with the application of the current PE definition. The ultimately more important discussion whether the rapid developments in the field of e-commerce make it advisable or perhaps even inevitable that the current PE rules should be changed, is under examination by the Technical Advisory Group on Business Profits; this TAG C which constitutes of representatives of OECD countries, non-member economies and the business community C has yet to report The OECD document consists of a step-by-step analysis of all the criteria that apply to the current PE definition. The representative of the Netherlands discussed this analysis; according to his opinion, the following observations could be made: a) A web site alone is never a PE (it is no tangible property, which is one of the requirements to establish a PE) b) With the so-called web site hosting, i.e. an Internet Service Provider (ISP) that, for example, owns a computer server in another country, allows a company that is in the business of selling products through an Internet (e-tailer) to run its web-site on this server C a distinction has to be made. For the e-tailer, the web site running on the server of the ISP does not constitute a PE (no tangible property). For the ISP, however, the server will in most cases establish a PE. c) According to the Netherlands, human intervention by (personnel of) the company owning the server is not necessary to establish a PE; the essential test lies in the "preparatory or auxiliary test" (if the activity of the fixed place of business is of a preparatory or auxiliary character, then no PE exists; see paragraph 4 of Article 5 of the OECD Model Tax treaty). d) The answer to this test will depend upon the nature of the functions performed by the server for the company that owns it. Are these core business activities (then the server would constitute a PE of the company) or not? e) An important distinction in practice seems to be between the ISP and the e-tailer. For an ISP, providing a communication link between its customers is its core business. Owning and running a computer server in another country is part of this

7 7 core business (providing communication); in such a case, the server is likely to constitute a PE for the ISP. f) It is a different story for the e-tailer, however. Suppose that the e-tailer does not run its web site on the server of an ISP, but owns the server itself. Then the issue arises whether the server has to be qualified as a PE of this e-tailer. Again, the nature of the functions performed by the server is essential. If it only provides with a communication link, then the activities will be of a preparatory or auxiliary nature. The core business of an e-tailer is selling a product; the use of a computer server to get into contact with potential buyers in another country and to conclude contracts is the use of a means of communication, one the same level as, for example, the use of a telephone line or of the postal service. In many cases the conclusion could then be that only preparatory and auxiliary activities are performed by the server, so that the e-tailer has no PE As a Dutch addition to this document, it was said that even if a PE could be established, it would be very doubtful whether any substantial profit could be attributed to this PE. In a functional analysis, it could come out that the server in almost all cases will only provide services which support the core business of the e-tailer and that therefore only a marginal profit could be attributed to it. Therefore, the Netherlands representative suggested that as a policy issue, it could be useful to keep the option on the agenda to simplify matters in this field and agree on the fact that a server can never be a PE (at least not for an e-tailer). Consequently, the activity performed by a computer server could be specified in Article 5 of the OECD Model as an activity (like other activities of a preparatory and auxiliary nature) which in itself would never constitute a PE In the discussion that followed, many participants expressed their concern that as a consequence of the OECD approach, there would be nom possibility to tax the profits of e-commerce in the country where the sales are made and where the server is located. For these countries, it is essential that this is possible. If the OECD would not pursue this idea, then, so was the opinion, there is a task for the United Nations in this field. It should be clear in the United Nations Model Convention that sales through e-commerce can be taxed in the country where the sales are made. The Netherlands representative took the opportunity to point out that in any case, on tangible goods import duties and VAT can be levied. It is therefore essential, in a period of e-commerce more than ever, to have a reliable customs service which shares its information with the tax administration The participants evinced keen interest in the subjects discussed in the Training Workshop and found the lectures thought-provoking and stimulating. They were advised to act as trainers for their colleagues and subordinates in their respective tax administrations and impart training on the subjects taught in the Training Workshop. The participants were satisfied with the training material and the arrangements made by the United Nations and the Government of People=s Republic of China The Second Interregional Training Workshop was concluded on 27 April 2001 after the

8 participants were presented with certificates by the Honourable Vice Minister of State Administration of Taxation, Mr Hao Zhaocheng in the presence of Mr Zhang Zhiyong, Director General, International Taxation Department, State Administration of Taxation, United Nations officials and members of the Steering Committee. 8