DEBATE ON INCOME TAX BASE: WORLD- WIDE OR TERRITORIAL

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1 IJER Serials Publications 13(7), 2016: ISSN: DEBATE ON INCOME TAX BASE: WORLD- WIDE OR TERRITORIAL Abstract: The authority of a state to impose or to collect taxation is based on two things, namely domicile as well as citizenship principle and source principle. The domicile as well as citizenship principle results into a form of taxation that based upon world wide income, meanwhile the source principle results into a form of taxation that based upon territories. Currently a shift from world wide to territorial system is becoming apparent, hence this article aims to provide enlightenment with regard to the strong and weak points of world wide income and territorial system of tax base. The implementation of world wide system is considerably unable to reduce tax base and prevent capital outflow. Meanwhile the territorial system is considered able to reduce the companies tax burdens, hence leading to an increase of competitiveness in the global economy. Keywords: income tax base, world wide income, territorial 1. INTRODUCTION Income tax base is separated into source principle, which results into territorial income tax base, namely taxation that is imposed in source countries; and domisile as well as citizenship principle, which results into world wide income tax base. According to the report made by PWC in 2013, more developed countries of OECD were shifting to territorial principle in terms of income tax base. 28 out of 34 OECD states have altered their world wide income system into a territorial one. The trend has been rising since In that period, nearly half of OECD states were shifting to territorial system. New Zealand and Finland, which used to change its territorial into world wide income system, is now changing its income tax base into the initial state of territorial system (McBride, 2013). There is a shifting phenomenon which has been happening eversince the international tax reformation, namely the increasing use of territorial tax system (Yoder, 1). A number of literatures have stated that most states tend to use territorial income tax base. Territorial system is a pragmatic response to practicality in a world where competition moves swiftly and globally. * milla.s.setyowati@gmail.com

2 2628 Milla Setyowati, Ning Rahayu, Nugraha Dwiyanto and Milla Sepliana Setyowati The experts who support the territorial system believe that the system provides an equal playing field for national companies to expand their business in other countries because companies from other states who also use territorial system will only need to pay tax in their source country. Meanwhile, companies originating from countries that use world wide income system will need to pay tax in two countries, namely the source country and home country, hence they are imposed with different tax tariffs from those imposed on companies that operate in the source country. Another reason that is used by proponents of territorial system is that this system will encourage national companies that operate outside of their respective countries to bring back the profit they have earned to their origin country, thus boosting the capacity of the national economy. (Roth and Yevgeniy, 2012). On the other hand, the opposition to the territorial system believes that the system will increase the occurrence of capital flight. National companies will choose to invest in tax haven countries in regards to running their business in contrast to their origin state, hence reducing the country s income. Aside from that, there will also be a decrease of job opportunities because business activities are diverted to other countries. 2. THEORETICAL FRAMEWORK Taxation in a country is determined by the taxation jurisdiction that the country adheres to, which eventually influences the treatment of taxation towards foreign subjects and objects. In general, the authority of a country to impose tax is based on two things, namely taxpayer status and source of income. According to taxpayer status, a country has the right to impose tax on individuals or bodies/organizations, if they are domiciled in the country (domicile or residence jurisdiction) or have citizenship status (citizenship jurisdiction). As a consequence, a country could maximize the taxation irrespective of income source (based on worldwide income). Tax is imposed on the country s residents as well as citizens who are not residents, however they domicile or are considered as the country s resident in accordance to rules and regulations that are applied. According to Mansury, the determination of tax subjects inside a country is based on their residence of the individual in the country, also known as residence criterion or fiscal domicile criterion (Mansury, 1998). According to Westberg, jurisdiction of taxation based on residence or domicile criterion is, among others, based on benefit principle, namely the taxation rights that exist because taxpayers receive benefits due to the cost that government has born to provide infrastructures, education, culture, and many other government activities (Westberg, 2002). Source jurisdiction is based on the assumption that source contries contribute to the income earned by individuals or bodies located inside the country s territory. A country could impose tax on individuals or bodies due to the income originating from the country.

3 Debate on Income Tax Base: World-Wide or Territorial 2629 According to the source, a country has the right to impose tax because individuals or bodies attain earnings that originate from that country (territorial jurisdiction). According to Surahmat, the determination of income source relies ont wo principal things, namely the type of the income and the determination of income source based on the country s tax law. In general, to determine the source of income, income types are differentiated in two categories, namely income from business (active income) and income from capital (passive income) (Surahmat, 2000). World wide income taxation is a tax system which recognizes all of the income that an individual or body earn from any source, including income from domestic and international source, active and passive income (Matheson, Perry, & Venung, 2013). This system of income regonition is commonly used by countries who adhere to citizenship jurisdiction, namely the system which imposes tax on its residents overall income. Countries which employs a pure world wide income system, unmodified and/or merged with other system, aims to maintain neutrality in relations to capital export because this system does not interfere with the decision to invest inside or outside the country. In addition to that, the world wide system also upholds justice, on both horizontal and vertical level. In order to prevent double taxation, governments can employ a mechanism of tax credits over income which has been taxed overseas in countries which use source-based income recognition system (Schenk, 2009). Territorial income taxation is a tax system which acknowledges income based on its source, namely tax that is imposed over income that is earned from the concerned country. In contrast to world wide income system, the income acknowledged in territorial system is the one which originate from the country where the individual or body earns that income (Matheson, Perry, & Veung, 2013). In a pure territorial income system, one that is not combined and/or modified with other system, neutrality in regards to capital import (in contrast to the world wide income system) can be boosted because the system treats every investor in the country in a similar manner, irrespective of their residential or domicile status. This system only impose tax on income that is earned from a country s territorial jurisdiction. In this system, tax is not imposed on income originating from outside the country, therefore creating a potential loss for countries that implement the system. As a consequence of only imposing tax on income orginating from within the country, the system does not recognize tax credits for specific income tax which has been paid overseas. A positive side of a territorial tax system is that the system is easier to be employed in terms of administrative affairs and easier to be obeyed by taxpayers. However, the downside of the system lies on the fact that it propels individuals and bodies to move their investment and activities to countries which impose lower tax or even tax haven countries (Schenk, 2009). Through a worldwide system with superiority on capital export neutrality, tax system provides justice, both on horizontal and vertical level. Horizontal justice means taxpayers

4 2630 Milla Setyowati, Ning Rahayu, Nugraha Dwiyanto and Milla Sepliana Setyowati with similar income and type of income, will bear equal tax burdens. By taxing income originating from overseas and providing credit facilitation, world wide system ensures that taxpayers who have income originating from outside the country will not need to pay lower taxes in comparison to taxpayers who do not have similar source of income. Vertical justice means taxpayers who have higher income will be imposed with higher tax. By including income from overseas as a taxable income, the world wide system ensures that taxpayers with larger income will be imposed with higher tax as well. Inversely, territorial system with an edge on capital import neutrality results into horizontal injustice, because in scenarios where two taxpayers have similar amount and type of income, they will have different tax burdens because their income are generated from different host countries (Matheson, Perry, & Veung, 2013). 3. METHODS This research employs qualitative approach to explain world wide and territorial income tax base in accordance to the purpose of the research. Qualitative approach is done by conducting qualitative analysis of literature studies, collection of primary and secondary data, as well as interviews with experts. This research is descriptive, in which it aims to provide a thorough explanation of findings from the collected data. This research aims to explain the strengths and weaknesses of both world wide and territorial tax base system. 4. ANALYSIS 4.1. World-wide Income Basis For experts who are familiar with world wide system, this system is considered better than territorial system. Using the system, concerns about the decrease of tax base as well as the increase of capital outflow will not manifest. If the income generated from overseas are not taxed, it is feared that capital outflow will occur. The high rate of FDI outflow will happen if many companies invest abroad, hence resulting to the decrease of domestic investment and job opportunities. This scenario depends on the balance of investments done abroad, FDI inflow, and the domestic saving interest rate; capital outflow may reduce the capital potential. Such reduction will lead to reduction of productivity and wage. In territorial system, there is a concern regarding the shift of capital and investment to tax haven countries. If investment is moved abroad and the income is not taxed, then the tax base will decrease and lead to reduction of tax revenue. On the other hand, government targets tax revenue based on taxable income and the need for a high tax revenue to afford the state s budget. Tax revenue as a source of income for a country will increase. Government which use world wide system can still gain tax revenue from the margin between domestic tax payable and taxes paid abroad. However, if the

5 Debate on Income Tax Base: World-Wide or Territorial 2631 government employs territorial system, it will not be able to generate any tax revenue at all, because the income generated outside of state s territory will not be taxable. Government will get the margin between domestic payable and tax credits if it employs world wide system. However, world wide system is deemed to have rendered foreign companies away from establishing its company in the country because they do not wish for their income which is generated from overseas to be imposed with high tax Territorial Base A country which applies territorial system, does not apply tax income generated from abroad as a taxable object, hence it does not become a part of the tax which needs to be paid by domestic companies. Those income will not become tax objects insofar as it remains outside of the country and it is not brought to its origin state. In the system, the income which exists outside of the country could be returned back to the country through repatriation process, in which it can be imposed with lower tax tariff or no imposition at all (PWC, 2013). Proponents of territorial system already believe that it is already high time for countries in the world to start implementing the system. That statement is based upon several reasons which basically aim to reach a national goal. One of the national goal which a state desires is to ensure people s welfare through domestic economic growth strategy. As a consequence, strategic means need to be exerted. For instance, by increasing companies productivity through means of creating a condusive business climate as well as providing support for businessmen in order to increase their competitiveness. One of the means to do it is by implementing a taxation policy which could reduce tax burden of companies and therefore increasing their competitiveness in the global economy. In the last few decades, many countries have begun to boost domestic companies through tax reduction and territorial-based taxation. In the last 4 years, 75 countries have cut its income tax in order to make companies more competitive. Other countries such as United Kingdom, Japan, and Canda have increased its companies more competitive by reducing tax from 18% to 16,5%. Aside from cutting tax tariff, other policies which could be implemented to improve the competitiveness of multinational company is by changing the taxation system on foreign income. Canada, United Kingdom, and Japan have shifted from world wide to territorial in terms of taxing companies foreign income. On the other hand, a majority of OECD countries have also adopted territorial system. At this point, United States is one of OECD member countries who still implement world wide income and corporate tax rate of approximately 30% (Hodge, 2011). Reflecting on United Kingdom s experience, the implementation of world wide system and high standard of tax tariff in Europe has rendered global companies willing to move their income to lower-tax countries. Basically, European Union allows capital to move freely among its member states. It resulted into a large number of United

6 2632 Milla Setyowati, Ning Rahayu, Nugraha Dwiyanto and Milla Sepliana Setyowati Kingdom companies deciding to move their income to countries with condusive tax climate in order to protect its foreign income from UK tax code. A 28% tax tariff in United Kingdom is high in contrast to other European Union countries, hence many companies are motivated to move their income to lower-tax-country such as Ireland, or countries with low tax tarif and world wide system such as Netherlands and Switzerland. As a consequence of such condition, the British government decided to start implementing changes in regards to international tax regulation in order to make the system more friendly to global businesses. One of the means was through Controlled Foreign Corporation Rules for 2012, which aimed to transcend into territorial base corporate taxation which reflects the global reality of modern business. The government tried to make CFC easier to operate and able to increase competitiveness. It yielded result the day after the British government announced the policy: around 2 multi national companies claimed that they would return their profit to United Kingdom (Hodge, 2011). Reflecting on the success of territorial system in other countries such as Japan surely becomes another factor which pushes policymakers to reform the tax system. In Japan, world wide system combined with high corporate tax rendered Japanese countries unwilling to bring their income back to Japan because they dread the high tax tariff. Since 2008, Japan s Ministry of Economy, Trade and Industry has expressed concern that the companies rejection will lead to the decrease of investment in Japan and will bring adversary impacts to the country s development in terms of technological innovation. Japanese government eventually decided that they would change the tax system from world wide to territorial. On August 2009, Japan claimed that most of Japanese companies had begun to conduct repatriation (Hodge, 2011). Another reason which pushes policymakers to recommend territorial system is the lack of fulfillment of a tax principle inside world wide system (Hodge, 2011), namely benefit principle. Many countries implement source-based taxation, which means that the country has the right to tax domestic income. One of the aspect in source-based taxation is benefit principle, that is an idea which connects tax with the benefits received by the government. Therefore, if foreign income is taxed in the origin country, then such treatment is considered as not reflective of the benefit principle of tax. Despite the many reasons which supports the notion that territorial system is able to fix the economy of countries in which it is being implemented, this policy also contains several risks which need to be anticipated. As written in The Fiscal and Economic Risks of Territorial Taxation, there are several fiscal and economic risks which must be anticipated by policymakers before implementing territorial system (Huang, Marr, Friedman, 2013). If foreign income is not taxed, then it is feared that may capital will flow out. The high rate of Foreign Direct Investment will take place if many companies invest abroad, and thus resulting into a decrease of domestic investment and job opportunities. It depends on the balance of investment done abroad, FDI inflow, and the rate of domestic saving interest; capital outflow could decrease

7 Debate on Income Tax Base: World-Wide or Territorial 2633 the capital s potential. The decrease of capital could impact productivity and wage. If these issues are not anticipated, then it is undeniable that the government s decision to implement territorial system will instead weaken domestic business, lead to prolonged deficit, and worsen the economic condition of the country. The first risk that needs to be anticipated from the territorial system is the rising tendency for companies to invest abroad. This system will only impose tax on income generated from the home country. Meanwhile the income derived from the host country is not a tax object in the home country. It is certain that it will become an incentive for multinational companies that invest abroad because the income generated from conducting investment abroad will not be taxed in the home country. It will become an opportunity to reduce companies tax burdens by not bringing income back to the home country. The implication that it has on the the country s revenue is that if it is allowed to continue, the territorial system might bring about a high potential loss for the government. If there are more companies which invest abroad, then indirectly it will influence national productivity. According to the Theory of Economics, it is believed that the territorial system will reduce domestic capital as well as workers productivity (Huang, Marr, Friedman, 2013). If low tax tariff imposed on foreign income manage to boost capital income, it is projected that the capital return will increase, however wage will decrease. Lower tariff tax imposed by overseas countries will certainly have its own appeal to the investors which will allure them to invest in that country. Furthermore, a tax system which does not make income derived from investment done overseas as a tax object will increase the interest of investors to invest abroad as opposed to domestically where the income will be imposed with lower tax. 5. CONCLUSION Income tax base is a discussion that revolves around macro level tax economy. This policy will certainly provide significant implications, not just to tax revenue, but it will also influence and be influenced by the state of national and international economy. Both systems have its strengths and weaknesses. The world wide system is expected to ensure that tax base will not decrease and that the capital outflow will not occur. Territorial system is projected to be able to fix the implementing country s economy, however it exposes risks, one of which is the increasing number of capital outflow. References Yoder, Lowell D. Tax Planning with the Possibility of a Territorial Tax System International Tax Journal 39.5 (Sep/Okt 2013): accountid=17242 McBride, William. New Zealand s Experience with Territorial Taxation 19 Juni taxfoundation.org/article/new-zealands-experience-territorial-taxation

8 2634 Milla Setyowati, Ning Rahayu, Nugraha Dwiyanto and Milla Sepliana Setyowati Roth, Diana Furchtgott, and Yevgeniy Feyman. The Merits of a Territorial Tax System. Manhattan Institute for Policy Research 29 Oktober html/ir_29.htm#.vtnzuigqqko Mansury, R. Perpajakan Internasional Berdasarkan Undang-Undang Domestik Indonesia. Jakarta: Yayasan Pengembangan dan Penyebaran Pengetahuan Perpajakan, Westberg, B. Cross-Border Taxation of E-Commerce. Amsterdam: International Bureau of Fiscal Documentation Surahmat, R. Persetujuan Penghindaran Pajak Berganda: Sebuah Pengantar. Jakarta: Gramedia Pustaka Utama & Arthur Andersen Prasetio Utomo, Matheson, T., Perry, V., & Veung, C. Territorial vs Worldwide Corporation Taxation: Implications for Developing Countries IMF Working Paper, (2013): 3. Schenk, A. Worldwide Versus Territorial Tax Systems: Comparison of Value Added Tax and Income Tax Wayne State University Law School Legal Studies Research Paper Series (2009): 3.