Chapter 1 – INTRODUCTION TO THE TAXATION OF INTERNATIONAL INCOME BY USING THE SOURCE AND RESIDENCE PRINCIPLES OF
TAXATION
When a countrys own citizens or residents transact business or invest abroad, or foreigners trade or invest within its domestic jurisdiction, the tax system as it affects these activities needs to balance carefully domestic and international economic objectives. On a global basis, countries need to maintain orderly tax regimes to promote international trade, and there is a need for accepted rules and conventions limiting any one countrys rights to tax its own citizens or residents operating or investing abroad, or the citizens or residents of other countries doing so in its own jurisdiction. Two mainstream principles or bases which have developed for this kind of “international” taxation are respectively the source and the residence bases. On the international level, these are then amplified by a network of bilateral Double Tax Agreements which seek to remove any remaining potential conflicts and to eliminate the danger of taxing the same income twice.
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Katz 5th Report on South Africa Residence and Source Based Systems
1.1 DEFINITION OF THE RESIDENCE PRINCIPLE
1.1.1 Under a residence system income which accrues to a resident of a
country should be subject to the taxes of that country. In the case of
the United States, all citizens, even if not resident, may be so subject
on their worldwide income; this is an exceptional position, and the
possibility of basing tax on citizenship is not considered further in this
report.
1.1.2 The basic rationale of a residence basis of taxation has been contrasted
to that of a source based system in the following terms by the
Appellate Division (Kerguelen Sealing & Whaling Co., Ltd v CIR 1939 AD 487, 10 SATC: 363):
“In some countries residence (or domicile) is made the test of liability
for the reason, presumably, that a resident, for the privilege and
protection of residence, can justly be called upon to contribute
towards the cost of good order and government of the country that
shelters him. In others (as in ours) the principle of liability adopted is
source of income; again, presumably, the equity of the levy rests on
the assumption that a country that produces wealth by reason of its
natural resources or the activities of its inhabitants is entitled to a
share of that wealth, wherever the recipient of it may live. In both
systems there is, of course, the assumption that the country adopting
the one or the other has effective means to enforce the levy.”
1.1.3 A less convincing argument is that resident taxpayers should all be
subject to the same tax system since they live in the same country. The
latter argument ignores the fact that the income in question is
generated under substantially different circumstances in other
jurisdictions. The differing tax treatment in the foreign country is
usually related to the particular circumstances pertaining to the
taxpayers operating in that system, for example low tax rates often
compensate for poor infra-structure or other deficiencies in order to
attract investment.
1.2 DEFINITION OF THE SOURCE PRINCIPLE
1.2.1 Under a pure source system income is taxed in the country where that
income originates, regardless of the physical or legal residence of the
recipient of the income.
1.2.2 In addition to the motivation emphasising enjoyment of the source
countrys resources as noted by the Appellate Division in the
Kerguelen case, a source system is also motivated by the degree to
which it ensures fair competition between taxpayers in the particular
jurisdiction and taxpayers (competitors) from other jurisdictions.
1.2.3 The primary right of the “source” country to tax “active” business
income is widely recognized internationally and soundly anchored in
the principles underlying double taxation agreements – even where the
taxing country has a residence system.
1.3 APPLICATION OF THE RESIDENCE AND SOURCE SYSTEMS
INTERNATIONAL TRENDS
1.3.1 Nowhere in the world are either of these systems applied with
any degree of purity.
1.3.2 In terms of double tax treaties, and in many instances under the
national regimes of residence based countries, these countries are
generally required to exempt income generated in the other contracting
state or to provide a credit for the tax imposed in the source state.
Accordingly, all residence based systems still tax non-residents on
income sourced within their jurisdictions.
1.3.3 Countries with a source system have gradually extended the scope of
their taxes by statutorily deeming certain types of income (especially
of a passive nature) to be sourced within their jurisdictions, and
therefore to be subject to tax there. (They then, too, grant relief to their
taxpayers for taxes suffered in the source jurisdiction.) The arguments
in favour of taxing passive income generated abroad are more
pragmatic than convincing. Essentially, it is argued that the state of
residence of the taxpayer has enabled him to accumulate capital (to
lend offshore), to develop intangible property (to license offshore), or
to acquire a capital asset (to lease offshore), and that the taxpayer does
not actively use the infra-structure of the other state where another
taxpayer uses the capital or asset.
1.3.4 Both these systems, albeit in hybrid form, are strongly represented
amongst the tax systems of the world. In Latin America there is still a
strong territorial sentiment, although fairly recently both Brazil and
Argentina changed over to a residence based system. In the case of
Argentina, the Commission had evidence from various sources that the
change, introduced by way of a few cryptic lines of legislation in
1992, is as yet unsupported by any form of regulation or detail
resulting in serious problems. Malaysia also experimented with both
systems. From 1948 to 1967 the countrys tax system was territorial,
with a remittance basis. In 1968 it changed to a worldwide system, but
this lasted only until 1973 whereafter it reverted to the territorial basis.
1.3.5 International bodies are also pointing towards territoriality or source as
a favoured system. In 1955 the International Chamber of Commerce
changed their earlier support for a word-wide basis of international
taxation to suggest that the source country should have the sole right
to tax international income. At its 1984 Buenos Aires conference the
International Fiscal Association pointed out the economic
disadvantages of worldwide taxation. The Association went on to
recommend a system of territorial taxation or exemption, and
appealed to governments who had adopted the worldwide basis to
reconsider their positions.
1.3.6 While the academic debate continues, the ultimate result of the two
systems is not that different once all the exceptions and compromises
are recognised. The system appropriate to a given country often is
dictated more by other factors such as economic strategies, net crossborder
capital flows, the relative sizes of the national and domestic
economies, relative tax rates, history, and administrative capacity.
5th Report – BASING THE SOUTH AFRICAN INCOME TAX SYSTEM
ON THE SOURCE OR RESIDENCE PRINCIPLE – OPTIONS AND
RECOMMENDATIONS
CHAPTER 2 – SOUTH AFRICAN HISTORY AND BACKGROUND
2.1 HISTORY OF INVESTIGATIONS
2.1.1 The first income tax laws in South Africa were based on the
principle that tax would be levied only on income sourced in the
Union. Since then, several investigations into the advisability of
this system have been made. In 1951 the Steyn Committee1
recommended that the source basis of taxation be retained. Its
reasoning was based mainly on the perceived complexity of
changing to a residence system, and the fact that it did not foresee
a material impact on revenue.
2.1.2 The Franzsen Commission2, on the other hand, recommended the
opposite in 1970. Its main arguments were that more income was
beginning to flow into South Africa without being taxed, South
Africas major trading partners were on a worldwide basis, the
worldwide basis enhanced the individuals ability to pay, and the
Income Tax Act had already deviated from a pure source basis
through the introduction of various deeming provisions. The
Government in a subsequent White Paper accepted these
recommendations, subject to further study on various aspects.
This intention to change to a worldwide system was never
pursued.
2.1.3 The Margo Commission3, which reported in 1986/87 also
reviewed the whole issue comprehensively. It recommended that,
subject to the possibility of extending some of the then existing
source deeming provisions, the source basis should be retained. It
highlighted two reasons which would militate towards a residence
basis:
(i) If exchange controls were lifted, a worldwide basis might
be instrumental in curbing consequential tax avoidance;
and
(ii) The “independent national states” that then existed (and to
some extent the existence of other countries in the rand
monetary area) exposed the system to schemes of
avoidance, and a worldwide system would help counter
this.
2.1.4 At the same time, the Margo Commission noted some
considerations in favour of retaining the source basis:
(i) It considered that legislation for and the administration of
a worldwide system would be considerably more complex
than the system then pertaining;
(ii) While income inflow from off-shore was increasing, the
failure of a source system to tax such income made
relatively little difference to the yield as in terms of
international convention, South Africa would have to
grant credit for the foreign taxes already paid; and
(iii) The fiscal benefits that might be derived from a
worldwide basis would be reduced as and when the South
African tax rates were reduced.
2.1.5 In conclusion, the Margo Commission advised that the disruption
caused by a change would not be justified by the possible
benefits. The Government White Paper following the report
accepted the recommendation. In consequence, the current
position is that South Africa still bases its tax system on the
source principle, although over the years the hybrid nature of the
system has grown through deeming provisions as to source,
especially in the passive income arena.
2.2 SOUTH AFRICAN BACKGROUND FACTORS
Various factors have a bearing on what may be an appropriate system for
South Africa.
2.2.1 An Open Economy
In 1987 the Margo Commission reported (in para. 26.2):
“The Republic has an open economy and seeks to create an
environment that will attract investment and facilitate trade. A
hospitable fiscal environment is seen as an integral part of such
endeavours. Transnational corporations are making valuable
contributions to the growth of developing countries through their
inputs of expertise and capital, and they should be encouraged.”
Since then, the democratisation of South Africa has triggered a
dramatic increase in the reintegration of the South African
economy with the global economy, and this process should
continue.
2.2.2 Protection of Financial Capital and Human Skills
While foreign investment in South Africa and South African trade
with and investment in other economies remain a vital part of any
growth strategy, outward investment must not become a longterm
export of South African financial capital and skills. Instead,
it should form another platform for South African economic
growth, centered around an influential, locally based multinational
sector.
2.2.3 Exchange Controls
South Africa still has exchange controls over residents.
Government policy is that the controls should go, but this is likely
to happen by gradual process rather than as one dramatic
measure. Certainly, as the controls are lifted, South African
residents are increasing the off-shore element of their investment
or operations. The Commission heard contradictory evidence as
to the likely investment patterns that would emerge when controls
were lifted, but the differences seemed to be more of degree than
of kind. Most agreed that there would be some net capital
outflow, especially immediately after major relaxations. Although
factors like the rate of exchange, the real return on investments,
and the gradualism in relaxing controls would influence the
suddenness of movement, it seems likely that the flow of income
to South Africa will increase. Approval for operational or real
investment by South African businesses off-shore is already being
granted more readily by the exchange control authorities, and the
Commission received little evidence of a likely major outflow of
direct investment capital.
2.2.4 Capital Flows
Disregarding any short term capital flows immediately after
exchange control relaxation, South Africa, as a developing
country, is likely to remain a net capital importer for a
considerable period. Nevertheless, it will be fully subject to the
international phenomenon of both financial and human capital
having become much more mobile than ever before.
2.2.5 Regional Headquarters Base
South Africas current source based tax system positions it well as
a head office, finance or management company location for
investment into Africa north of its borders. With the expectation
of an important South African role in regional or even continental
economic revival, this will impact on South African investment
into Africa, and non-African investment into the continent via this
country with its relatively developed financial structure and other
infrastructural advantages.
2.2.6 Treaty Network
Since 1987, South Africa has dramatically increased its network
of double taxation treaties. With the exception of the United
States and Japan, the country now has treaties with most of its
major trading partners (the treaty with the USA has been signed
and negotiations with Japan and Australia have commenced).
1First Report of the Committee of Enquiry into the Income Tax Act (The Steyn Committee Report), UG
No. 75-1951 (Pretoria: The Government Printer), para. 68, p. 19.
2Commission of Enquiry into Fiscal and Monetary Policy in South Africa (The Franzsen Commission
Report). Taxation in South Africa: Second Report. RP 86/1970 (Pretoria: The Government Printer
1970), para. 20.
3Report of the Commission of Inquiry into the Tax Structure of the Republic of South Africa (The Margo
Commission Report), RP34/1987 (Pretoria: The Government Printer 1987), para. 26-3.
5th Report – BASING THE SOUTH AFRICAN INCOME TAX SYSTEM
ON THE SOURCE OR RESIDENCE PRINCIPLE – OPTIONS AND
RECOMMENDATIONS
CHAPTER 3 – POLICY OPTIONS – OBJECTIVES AND AN OVERALL
APPROACH
3.1 CONSIDERATIONS RELEVANT TO BASING THE TAXATION
OF INCOME ON EITHER THE RESIDENCE OR THE SOURCE
PRINCIPLE
Several objectives for a new system were advanced in evidence by
various parties. Conflicts amongst these are inevitable, but a balanced
system would seek to find the optimal compromises. The Commission
believes that the following objectives should be accommodated to where
feasible.
3.1.1 Generation of tax revenue
3.1.1.1 The primary function of the tax system is to raise
revenue for the state. With the mobility of capital in
the modern world, the evidence is that once relevant
exchange controls are lifted, South African residents,
including the institutions, will make considerable
passive investments off-shore. From a purely revenue
viewpoint, a worldwide system will therefore be more
effective in securing the tax revenue on income from
such investments.
3.1.1.2 Direct investment which relates to active business is
dictated more by real commercial factors and is
therefore less mobile. It is difficult to project the
potential yield of a worldwide income tax system on
active or business income. Unlike passive income,
direct investment income cannot be switched in and
out of South Africa or between foreign jurisdictions.
While it is difficult after many years of foreign
investment restrictions, both through exchange
controls and through political factors, to predict the
potential revenue loss on income from such direct
investment, the lesser mobility will tend to slow down
any tax-opportunistic export of capital. Most foreign
countries tax the profits that derive from investments
in their jurisdictions. Even if South Africa were to
grant a credit for those foreign taxes (as opposed to
exempting income already taxed), the gain to the
fiscus would be restricted to the excess of South
African tax over the source country tax. It was with
this in mind that the Margo Commission commented
in their report (para. 26.19):
“The fiscal benefits resulting from the introduction of
a world-wide basis of taxation would be reduced if
there were a reduction in South Africa of the
individual and/or company rates of tax, as has been
recommended by the Commission …”
3.1.1.3 On an overall basis it is to be noted that, even if the
residence/source options were fairly consistently
applied, the revenue difference for South Africa would
be small in view of the fact that the South African
Gross National and Gross Domestic Products vary by
only one or two percentage points.
3.1.1.4 The Commission concludes that, from the perspective
of collecting revenue, adopting a residence or source
basis will make little if any difference as regards direct
investment (referring to active income), but that as
regards passive investment, a residence or worldwide
system will bring a revenue advantage.