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The 'Genuine Link' Requirement for Source Taxation in Public International Law

Juliane Kokott, Avvocato generale presso la Corte di giustizia dell'Unione
europea, Lussemburgo

Ai fini dell’esercizio della competenza, la Corte internazionale di giustizia richiede la sussistenza di un “vero e proprio collegamento”. Nella tassazione internazionale del reddito, due tipi di collegamento sono stati ormai stabilmente individuati: la residenza e i principi della fonte del reddito che puntano l’attenzione sullo Stato nel cui territorio è stata creata la ricchezza tassata.

Questo quadro è stato sviluppato, in particolare, per attività industriali “reali”. Ora, al contrario, si trova a dover operare in un’economia che non ha necessariamente un le­game esclusivo con il territorio di un singolo Stato, come avviene ad es. per i servizi di­gitali. Gli Stati, l’Unione Europea e l’OSCE stanno cercando di adattarsi a questi nuovi sviluppi. In generale, si può dire che sta guadagnando sempre più terreno il principio della localizzazione della ricchezza basata su luogo in cui si trova l’utente o in cui avviene il consumo.

PAROLE CHIAVE: tassazione - internazionale del reddito - competenza dello stato - criteri di collegamento

The International Court of Justice has required a ‘genuine link’ for the exercise of jurisdiction. Two kinds of links are firmly established in international income taxation: the residence and the source principles, the latter relying on the State in whose territory the value was created. This framework was developed for the ‘brick and mortar industry’. It now has to be adapted to an economy, which is not necessarily linked to the territory of a particular State, as e.g. digital services. States, the European Union and the OSCE are trying to adapt to these new developments. Generally, the user or consumption – based principle is gaining ground.

Sommario:

Section A. Introduction. - I. The Lotus Case and the Principle of Territoriality. - II. The Nottebohm Case and the 'Genuine Link'. - III. The Reasonable Exercise of Jurisdiction. - Section B. Links/Nexus in Tax Law. - IV. Residence Taxation. - V. Source Taxation. - Section C. The Genuine Link Requirement for Source Taxation. - VI. Lack of Adequate Rules. - VII. Virtual Establishments, Place of Consumption, and the Destination Principle. - Section D. The Future: Apportionment Or Move Towards Indirect Taxation? - VIII. Apportionment. - IX. Move Towards Indirect Taxation. - X. Conclusions. - NOTE


Section A. Introduction.

My topic, the ‘genuine link’ requirement for source taxation in public international law, is broader than the general topic of this book, digital economy taxation. Rather, rethinking genuine link or nexus requirements is an issue concerning the modern globalized economy as such. The underlying question, i.e. in which country persons or transactions can and ought to be taxed, is not limited to the digital economy [1], even though it seems most vital there. [2] Some, including the Confédération Fiscale Européenne (CFE) [3], therefore maintain that creating a special regime for digital companies – ‘ring-fencing’ them – would violate the ‘principle of neutrality’ espoused under the internationally agreed-upon Ottawa framework. According to this Ottawa Principle of Neutrality, ‘[t]axation should seek to be neutral and equitable between forms of electronic commerce and between conventional and electronic forms of commerce.’ [4] But, of course, the notion of genuine link can be understood differently with regard to the specific nature of the business in question. As a starting point, let me explain the concept of genuine link in public international law (Section [A]), then briefly refer to the usual links in tax law (Section [B]), in order to reflect on links or nexus with respect to source taxation (Section [C]), and, finally, on potential future developments (Section [D]). In light of the principles established by the Permanent Court of International Justice (PCIJ) in its Lotus Case [5] and the International Court of Justice (ICJ) in its Nottebohm Case [6], restrictions on a state’s power to tax cannot be presumed as long as there is a ‘genuine link’ between the taxing state and the taxpayer or the subject matter. [7]

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I. The Lotus Case and the Principle of Territoriality.

In the Lotus Case, the PCIJ stressed the principle of territoriality, as did recently Advocate General Bobek in the tax case Hornbach-Baumarkt before the Court of Justice of the European Union (CJEU).[8] The facts underlying the Lotus Case were as follows: On 2 August 1926, a collision occurred on the high seas between the mail steamer Lotus, flying the French flag, and the collier Boz-Kourt, flying the Turkish flag. The Boz-Kourt sank and eight Turkish nationals lost their lives. Upon arrival of the Lotus in Istanbul, the Turkish authorities made inquiries and undertook criminal proceedings against both Lieutenant Hassan Bey, the captain of the Boz-Kourt, and the officer of the watch on board the Lotus at the time of the collision, Lieutenant Demons, a French citizen. The issue was whether Turkey had violated principles of international law by instituting proceedings against a French national acting on board a French vessel on the high seas. France maintained her exclusive jurisdiction as flag state. According to the PCIJ, the first and foremost restriction imposed by international law upon a State is that – failing the existence of a permissive rule to the contrary – it may not exercise its power in any form in the territory of another State. In this sense jurisdiction is certainly territorial; it cannot be exercised by a State outside its territory except by virtue of a permissive rule derived from international custom or from a convention, [9] or with the consent of the other State concerned. [10] This restriction refers to a state’s jurisdiction to enforce rules, which cannot be exercised extraterritorially. Thus, normally, a state cannot collect taxes or undertake audits in another state’s territory. Joint audits by the fiscal authorities of two different Member States of the European Union (EU) in the territory of one of those states, as they have been introduced recently, are permitted by the consent of the participating states and by the supranational law of the EU. [11] However, the Court continued, it does not follow that international law prohibits a State from exercising jurisdiction [to prescribe or to adjudicate] in its own territory, in respect of any case which relates to acts which have taken place abroad, and in which it cannot rely on some permissive rule of international law. [12] International law does not contain a general prohibition on states to extend the application of their laws [continua ..]

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II. The Nottebohm Case and the 'Genuine Link'.

In the Lotus Case, the PCIJ stressed the principle of territoriality, as did recently Advocate General Bobek in the tax case Hornbach-Baumarkt before the Court of Justice of the European Union (CJEU). [17] The facts underlying the Lotus Case were as follows: On 2 August 1926, a collision occurred on the high seas between the mail steamer Lotus, flying the French flag, and the collier Boz-Kourt, flying the Turkish flag. The Boz-Kourt sank and eight Turkish nationals lost their lives. Upon arrival of the Lotus in Istanbul, the Turkish authorities made inquiries and undertook criminal proceedings against both Lieutenant Hassan Bey, the captain of the Boz-Kourt, and the officer of the watch on board the Lotus at the time of the collision, Lieutenant Demons, a French citizen. The issue was whether Turkey had violated principles of international law by instituting proceedings against a French national acting on board a French vessel on the high seas. France maintained her exclusive jurisdiction as flag state. According to the PCIJ, the first and foremost restriction imposed by international law upon a State is that – failing the existence of a permissive rule to the contrary – it may not exercise its power in any form in the territory of another State. In this sense jurisdiction is certainly territorial; it cannot be exercised by a State outside its territory except by virtue of a permissive rule derived from international custom or from a convention, [18] or with the consent of the other State concerned. [19] This restriction refers to a state’s jurisdiction to enforce rules, which cannot be exercised extraterritorially. Thus, normally, a state cannot collect taxes or undertake audits in another state’s territory. Joint audits by the fiscal authorities of two different Member States of the European Union (EU) in the territory of one of those states, as they have been introduced recently, are permitted by the consent of the participating states and by the supranational law of the EU. [20] However, the Court continued, it does not follow that international law prohibits a State from exercising jurisdiction [to prescribe or to adjudicate] in its own territory, in respect of any case which relates to acts which have taken place abroad, and in which it cannot rely on some permissive rule of international law. [21] International law does not contain a general prohibition on states to extend the application of their [continua ..]

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III. The Reasonable Exercise of Jurisdiction.

The United States (US) Restatement (Fourth) of Foreign Relations Law also states that customary public international law governing jurisdiction to prescribe requires ‘a genuine connection between the subject of the regulation and the state seeking to regulate’. [27] The US, a major tax jurisdiction, generally follows customary public international law in this respect, exercising jurisdiction to prescribe on each of the traditional bases recognized internationally. Moreover, in assessing the geographic scope of federal law, US courts apply three principles of interpretation. The first one is a presumption against extraterritoriality based on ‘the comity of nations’. [28] They ‘interpret federal statutory provisions to apply only within the territorial jurisdiction of the United States unless there is a clear indication of congressional intent to the contrary.’ [29] The second one is the principle that ‘[i]n interpreting the geographical scope of federal law, US courts seek to avoid unreasonable interference with the sovereign authority of other states’. [30] The third one is the principle of avoiding conflicts with customary international law. [31] This common law presumption has its roots in an 1804 Supreme Court case according to which an act of Congress ought never to be construed to violate the law of nations if any other possible construction remains. [32] But later, customary international law rules on prescriptive jurisdiction became less territorial, as we have seen from the above-cited Lotus and Nottebohm Cases. [33] The more the US, as well as the EU, adopt extraterritorial rules, the more comity or friendship and respect between nations are indeed needed to resolve the resulting jurisdictional conflicts. [34] In contrast, a state’s jurisdiction to enforce rules is in principle strictly bound to its territory. [35] Consequently, tax laws may refer to persons and property outside the territory of the regulating state, but, generally, there would be no jurisdiction to enforce, i.e., to collect such taxes abroad. However, Article 11 of the Organisation for Economic Co-operation and Development (OECD) Convention on Mutual Administrative Assistance provides that ‘the requested State shall … take the necessary steps to recover tax claims’ of the applicant State ‘as if they were its own tax claims’. But not all states are [continua ..]

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Section B. Links/Nexus in Tax Law.

Two types of tax jurisdiction are generally recognized: (1) the unlimited jurisdiction to tax persons on the basis of their nationality, domicile, or residence and (2) the limited jurisdiction of the source country.

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IV. Residence Taxation.

In most countries, it is not citizenship but rather residence that determines the tax jurisdiction over an individual (residence taxation). For the US, an individual is a taxable person if he or she is either a resident or a citizen. Usually, an individual’s residence depends upon the length of his or her physical stay. Roughly, if a person spends half a year or more in a particular country, he or she is considered a resident for that year. [38] But merely maintaining a residence in a country without actually being there might suffice. For companies, there are basically two nexus for ‘residence’ taxation: (1) their place of effective management or (2) their place of incorporation. [39]

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V. Source Taxation.

The principle of source taxation, by contrast, relies on the source (country) where the income is generated.[40] There are more and more individuals and companies whose ‘residence’ is in one country but whose business is carried out and whose income is generated in another country. In such cases, the principle of residence-based taxation does not seem appropriate.

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Section C. The Genuine Link Requirement for Source Taxation.

Source taxation, as opposed to residence taxation, thus relies on the idea of taxation by the state within whose territory the value is created. Such taxation is traditionally based on business done or property located in the territory of a particular state, or transactions that occur, originate, or terminate in the territory of that state or have some other substantial connection to that state. Insofar as taxation is source-based, the nationality, domicile, residence, and presence of the parties to such transactions are irrelevant. [41]

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VI. Lack of Adequate Rules.

But, as EU Commissioner Moscovici has pointed out, our tax framework does not fit anymore with the development of the digital economy or with new business models, [42] unless it is understood differently. First, in the digital economy – e.g., in the on-line advertising business – it is possible for values to be created all over the world by people from different nations, who might, in addition, move across borders. Second, as value in the digital economy can be created anywhere, companies are free to choose low-tax countries, such as Ireland, for their headquarters. That practice cannot always be said to be ‘abusive’, as those companies do not necessarily evade taxes in a particular country where they should be paid. [43] In principle, the lack of adequate rules cannot be attributed to – let alone be a basis for reproach of – the taxpayer in all of the cases. Therefore, it is not clear whether just applying all base erosion and profit shifting (BEPS) Action Plan [44] and EU anti-tax avoidance measures could solve the problem, as it is sometimes maintained. [45] And third, nowadays, users also contribute to the value of a digital enterprise. [46] Nevertheless, even Internet giants like Amazon generally rely on a functioning state structure including courts, energy, transportation, and waste disposal, just as other tax-paying businesses do. [47] Therefore, they should also be taxed similarly to other businesses. However, many digitalized businesses can be heavily involved in the economic life of different jurisdictions without any (significant) physical presence (scale without mass). [48] Therefore, the traditional nexus rules do no longer work. Failure to adapt international nexus rules has led to unilateral measures in many countries, including EU Member States. [49] Especially within the EU, unilateral measures tend to cause problems with regard to the functioning of the internal market, the basic freedoms, and the general prohibition of discrimination. A new perspective with regard to nexus rules is, therefore, badly needed. [50]

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VII. Virtual Establishments, Place of Consumption, and the Destination Principle.

This, of course, leads to the discussions about ‘virtual establishments’, ‘significant economic presence’, and ‘intangible presence’ and how those terms could be defined. The starting point is that tax jurisdiction relies on the idea that there should be a fair relation between state-provided services, benefits, and opportunities [51] on the one hand, and taxation on the other. a) Redefining Territoriality. – In some types of businesses, the only reliably determinable link to the territory of a state and, thus, to the internationally recognized principle of territoriality, is consumption. But, whereas a citizen, resident or person doing business in a state can be presumed to profit from the services, benefits, and infrastructure of that state, the same does not hold true as easily when it comes to selling or providing intangible services in a country via the Internet. Sales and consumption are recognized nexus for sales taxes and value-added tax (VAT) but not, traditionally, for income taxes. Factors like sales and consumption can be used to apportion income among several states but, traditionally, only under the condition that the taxable person has some, even intangible, presence there. These factors alone have not been considered sufficient to establish the necessary link for income taxation.[52] However, EU Member States have occasionally recognized that the taxpayer need not have a tangible, physical presence in a state for income to be taxable there[53]. According to that view, any corporation that regularly exploits the markets of a state should be subject to that state’s jurisdiction to impose an income tax, even if not physically present there. [54] Under Article 5 of the Commission’s new proposal on taxing digital services, taxable revenues obtained by an entity are to be treated as obtained in a Member State if the users of that taxable service are located in that state. [55] Similarly, the OECD, in its 2015 OECD BEPS Action 1 Report, stated that ‘[f]or consumption purposes internationally traded services and intangibles should be taxed according to the rules of the jurisdiction of consumption’. [56] Numerous tax jurisdictions are already taking their lead from the OECD’s recommended approach to taxing the digital economy. [57] This indicates that these states agree on the destination principle. The destination principle has the additional [continua ..]

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Section D. The Future: Apportionment Or Move Towards Indirect Taxation?

Two problems, thus, remain: First, as mentioned above, sales and turnover may provide an important factor for apportioning the tax load of a taxable person in a particular state. Yet, those factors are not generally recognized as a sufficient link for income taxation in the first place, even though state practice seems to be in the process of changing. Second, as turnover does not equal profits, a destination – or consumption based nexus leaves us with the problem of determining the profits of the corporation.

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VIII. Apportionment.

If those two problems can be overcome – that is, if there is some (potentially intangible) presence and if a corporate taxpayer’s business income or ‘apportionable income’ can be determined – apportionment could mitigate the problem of ‘unfair’ distribution of tax revenues between the Member States of the EU. [74] Member States would have to use an apportionment formula to calculate the percentage of any income that is subject to their income tax. Apportionment, which has been practiced in the US, Canada, and Switzerland [75] for decades, was already suggested to the European Commission at the beginning of this century [76] and underlies the Commission’s 2018 DST Directive Proposal. [77] However, it presupposes the adoption of the Common Consolidated Tax Base. [78] Though the US Supreme Court upheld California’s proportionate taxation of the worldwide income of unitary businesses, [79] California soon repealed its unitary business tax and such apportionment is rather used in interstate relations, but not when one of the taxing entities is a foreign sovereign. [80] In any case, unitary taxation with apportionment but without a common consolidated tax base creates a risk of double taxation. But, if generally applied within the EU on the basis of a common consolidated tax base, taxing only the relevant percentage could avoid double taxation without any need to conclude double taxation agreements. EU Member States would then have to agree on an apportionment formula. In the US, there has been a development over the past twenty years, from a formula with three equally weighted factors – (1) sales, (2) payroll, and (3) property [81] – to an enhanced or single sales factor [82]. This mirrors the development of the modern, digitalized economy where sometimes only sales or consumption can be linked with certainty to a specific state territory. [83] The sales factor is the ratio of the taxpayer’s sales within the territory of the taxing state to the taxpayer’s total sales. Even though apportionment is conceptually simple, it may prove difficult in practice to calculate with precision the amount of income that is properly taxable in a particular state. Nevertheless, the apportionment rules developed in the US do provide a ‘reasonable approximation’ of a corporation’s in-state level of activity and therefore sufficiently [continua ..]

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IX. Move Towards Indirect Taxation.

As consumption typically relates to indirect taxes, an alternative would be to globally enhance VAT and to work on its effective collection worldwide. [89] Both source and residence taxation have become more and more difficult to handle for a growing category of cross-border economic activities. VAT, on the contrary, is successfully being introduced in more and more countries and is constantly becoming more important. [90] With respect to the present issue, businesses whose value creation cannot be localized reliably could be obliged to collect a potentially higher VAT on their goods and services. [91] That approach, combined with the destination principle, would also affect the allocation of tax revenues between the state of the corporation and the state of consumption; tax revenue in the countries of the shareholders might decrease whereas tax revenues in the countries of consumption might increase. Such a result would meet some of the concerns underlying the quest for an adaptation of the nexus requirement by recognizing the concept of a significant economic presence while posing a significantly lower risk of double taxation. However, the trend from direct towards indirect taxation may hit the wrong persons, namely consumers instead of big business.

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X. Conclusions.

The foregoing leads to the following two conclusions: (1) Income taxation presupposes a genuine link to the taxing state. Just providing or selling services via the Internet has not generally been considered sufficient. However, state practice is becoming more lenient. The notion of user -or consumption-based value creation is gaining ground. (2) Insofar as some link to the taxing state can be established through at least an intangible presence, apportionment can contribute to a fairer distribution of tax revenues between EU Member States. However, it presupposes a common consolidated tax base and at least similar apportionment formulas.

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NOTE

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