Tolley® Exam Training ADIT PAPER 1 PART I CHAPTER 2

CHAPTER 2

TAX AND TAX SYSTEMS

In this chapter we will explore:

– common factors inherent in federal and municipal tax systems
– Adam Smith’s four axioms of efficient tax systems: equality, certainty, convenience
and economy in collection, including lack of intrusion
– global trends of lower tax rates and widening of the tax base

2.1 Introduction

In this chapter, we will look at some elements of taxation law that can be found
around the world. This chapter is important as it gives an understanding of some of
the ways in which domestic tax law can operate. Later on in the manual we will
see how domestic rules operate when a DTT is in place.

2.2 Federal Systems and Local-level Taxes

We can subdivide tax systems into the following areas, which are applicable to tax
systems at both the federal and local levels in a sovereign state:

• Direct taxes

• Indirect and transaction taxes

• Branch profits tax

• Source and residence concepts

• Income determination

• Losses

• Group taxation

• Tax incentives

• Anti-avoidance measures

• Withholding taxes

• Tax sparing

• Double taxation relief

Let’s look at each in turn.

Direct Taxes

These are taxes on income, profits and gains. They can be:

• ‘flat’, ie a single tax rate applies,

• ‘progressive’, ie increasing rates of tax apply on higher levels of income and

gains, and

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• ‘regressive’, ie decreasing rates apply to higher levels of income or gains,

which are less common in practice.

Many tax systems distinguish between:

• profits arising from ‘capital’ assets (ie those that are held as investments or as
part of a trade to enable the trade to be carried on) and

• those from ‘revenue’ activities (ie on-going activities which provide an

income, eg a trade or rental activity).

Sometimes capital gains are not taxed (eg in Jersey and other low tax
jurisdictions).

Different taxes apply to different ‘persons’, ie individuals, companies and

corporate bodies. Income tax, corporation tax, social security, wealth and
inheritance taxes are common.

Determining which people or bodies are liable to which taxes is sometimes not
straightforward. Some corporate bodies are ‘opaque’/‘non-transparent’ in nature
and subject to a corporation tax, others are regarded as ‘transparent’ and the
individuals or companies that own those bodies are subject to tax (eg in the case
of many partnerships) but not the body itself.

The distinction between ‘transparent’ and ‘opaque’ entities, ie ‘entity

characterisation’, is discussed in more detail in later chapters.

Indirect and Transaction Taxes

These are taxes on the proceeds of transactions.

They include sales taxes, value added tax, registration and stamp taxes. Generally,
unlike a direct tax, the tax is applied to the proceeds of the transaction with no
regard for deductions against the proceeds.

As in the case of direct taxes, sometimes there is a distinction for a transaction that
is ‘exempt’ from tax and one that is subject to ‘zero rate’ – the UK value added tax
makes such a distinction.

As much as any other tax, these taxes may take into account whether the items
being taxed are an economic necessity or a luxury. The latter are generally subject
to higher taxes.

The reason why certain taxes are called ‘indirect taxes’ is that the customer does
not pay the tax directly to the tax authorities; the supplier of the goods or services
does so.

In a wider economic sense all taxes can have an indirect effect; the price of
goods can be a reflection of direct taxes as well as indirect taxes.

Branch Profits Tax

Some states apply a higher rate of tax on foreign companies with a permanent
establishment or branch in their state. The US does (30% on after-tax net profit,
additional to ‘normal’ tax, applied to foreign companies).

There is a strong contention that in the case of the EU such a tax is discriminatory
and contravenes the freedom of establishment concept. In the case of other

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countries a possible line of argument is infringement of the non-discrimination

article of a tax treaty. The application of such an article is discussed in a later
chapter. The question then arises, as in the case of the US, whether subsequent
domestic law enacted after the ratification of a tax treaty overrides the terms of a
tax treaty (the concept of treaty override is discussed in a later chapter). The
additional amounts payable under a branch profits tax may be held to be
equivalent to a dividend withholding tax, which would have been payable by a
local company if a distribution had been made of the same amount of profits
made by the branch. If that is the case a taxpayer could still claim discrimination if
the dividend withholding tax under the relevant tax treaty would have been less
than that charged under domestic law.

Source and Residence Concepts

These are the connecting factors applied by a state in taxing income and persons.
We will look at these in more detail in a later chapter.

Income Determination

This covers a whole host of issues in relation to the different factors that affect
income measurement, ie what deductions can be offset against the gross income
(eg depreciation: see below), what valuation factors are used in deriving income
(eg stock valuation), how inter-company dividends are assessed, how foreign
income and dividends are assessed, to what extent the tax rules follow
international accounting standards.

A state may allow the depreciation shown in the accounts as a deduction for tax
purposes (typically in continental Europe), or there may be specific rules giving
different rates of depreciation for different assets. In the UK depreciation for tax
purposes is referred to as ‘capital allowances’. It may be possible to obtain
enhanced allowances in the first year for certain capital expenditure, which is
possibly subject to a claw-back at a later date when the asset is sold by the
business. There are rules that allow the written-down values to be preserved on
mergers or take-overs or reorganisations, so that the capital allowances due
remain the same despite changes in ownership.

Losses

Tax losses are treated in different ways. Most jurisdictions allow such losses to be
offset against other income in the same period or future periods (for example,
indefinitely in the UK against total profits, subject to a restriction, or in the US, pre-
2018 up to twenty years, post-2018 indefinitely). Some jurisdictions permit losses to
be carried back. In the UK trading losses for companies can be carried back
against total profits of the previous 12 months, or in some instances a further two
years. In the US pre-2018 net operating losses could be carried back two years –
this carry back was removed in the 2018 tax reforms.

Group Taxation

In certain countries losses of one company can be offset against another’s profits
where they are within the same group or consortium as defined. In the UK a group
relationship can exist where there is a 75% (or less in the case of a consortia)
relationship between companies whereas the US requires an 80% relationship
between group members. Unlike the UK, the US has a formal tax consolidation
system whereby a company’s tax results are included in the parent company or
representative company’s results. Intra-group transfers of assets can be tax free
and so can the payment of dividends.

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Tax Incentives

Every country has different degrees of economic advantage, as the famous

nineteenth century economist David Ricardo’s exposition of ‘comparative
advantage’ made plain. Some countries are more able to provide certain
products or services than others. Natural advantages arise from geographic
location and climate.

Imposing tariffs tends to hinder the process of trade between nations and
therefore can lower overall global output to the disadvantage of all nations. The
purpose of the 1947 General Agreement on Tariffs and Trade (and subsequent
agreements) was to provide a global framework for worldwide trading stability.
These issues are addressed in Part V of this manual. Besides tariffs, some countries
employ tax incentives to try to gain a competitive advantage. These may or may
not be to the benefit of global trade.

Typically, a number of countries provide tax credits for research and development.
For example, UK companies may obtain a tax credit on certain R&D expenses.
These credits can be in addition to the normal tax deduction of those expenses. In
the UK small and medium companies receive an enhanced deduction of 230% for
R&D expenses as well as a payable tax credit of 14.5%. The Australian R&D system
gives a (refundable) R&D credit of currently 43.5% for companies with group
turnover less $20m, 38.5% (non-refundable) for all other eligible entities.

Other incentives exist to encourage specific economic behaviour, such as

increasing employment or exports or conversely inbound investment, eg in the
form of tax holidays or tax-free zones. The OECD or EU may regard some of these
state incentives as ‘harmful conduct’. However, this is a highly controversial area
as such incentives may in economic terms also advantage other nations.

Anti-avoidance Measures

As we will see in later chapters, the OECD, EU and the UN are increasingly
encouraging countries to introduce anti-avoidance measures to counter ‘harmful
tax practices’ by taxpayers within states or between taxpayers in different states.

Withholding Taxes

Worldwide tax guides produced by professional advisers generally provide details

as to the rates of withholding taxes applying to the payment of dividends, royalties
and interest. Under domestic law a state can require a person to withhold tax on
making a payment to another person. Thus a withholding tax is suffered by the
recipient, although the payer deducts it and pays it to the tax authority. The tax is
normally applied to gross payments (eg subject to the terms of a tax treaty, the US
applies a 30% tax on dividends, interest and royalties; similarly the UK applies a
withholding of 20% to interest and royalties, subject to treaties and certain
statutory exclusions).

As we will see in a later chapter, the domestic rates can then be reduced by
bilateral double tax agreements with other countries.

In some cases the rates can be reduced to 0% eg if the EU Directives on the

payment of dividends between parent and subsidiary companies in EU Member
States (2011/96/EU) and on the payment of interest and royalties (2003/49/EC)
apply (we will look at this in a later chapter). The EU is considering updating its
withholding tax system (consultation in 2022), as the current approach is
considered complex, costly and is not delivering the right results for financial

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intermediaries, investors and tax authorities. This would simplify matters with a focus
on the benefits of potential standardisation, lower costs and better compliance.

Tax Sparing

Some tax treaties enable an investor to obtain a tax credit for foreign tax not
actually paid, but which would have applied but for the existence of a tax holiday
of some sort. Typically, this incentive, known as tax sparing, was designed to
encourage inbound investment in developing countries. However, the availability
of such relief is now less frequent as those countries become more developed.
There is more detail on tax sparing in a later chapter.

Double Taxation Relief

Such relief is either available under domestic law (referred to as ‘unilateral’ relief)
or under the terms of a tax treaty (‘bilateral relief’). There are three ways of
obtaining relief for foreign tax charged on income subject to tax under domestic
law:

1. Exemption. A typical example is the Dutch participation exemption from

Dutch tax on dividends received by a Dutch company or the UK dividend
exemption system applicable from 1 July 2009. Similarly, in the UK capital gains
on the sale of qualifying shareholdings might be exempt from tax.

2. Credit relief. The foreign tax reduces the charge to domestic tax by being set
off against that tax – typically there is a cap on the foreign tax available for
credit equal to equivalent domestic tax rate on the income assessable to tax.
The UK system is in the main based on a credit relief (or deduction where it is
not possible to obtain credit relief: see below).

3. Deduction against assessable income. This is normally the least beneficial way
of relieving a foreign tax except where there are overall losses. Foreign tax is
treated here as a deductible expense which may be included in losses.

The above methods may equally apply to the relief of local municipal taxes
against federal level tax. In the US local state taxes may be deducted for federal
tax purposes. Certain foreign local state taxes, as well as federal taxes, can also
be credited for UK tax purposes. Again each of the above will be considered in
more detail in a later chapter.

2.3 Adam Smith’s Four Axioms for Efficient Tax Systems

Over 240 years ago (in 1776) the Scottish economist Adam Smith’s The Wealth of
Nations was published to great acclaim. Besides the famous concept of the
‘invisible hand’ and the advantages of the division of labour, the main focus of the
text is on the economic history of nations. It includes a significant exposition on
taxes in the chapter headed, ‘Of the sources of the general or public revenue of
the society’ (Book V, Ch 2).

To quote:

‘All nations have endeavoured to the best of their judgement, to render their
taxes as equal as they could contrive; as certain, as convenient to the
contributor, both in the time and in the mode of payment, and in proportion
to the revenue which they brought to the prince, as little burdensome to the
people.’

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The above comments follow on from four stated axioms, or maxims (accepted
truths), that should be present in all efficient tax systems. These are:

• equality;

• certainty;

• convenience of payment; and

• economy in collection.

These are discussed in turn below.

Equality. Taxpayers should pay tax in proportion to their respective abilities to pay
tax, ie in proportion to their relative earnings. Adam Smith compared this to the
joint tenants of an estate who should pay maintenance payments in accordance
to their interests in that estate.

Certainty. It needs to be clear as to the amount of tax that needs to be paid, the
timing of the payment and the manner of the payment. If these are not certain,
but are arbitrary, then ‘every person that is subject to that tax is put more or less in
the power of the tax-gatherer, who can either aggravate the tax upon any
obnoxious contributor, or extort, by the terror of such aggravation, some present or
perquisite to himself’. Uncertainty leads to corruption. In Adam Smith’s eyes,
uncertainty was a far worse evil than inequality in the burden of tax.

Convenience of payment. Tax ought to be levied at a time which is most likely to

be convenient to the payer. In this sense taxes on consumables (ie indirect tax,
such as value added tax) are a convenient tax for the consumer (and may be
argued to be convenient to the supplier since he has earned the revenue from
that sale to pay the tax).

Economy in collection. The cost of raising taxes should be minimised. Adam Smith
made a number of observations as to factors that affect such costs:

1. The number of tax officers and their pay needs to be proportionate.

2. The levying and assessing of taxes can divert the attention of businesses from
dealing with their day-to-day commercial activities, which can benefit the
nation far more by increasing employment and output.

3. Penalties and forfeitures for the non-payment of tax may ruin an individual
who might otherwise have used his capital to the benefit of the community
and increased employment. Great care therefore needs to be exercised by
government to avoid exacerbating difficult financial situations of taxpayers to
the long-term detriment of society.

4. Frequent visits and ‘odious’ examinations by tax officers may expose taxpayers
to ‘much unnecessary trouble, vexation, and oppression’. Although it is not
possible always to measure the cost of excessive acts it can be
psychologically damaging to the taxpayer as well as a waste of his, and
indeed the government’s, time and resources, leading to diversions damaging
to the economy.

Interestingly, in 2017 the OECD and the IMF published a report – Tax Certainty –
outlining a set of approaches to help policymakers and tax administrations shape
a more certain tax environment. Later reports show clearly that this remains a
priority for both taxpayers and tax administrations. For example, changes that are
being made within the global community with regard to dispute prevention (rather

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than resolution), country-by-country reporting, joint audits and the work to make
transfer pricing rules simpler and easier are all found to be contributing to greater
tax certainty. The OECD held its first ‘Tax Certainty Day’ in September 2019, which
brought together tax administrations from over 50 countries. The event provided
an opportunity for tax policy makers, tax administrations and business
representatives to review and discuss further improvements in both dispute
prevention and resolution.

A second such day was held in November 2020. Comments were invited on the
review of the implementation of BEPS Action Point 14 (Making dispute resolution
mechanisms more effective) which includes one of the minimum standards. The
discussions covered bilateral and multilateral mutual agreement procedure (MAP)
processes as well as the International Compliance Assurance Programme
(discussed in a later chapter), and the use of advance pricing arrangements
(APAs). Then in November 2021, a third Tax Certainty Day was held, during which
the latest MAP statistics were issued. Tax officials and stakeholders met virtually to
review the tax certainty agenda and discuss how to improve dispute prevention
and resolution – which remains a key area of discussion.

When you consider the calls for companies to pay their fair share of taxes, the
desire for greater clarity and certainty in modern tax regimes, and the move
towards online submissions and payments, it can be seen that the above
concepts are as relevant today as they were 240 years ago.

2.4 Trends in Taxation Globally

Until recently the main trend since the mid-1980s has been for global corporate tax
rates to be reduced (consider the UK’s 2022 CT rate of 19% compared to a rate of
30% in 2007) and for the tax base (ie the taxable income and profits) of taxpayers
to be widened. The latter has been partly achieved by reducing the availability of
accelerated tax depreciation allowances (eg in the UK the reduced scope of
100% first year allowances) and the removal of special tax reserve deductions and
reliefs (eg in Scandinavian countries). The US tax reforms reduced corporate tax to
21% in 2018, a significant drop from 35%.

Many Eastern European countries have introduced low flat rates, in the order of
18%. Until recently, this had been something of a global trend as nations also
considered a policy of further removals of incentives, which may distort investment
behaviour, and taxing businesses more closely on their accounting results based
on international accounting standards. The EU accepted that Ireland could apply
a 12.5% corporate tax rate on active (as opposed to passive investment) income
as from 1 January 2003.

This ‘race to the bottom’ in corporate tax rates in some countries is also a sign of
tax competition between states, which is something the OECD has indicated it
does not support, as can be seen in BEPS Action Point 5, which specifically focused
on what it called harmful tax competition. That action point considered regimes
which target certain types of income, such as beneficial tax rates for intellectual
property (IP) income (so called ‘patent box’ arrangements), and requires states to
introduce substantial activity requirements to connect such income to the R&D
activity which generated the IP. As already noted, in 2019 countries such as
France and Germany had suggested a minimum effective corporate tax rate was
needed globally. This was linked with the ongoing OECD work on the taxation of
the digital economy, and this can now be seen in the latest proposals in this area,
in particular the proposed Pillar Two which puts forward such a global minimum tax
rate (see later chapter).

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Indeed, such matters have been accelerated by the COVID-19 pandemic, and
the need for states to increase their tax take in order to fund the support provided
during the pandemic. The new US administration under Biden is in favour of an
approach which imposes such a minimum tax rate on a global basis. An updated
version of the Pillar Two proposals, which implements the GloBE regime to
counteract base erosion (part of BEPS 2.0, as noted in the previous chapter),
includes a minimum corporate tax rate, which the US proposed to be set at 21%.
At the G7 meeting in June 2021 whilst agreement was reached on a global
minimum rate, the rate suggested would be ‘at least’ 15%, rather than the much
higher US proposal. Then in July 2021 a statement was issued by the OECD which
committed 130 countries, including the G20 states, to go forward with the ‘Two-
Pillar’ proposals, including a 15% minimum tax rate. Notably nine countries did not
agree at this stage (although later agreement was reached), including Ireland
(which has a 12.5% corporate tax rate) and Hungary (which has a 9% corporate
tax rate), amongst others such as Estonia, Barbados, Kenya and Nigeria. Further
discussions on the technical details have been ongoing with implementation
proposed for 2023.

There is a tension between the perceived need for governments to make welfare
and infrastructure improvements, and now to ‘pay’ for the pandemic, and the
desire of taxpayers to pay less tax, especially when taxes represent over 40% of a
nation’s GDP. Combatting tax evasion and avoidance would help tax revenues,
and the proposals under the BEPS project are for many countries now a reality,
following the multilateral instrument implementing treaty changes which came
into force on 1 July 2018. However, the taxation of the digital economy, and digital
businesses, has remained a problematic area and the 2021 agreement with
regard to the Two-Piillar approach, as seen in later chapters, is long overdue.

More generally, as a response to the pandemic and other economic pressures,

some countries have already started to increase their tax rates - for example Biden
has proposed to increase the US corporate tax rate to 28% from 2023.

One area which is receiving more attention is the issue of energy taxes, and
environmental taxes. Recent OECD reports support higher energy taxes. It is also
suggested transferring a proportion (a third) of additional revenues generated by
carbon pricing reforms to poor households to improve energy affordability. The
OECD observed in its 2019 report that well-designed systems of energy taxation
would encourage citizens and investors to favour clean over polluting energy
sources. However, the report notes that whilst fuel excise and carbon taxes are
simple and cost-effective tools to limit climate change, the politics of carbon
pricing often proves challenging. It concludes that governments are not deploying
energy and carbon taxes to their full potential, citing evidence that tax structures
are poorly aligned with the pollution profile of energy sources and that taxes
generally are not being used to provide meaningful carbon prices for any fuel. This
is an area where there is still some way to go. In 2022/23 we have seen other
pressures on fuel taxes, as the price of oil soars under the pressure of political
instability in Eastern Europe. In the meantime the EU published new proposals in
2021 on energy taxation, its Green Deal, which proposes higher taxes on the most
polluting energy products, on the basis that the EU intends to become carbon
neutral by 2050. The EU is also pushing Member States to introduce green taxes.

Environmental tax issues for developing nations are also under consideration by
the UN Tax Expert Group.

It is also notable that a 2017 EY report stated that a significant proportion of tax
and finance executives considered that geopolitical uncertainty was shifting tax
risk from emerging markets to developed economies, such as the US, the UK,
Australia, China and India. Such global uncertainty continues, with the added

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prospect of trade wars on tariffs, the fall out from the COVID-19 pandemic,
political instability in Eastern Europe, and the prospect of rising inflation and
recession. The move towards greater information exchange and tax co-operation
since BEPS has helped to counteract such tax risks to some extent, and preventing
avoidance is often high on the agenda when recession means a lower tax take
more generally.

We will see in a later chapter that there has been a marked increase in
transparency in tax systems with significant global information exchange
becoming the norm, in addition to the concerted actions which have been taken
to prevent tax avoidance and the current push to stop global base erosion.

2.5 Points to Consider

This chapter contains subjects which tend not to be the main area of a question
themselves, but which are very useful as concepts or examples to bring in as part
of an essay. An understanding of different taxes and tax systems will help when
looking at the other chapters in the manual, and with putting the discussions in
context. It will also assist with terminology.

Issues such as the need for tax certainty, or the trends in global taxation more
generally, are likely to be useful to include in questions that ask about topical
issues, such as the move towards greater cooperation in tax matters, as
evidenced by the work on matters such as the Common Reporting Standard, or
the BEPS project, as well as the work undertaken more recently to combat tax
avoidance, such as the Pillar Two proposals (GloBE) and the minimum tax rate (see
later chapter on these issues). This chapter provides some good points which can
provide illustrations for different types of essay which might ask you to discuss or
comment on such topics.

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