Malta: The Tax Challenges Of The Digital Economy – Article 2
Main principles of direct taxation – Domestic Tax Rules
In our second article in a series of articles on the tax challenges of the digital economy, we shall be providing you hereunder with a brief overview of the principles of direct taxation, with a focus primarily on the taxation of cross-border income under domestic laws.
There are a number of principles which have guided the development of taxation systems. These include:
1. Neutrality, where a tax system seeks to be neutral and equitable between different forms of business activities.
2. Efficiency, where compliance costs to business and administration costs to tax authorities should be minimized as much as possible.
3. Certainty and simplicity, where tax rules should be simple and clear for everyone to understand. Complexity in tax systems might also trigger aggressive tax planning.
4. Effectiveness and fairness where tax systems should produce the right amount of tax at the appropriate time while avoiding both double taxation and double non-taxation.
5. Flexibility whereby tax system should be durable but at the same time flexible to keep and adapt to the changing needs of the economy.
A State’s right to tax depends on territory and residence, i.e. a State’s power over a territory to tax income derived within that territory and its power over a particular set of subjects to tax worldwide income derived by such subjects.
Domestic tax rules for the taxation of cross-border income generally takes into account the taxation of income derived from investments made by resident companies outside the country and the taxation of income derived from investments made by non-resident companies in the country. With respect to inbound investments in the country, the term ‘residence’ is crucial. Countries have different meanings of the term ‘residence’, with some adopting the place of incorporation as the crucial factor in determining residence while others adopt the concept of effective management and control. With respect to outbound investments made by non-resident companies, some countries use the world-wide system of taxation while others use the territorial system of taxation. Many countries use a combination of both systems.
A country having the former system will subject its residents to tax on all their income, irrespective of the country of source. This means that the country of residence must collect information on the foreign source income received by its residents. Under a territorial system of taxation, countries tax non-residents on income derived within their territory.
With respect to the taxation of income derived by non-residents, different countries adopt different methods. The concept of source rules is often similar to the concept of permanent establishment (PE) whereby only profits derived from a PE will be taxable. To avoid the impracticability of determining expenses, most countries tax income derived by non-residents by means of a withholding tax which is calculated on the gross income received, albeit at a very reduced rate. Such income often consists of interest, dividends and royalties.
