 Hello and welcome to the session. This is Professor Farhad and this session will look at tax jurisdiction. We will be looking at the worldwide approach, the territorial approach and anything in between. This topic is covered in international accounting as well as an international taxation course. This topic is covered on the CPA as well as the ACCA exam. LinkedIn is unique to connect with me if you haven't done so. It's greatly appreciated. YouTube is where you would need to subscribe. I have 1,500 plus accounting, auditing, finance and tax lectures. If you like my lectures, please like them, share them, put them in playlists, let the world know about them. If you listen to my lectures, it means you are benefiting. It means you could benefit other people as well. Share the wealth. On my website, farhadlectures.com, in addition to the lectures, I have notes, PowerPoint slides, practice multiple choice. And if you're studying for your CPA exam, I have 2,000 plus CPA questions. Please check it out. StudyBuddyPal.co is an artificial intelligence, StudyBuddy platform that match with a CFA or a CPA if you're looking to study with a group. They're located in 85 countries and 2,800 cities. A disclosure upfront about this topic, you just wanna let you know that this topic is complex. You could hire two experts and may give you different responses, especially if you hire an accountant versus a lawyer or two lawyers that have different risk alternative. So just make sure this video is for educational purposes. It's gonna help you learn the terms, explain the issue of needs to be explained to someone, but this is not a legal advice. So the first thing we're gonna look at is the scope of tax jurisdiction. What is the scope? Well, we're gonna be looking at two extremes. And those two extremes are worldwide approach and territorial approach. So simply put, what scope does government have in taxing you? Well, they could use the worldwide approach. What's the worldwide approach? It means all income of a resident of a certain country or a company incorporated in that country is taxed by that country, regardless where the income is earned. And this is basically very broad. It's a big scope. Simply put, if you are a resident of that country or if your company is incorporated in that country, it doesn't matter where you make your money. Let's assume you are a US. It doesn't matter where you make the money, the US will tax you. So foreign source income is taxed by the country of residents. For example, under worldwide approach, Canada can impose a tax on dividend income that the Canadian company earned in Hong Kong, even though the company was earned in Hong Kong, if Canada uses the worldwide approach, they have that reach, they have that long hand that could reach that income and tax that income. This is the worldwide approach. The territorial approach, well, simply put, only the income earned within the borders of that country is taxed. So simply put, if you operate within the borders of our country, this is when we tax you. Otherwise, if you are not operating within our borders, we do not tax you. This is basically, it's the other extreme because it's very limited, only if you operate there. So simply put, the dividend income earned by a resident of Botswana from investments in South Africa, South African stock will not be taxed in Botswana. Only a few countries follow the strict territorial approach to taxation. Some countries, the Dominican Republic, the Gabon and Jordan and Hong Kong as well. So those are the two extremes. That's the first thing we're gonna start with. Then we have to differentiate between when you operate as a branch versus a subsidiary. And this is important, especially for US when I start to talk about the US. It's very important to, how do you classify yourself? First, simply put, what's your legal form? Are you operating as a branch or are you operating as a subsidiary? Remember in the first one, when I started with this series of international taxation, I said your legal form is important. Now we're gonna talk a little bit more about the legal form. If you operate as a branch versus if you operate as a subsidiary, okay? If you operate as a branch, you're gonna be paying, this is called direct taxes and I'm gonna explain this in a moment. First of all, if you operate as a branch, you are not a separate legal entity of the parent company. So let's assume a US company, they have a branch in Mexico. If they're operating as a branch, well, guess what? That branch, in a sense, it's part of the parent company, it's not part of the US company, okay? And most companies, they would likely start as a branch. Basically, when you start to expand in a territory first, you might have a representative, an office, a branch. Then you eventually turn into subsidiary. So simply put, the income, any income that the branch earns, for example, the Mexican branch, our Mexican branch, it's basically USA income. Why? Because we're operating as a branch. Now, if we operate as a subsidiary, subsidiary is considered a separate legal entity from the company, from the parent company. Although it's owned by the parent company, but since it's incorporated in the foreign country, it's considered a subsidiary. Now, what's gonna happen is this, the income that the subsidiary earned, it's not income. Like for example, if we operated in Mexico as a subsidiary, it's not income until we send that money to the US in form of dividend, okay? Now this is important because the subsidiary gives you more flexibility. What does that mean? It means our subsidiary in Mexico will not send us any money unless in the US, the parent company is not doing well. If we're not doing well, let's repatriate some income and pay taxes on that now. It gives us some timing flexibility. And usually when you have a subsidiary, you're really sourcing your manufacturing facilities or you're actually manufacturing in that country. So simply put, a subsidiary from a business perspective, it means you are more involved. But all that you have to know is this from an overall picture. If you are a branch, you are still part of the parent company. If you are a subsidiary, in a sense you are independent. You are independent. Now in the US, there was a recent change in the law which we'll talk about in this session, okay? Now, again, back to the two extremes, we said the companies used the worldwide approach or those are the two extreme or the territorial approach. Most use the hybrid approach. So most countries, they don't go with either extreme. They used some type of a hybrid approach, okay? Tax some type of foreign income, but not others. Now, which is which we're gonna talk about a little bit further. For example, income earned by a foreign branch might be taxed by the parent company home country. Remember, a branch is basically still considered part of your company, but the income earned by a foreign subsidiary may be exempt from the home country taxation. So you tax the branch, you don't tax the subsidiary. This is referred to the term as participation exemption system. That's what the system called. And a majority, 28 of the 34 OECD member countries exempt some or all the foreign subsidiary income. So this is basically the developed countries mostly use the system. They participate in the system to a degree, to one degree or another. For example, Australia and New Zealand exempt 100% of foreign subsidiary income from all countries. So very subsidiary, you're exempt. We don't have to tax you. Germany and Japan exempt 95% but the most the majority of the income. Greece exempt 100% of income earned by a foreign subsidiary in the EU. Whereas Finland exempt 100% of income earned in the EU countries and in non-EU countries. With whom Finland has a tax trade and we'll talk about tax regulators. So the point is they use some sort of a hybrid approach. There is no one size fits all. Luxembourg for example, exempt 100% of income earned in countries with an effective corporate income tax rate of at least 10.5. So if you're paying 10.5, we're gonna exempt you. Turkey exempt 100% of income earned by foreign subsidiaries located in countries with an effective corporate tax rate at least 15. Now in Turkey, you have to be paying at least 15. Again, notice the different. Now let's talk about the US and we're gonna break the US into pre-2018 and post-2018. Pre-2018, so before 2018, the United States had a very strict worldwide approach to corporate income taxes. And what was that approach? Well, branches, obviously we know about branches. Foreign branch income was taxed in the United States and foreign subsidiary income was subject to US tax when the dividend from that income was repatriated to the US parent company. Simply put, think of Apple in Ireland what I talked about in the prior session. Simply put, prior to 2018, if you are a branch, you are taxed as if you are in the US. If you are a subsidiary, that's okay. We don't have to tax you until you send that money home. Once you send that money home, you are taxed as dividend. Now, this was a disadvantage for US companies and what's only a disadvantage, the US economy was losing money. Money was sitting overseas. So what the government said and President Trump decided to do is to make the US more competitive. The first thing they did, they lowered the corporate rate to 21%. Then they moved from the worldwide approach. So this worldwide approach is no longer used to something called partial territorial system of taxation. Okay, so it's more participation exemption. Hybrid system. And what does that entail? Well, starting in 2018, dividend received from foreign subsidiary generally no longer subject to US corporate income tax. So simply put, send that dividend home. Not a big deal. We're not gonna tax you. And to be more specific, a US parent company is entitled to 100% dividend received deduction DRD for dividend that received from any 10% or more greater owned foreign subsidiary. So simply put, if you own more than 10% of the foreign subsidiary and that sends you money, then we will not tax you. Just talking about Apple. So if Apple now sends 100 million in dividend to the US, well, that's dividend income. That's income and that's taxable. Then the government would come in and say, okay, you are entitled to something called dividend received deduction, DRD of 100 million. Simply put, all in all, you're not gonna pay taxes on that income. So that's the huge change. Now, also what the government did just to kind of FYI, maybe this will be a discussion and a separate topic. They gave companies like a period of time. And if you have any money overseas, you can bring them now old money, basically money that was considered dividend. And if you bring them, we'll give you a tax break. Again, we'll talk about this later on. This is for the money prior to 2018. So if you want to repatriate that money, if you wanna bring it home, then we'll give you a tax break, one time tax deal. Another complication with taxes is the basis of taxation. Now we talked about the scope. The scope is either worldwide territorial or in between, but there's also more complications of taxation. And that's basically a secondary level of taxation. Regardless of the approach used in determining the scope, a second issue related to the jurisdiction is the basis for taxation. So simply put, okay, we're using either a scope, the scope either territorial or worldwide or in between, but also how am I taxing you based on what? Okay, well countries generally could use more than one base. They could use a source. If you're making the money in my country, in my territory, then I'm gonna tax you based on that. Or if you are a citizenship of my country, I'm gonna tax you based on that. Or you are a residence or a combination of all of those. So simply put, it's not only the scope that we have to worry about. It's okay, it's what scope does that country uses in when they tax you on what basis? Okay, for example, the scope could be the scope and citizenship. So simply put, the scope could be worldwide and worldwide and citizenship. Simply put, I'm gonna tax you anywhere you are in the world as long as you are a U.S. citizen from any income you have, which is this is very strict. If you are a U.S. citizen, you can't run away. Well, what about if you are, I'm gonna tax, my scope is worldwide and I'm gonna tax you based on citizenship and residency. Now you can't hide. Now even if you're a residence, now you have to pay taxes as well since we use worldwide and residency. So this is how it works. Obviously, all countries, you have to understand that all countries use the source. Basically, if you're making money and my jurisdiction and my territory, you're gonna be paying taxes there, okay? So that's pretty straightforward source. But let's talk about each one of them separately. Starting with the source of income. When you talk about source of income, think about Hong Kong. Hong Kong use the source of income. In general, almost all countries assert the jurisdictional authority to tax income where it's earned. This hopefully makes sense. If you're making money in my country, I'm gonna tax you in my country, okay? Regardless of the residence or citizenship of the recipient. So as long as you're making the money in my country, and usually Hong Kong is known for that. They tax you based on the money that you make in Hong Kong, okay? An example would be United States tax and dividend paid by Microsoft to a stockholder in Brazil because the dividend income was earned in the U.S. Although you're in the Brazil, you're in Brazil, you receive the dividend from Microsoft, that money was made in the U.S. You have to pay income in the U.S. So this is based on the source of income. Basically, if that money was made in my territory, you're gonna be taxed on that money. Another basis is citizenship. And this is very stringent. Simply put, citizenship says, as long as you are a citizen of my country, I don't care where you are. I don't care where you make the money. You have to pay taxes. Under the citizenship approach, which is a stringent approach, citizens are taxed by their country of citizenship regardless where they reside or the source of income being taxed. So it doesn't matter where you live or where you make your money. You might live in one country, work in another country in your citizenship of a third country. If you're a citizenship of the U.S., now let's assume you're the citizenship of the U.S. You live in Belgium, okay? And you have a business in France. Well, it doesn't matter where you are or where your business is. Any money you make in France, Belgium, it doesn't matter you are a U.S. citizen. You're gonna be paying taxes on that, okay? The United States is unusual among countries that tax based on citizenship. So remember, the U.S. used to be worldwide and citizenship, very, very stringent. It's not only worldwide citizenship and residence too. You're gonna see in a moment, okay? A U.S. citizen who lives and work overseas will be subject to the income tax on his or her worldwide income regardless of where that citizen earned their income or regardless where they reside. You have income and you are a U.S. citizen. You have to pay taxes. You have to file an income tax return. In addition to the citizenship, the U.S. says residency. Under the residency approach, resident of a country are taxed by the country in which they reside. Now, different countries will have a different residency requirement. For example, in Australia, you have to be, you have to live there more than six months to be resident of Australia, to be considered a resident. In the U.S., if you live 183 days, or if you have a green card, you are a residence of the U.S., So some countries, what they say, they would say they will base on residency. If you are a residence of our country, it doesn't matter whether you are a citizen or not, you are subject to taxation. For example, assume a citizen of Singapore resides permanently in the U.S. and earns dividend from an investment in the shares of a company in the United Kingdom. So from Singapore, lives in the U.S., the money coming from United Kingdom, tax it on the basis of residence. This individual will be subject to the U.S. taxation. Why? Because the U.S. uses the residency as well. Well, if you're a resident, you have to pay taxes. Although you are a citizen of Singapore, it doesn't matter. You live in the U.S. You pay taxes on that money in the U.S., although you earn it in from the U.K. The United States is one country that taxes on the basis of residence and, remember, in citizenship. So whether you are a residence or citizenship, you have to pay, you have to file tax return, okay? So for tax purposes, a U.S. resident is any person who's a permanent resident, which is holding a green card, okay? Of the United States as evidenced by either holding a permanent resident permit issuing by the U.S. Citizenship and Immigration Services, known as the green card. It's not really green, but it's still called green card. Or being physically present in the U.S. for more, for 183 days or more in a year, okay? This is called the physical presence tax. Note that because the United States' levy taxes using the worldwide approach, the worldwide income of an individual holding a U.S. permanent resident card is subject to U.S. taxation, even though they currently actually live outside the U.S. So if you hold, if you have a green card, guess what? Now you have to file an income tax return by law, okay? Companies created or organized in the U.S. are considered to be U.S. resident for tax purposes. So if you incorporate your company in Delaware, in Idaho, in Pennsylvania, and whatever, in New York, whatever state you incorporated, nearly are considered a U.S. resident. A foreign branch of a U.S. corporation is also considered a U.S. resident. We already talked about this. And it's subject to U.S. income taxation. So if you're a branch, you are subject to that. However, foreign subsidiary of a U.S. parent company is not considered to be a U.S. resident. And since 2018, we talked about this. Foreign subsidiary's income generally is not taxed in the U.S. Why? Because the government gives you what's called a tax, tax, dividend-received deduction, which is a phantom tax deduction. A phantom means it's a makeup deduction. But nevertheless, it's a deduction. So we'll take it. Now, as you can tell, because we have different scope and different basis, something what's gonna happen in an individual or a company could be subject to more than one tax at the same time. So the combination of either worldwide or participation exemption approach combined with the basis of taxation could lead to overlapping tax jurisdiction, which in turn lead to double or sometimes triple taxation. Just think of a person, a German citizen residing in Chile. So this individual is from Germany, lives in Chile, and they have investment in Austria, okay? Then this individual might be expected to pay taxes in Germany, basis on their citizenship, Chile based on the residency in Austria because you made the money in Austria. So you'll pay taxes three different times. So just wanna show you the complication or the double taxation or the triple taxation effect. And this is true if you are a corporation. Same thing, you are a corporation, you are a citizen of one country, you're incorporated in another country and you make money in a third country. So you could be subject to three different taxes, okay? The most overlap of jurisdiction for corporation is a situation in which the home country taxes on the basis of residency and the country in which the foreign branch or subsidiary is located basis on the source of income. And look, if you're making money in a certain country, it makes perfect sense that the country in which you are operating under, operating in geographically tax you. But if also the country that you belong to, okay? Your home country taxes you, now you're being taxed twice. Okay, so just before I proceed, I want you to see that it makes sense to pay taxes where you are located. It makes sense in a sense that, yes, if you're operating in my jurisdiction, you have to pay taxes there. The issue becomes what about your home country, your citizenship country? Are they gonna make you pay taxes as well? Okay, so without some relief, this could result in a tremendous tax burden for the parent company because they have to pay taxes twice. I mean, think about it. Income earned by a Japanese branch of an Australian company would be taxed at an effective Japanese corporate income tax rate of 31%. That makes sense. If you are a branch operating in Japan, they're gonna charge you taxes because you're operating in that country. And you're gonna pay taxes in Australia because you are an Australian branch, you're gonna pay 31%. That's an aggregate of 61% in taxes. So the Australian parent company has a 39% of the profit after income taxes. So you made $100, simply put 61 is absorbed in taxes alone and you have 39 profit to pay all your other expenses. Well, at that rate, there's this disincentive to establish operating overseas. So what we're looking at now is we need to look at a solution from this double taxation. Okay, otherwise companies would not operate overseas. And obviously there is a solution but first I wanna show you the problem. So what is the solution? Well, if you have a double taxation, we have to kind of think about neutrality. We have to think, companies or countries, they need to keep the tax factor out, help each other to keep the tax factor out. Now, within a specific national tax system, we have something called neutrality. And what's neutrality? Basically, you have to create the tax system where it's keep the tax decision outside of the business decision. What does that mean? The tax system should remain in the background and business investment and consumption decision should be made for non-tax purposes. So simply put, you should create a tax system not to influence business decisions. The tax system should be neutral. It should not influence your investment decision, your business decision or consumption. So simply put, it should be neutral. It should not really be the main factor in your decision. Otherwise, the government basically is controlling your life in a sense. Now, from an international aspect because we're talking about international trade, the tax system, what they say, they should be capital export neutrality. Simply put, when I move from one country to the other, I don't want to have the tax system as a burden. So a tax system meets the standard of the taxpayer decision whether to invest at home or invest overseas is not affected by taxation. And this is what we meant by capital export neutrality. Don't burden me with taxes. Make a system where you don't burden me with taxes. So double taxation from overlap and tax jurisdiction preclude a tax system from achieving capital export neutrality. So simply put, if you have double taxation, it's gonna be disincentive. I'm gonna be paying taxes twice. Therefore, all investment would remain home. Therefore, we'll have less international trade, less foreign investment. So to achieve this, okay, most countries have one or more mechanism for eliminating this problem of double taxation. So that's what we're gonna be talking now about foreign tax credit or allowed deduction for your taxes that you paid overseas. Simply put, I'm showing you the picture. We have double taxation problem and that will hinder international trade. So what relief do we have? What relief do we have? We have several reliefs. The first one is double taxation of income earned by a foreign operation, generally arises because the country where the foreign operation is located, tax the income at its source. And the parent company taxes the parent home country taxes worldwide income on the basis of residency. So this is why we have this problem. Once I know I'm repeating myself, but the point is you should pay taxes in Brazil. So if you're a Brazilian company, you should pay taxes in Brazil. But if your citizenship is Argentinian, but you belong to Argentina, now if you're gonna be paying taxes in Brazil, then paying taxes in Argentina, then you're paying taxes twice. So someone, someone will have to give up either the Brazilian government will have to say, okay, you operate with us, we're not gonna pay taxes or the Argentinian company will have to say, well, since you are a citizen of us, but you're operating in Brazil, we're gonna give up paying, you don't have to pay us taxes. So someone will have to give up. And I'm sure you, you know, at this time, the international norm, that is the source, should take precedence over residency. So if I'm making money in Brazil, although I am an Argentinian company, I should pay the priority or the what takes over the priority is should be, I should be paying tax in Brazil. What should the Argentinian government do? It should give me some type of a relief that therefore I'm not double taxed. And the same concept would apply if a Brazilian company, now we're gonna switch the example. If a Brazilian company is operating in Argentina, the Brazilian company will have to pay taxes in Argentina, then the Brazilian company will have to give them some sort of a relief, this way they're not taxed twice. So the source where you make the money should take priority over the residency. And hopefully this makes sense. This makes sense. Let's talk about how to obtain relief from double or triple taxation. One way would be is to exempt all or some of the foreign income from taxation by adopting a participation exemption approach. Basically, I'm not gonna tax certain income or territorial approach. Simply put, I only tax you if you operate within my jurisdiction. This is one way to avoid the double taxation. This way, if you're operating outside my jurisdiction, although you are my citizen or my residence, I don't have to tax you. The second approach would be to provide relief from double taxation would be allow the company to have a tax deduction. Deduct the taxes paid to foreign government. Simply put, if you paid $100,000, I'm gonna give you a deduction, not credit, a deduction. Basically, you can deduct this $100,000 on your deduction. I'm gonna let you deduct $100,000 in expenses on your income statement to compute your taxable income. The third approach has the most value is relative to number two is to give you credit for the taxes paid. So if you paid $100,000 in taxes in Brazil, and if you're a US company, I'll give you a credit as you have paid $100,000 in the US. Obviously, the US expect the Brazil to treat us the same, treat the US companies the same, okay? So this is known as the foreign tax credit which result in a direct reduction in the amount of tax that otherwise would be owned. And we're gonna discuss this later on in a separate recording, because we want to see how does foreign tax credit work because using numbers will make more sense. Now, if you have any questions about this lecture, please email me. I suggest you visit my website for additional resources such as notes, PowerPoint sites, multiple choice as well as additional resources if you're studying for your CPA or CMA exam. Study hard, stay motivated, and good luck.