International Tax Policy and Foreign Investments
Giorgi Kuparadze Faculty of Economics and Business at TSU
In the modern stage of enhanced globalization and internationalization of economic relations among countries foreign investments are playing important role.
Inflows of FDI for small countries are the main source of economic growth. For this part -international tax policy and international fiscal coordination are important.
Development of capital and technological markets has increased the variety of income sources of individuals and legal persons. Sources of income have diversified not only by economic fields but also from different countries of the world. In terms of strengthening of trade and economic relations between countries, most actual question is the taxation of international transactions. Furthermore, increasing of geographical areas of enterprise activities causes fall of these economic units within the different tax regimes. Different tax regimes have important influence on globally united capital and on final results of MNE-s. In addition from the perspective of the world economy different tax regimes have influence on the decisions whether to invest or not in a concrete country. Thus the tax regime of each country becomes interrelated, raises questions of regulations of international tax relations among countries. Tax problems are especially connected with the cases when entity is in one country and the source of income in another country.
In most countries, returns from trade and investment within national borders are subject to income taxation. Taxation of these incomes depends on inter-tax regimes of countries, also on the ratified international tax conventions.
Main aims of international tax relations are: avoidance of double taxation, state control on payment of taxes and encouragement of investment by non- discriminative taxation.
Generally accepted principle of international tax relations is that a country is free to a levy tax on taxable object only within its borders and this right doesn’t include the object which arises on other states territory.
Tax laws normally cover two kinds of activities: The activities of a resident of that country in foreign countries and the activities of non-residents in that country.
There are generally three primary objectives underlying countries incorporation of international tax rules into its tax legislation1: National wealth maximization, Tax equity or fairness, Economic efficiency.
Taxation of international transactions determines the allocation of tax revenues between countries. National wealth maximization principle means countries aim to increase its share in levied taxes; this principle covers incomes from individual investments made abroad and also to donor countries taxes. Tax equity means to form equal taxes on all different incomes in spite of source. Economic efficiency means to encourage development of competition forces in national economy. In ideal such tax rates doesn’t have any influence on investment decision making process. This means that after tax income should not decrease at level that will discourage investment. Countries are trying to avoid such rules that cause the outflow of investment and experience.2
According to the global aims of international tax policyS of one country must not be in collision with other countries tax policy. In our globalised world where capital freely moves between countries, none of the government will adopt such tax burden that will cause outflow of investments or their minimal inflow. When countries international tax policy is not competitive to other countries this arises arbitrage possibilities when the main aim of companies tax planning becomes to gain advantage by asymmetric international tax regimes. Optimal international tax policy is based on the capital import neutrality and capital export neutrality.
Capital import neutrality implies that tax regimes ought to be the same to the income of resident and nonresident investors. Generally tax policy is the factor in investment decision making process-if foreign investments are taxed differently compared with the local investments tax system becomes unfair and distorts rational decision making process.
For attaining tax equity and efficiency country must adopt capital import neutrality. Capital import neutrality is aimed to attain equal taxation of foreign and local investments.
Local investors always oppose fact that unlike them foreign investors are taxed at less rates.(especially in cases when local investor’s capital is in immovable form) and when local investor’s capital is immovable, in conditions of asymmetric taxation, they establish offshore economic units and then are investing as the foreign investors.
Non existence of capital import neutrality distorts economic efficiency because foreign investors have competitive advantage. Their cost structure does not include tax costs. Such approach was implemented in China when government offered to qualified foreign investors tax holidays for ten years in certain fields of investment. Same relief was not spared on local investors. Local investors opposed such policy and they often established offshore economic units to invest as foreign investors. Thus all this caused inefficient allocation of recourses.3
Capital import neutrality means equal taxation of foreign and local investors; capital export neutrality implies equal taxation of local investors in spite of investment country. These incomes include returns of foreign investors derived in the country and also the income of residents from another and resident countries. On investment decisions a significant influencing factor is resident countries tax policy.
To achieve tax equity and fairness country must pursue capital export neutrality strategy. This approach means (as we already stated) equal taxation of investors income despite of residence. For taxpayers this means that they face the same effective tax rates-as in the case of investing in resident or nonresident country. In such policy approach country`s tax policy neither encourages nor discourages outflow of investments-it’s neutral to the investment decisions. For practical implementation of capital import neutrality tax administrations must include in tax base whole income (world income) of taxpayer-as domestically sourced income as well as incomes from foreign sources. If foreign source income is excluded from tax base in fact this means encouragement of investing in foreign country that will result in distorting of economic efficiency. In addition, local investors, whose capital is in the form of immovable property, reckon tax system as unfair.
In case of small countries that have negligible impact on global capital markets capital export neutrality is less profitable, especially when other countries adopt more flexible tax policy. In forming its tax policy a country must take into account properties of other countries tax policy and especially of its trade and investor partners that are competitors in importing of capital. To summarize, where capital export and import neutrality prevails a country international tax rules will not influence the investors decision one way or another, in which case the rational investor will seek the investment that gives him or her the greatest return, thus ensuring the most efficient allocation of recourses. Therefore, ceteris paribus, capital export and import neutrality allows capital to be allocated globally in the most efficient way by giving investors the highest, risk adjusted pre-tax returns on their investments.
Some countries tax their residents on whole (world) income, others only on domestically generated income and some use the combination of those approaches. So income from investments may be taxed twice on the same income, which is transmitted to donor country. This fact is known as the double taxation4.
Double taxation despite of forms creates real barrier to the movement of goods, capital and people-especially to capital. For this reason there are implemented instruments in international taxing to avoid double taxation.
Tax laws which cover foreign elements mainly are connected with two aspects: The activities of a resident of that country in foreign countries, the activities of a nonresident in that country.
These two aspects are base for countries in international tax law, which are known as jurisdiction based on residence and on source. Double tax agreements ratified between two or more countries are the most reliable way of avoiding double taxation on investment. These treaties play an important role in the development of movement of capital, goods and working forces. The other main of “Double Tax Conventions“ is to strengthen fiscal function of taxes, not to allow to decrease countries tax base, when economic entity has relations with more than one country.
DTA is often referred to as a “Double Tax Agreement” , Double Tax Treaty, Double Tax Convention, or simply a Tax Treaty .Tax treaty is defined in the international tax glossary5 as a,, term generally used to denote an agreement between two (or more) countries for the avoidance of double taxation” in fact there are various types of tax treaty of which the most common are treaties for the avoidance of double taxation on income and on the capital (usually known as a comprehensive income tax treaty) such treaties are also commonly expressed to be aimed at prevention of fiscal evasion. In avoiding double taxation such treaties also provide the distribution between the treaty partners of the rights to tax, which may either be exclusive or shared between treaty partners.
Avoidance of double taxation primarily is aimed for the taxpayers and also to the tax administrations. The way for it to distribute tax rights between treaty countries.
The OECD Committee on Fiscal Affairs has summarized the purposes of Data’s in the following way6: The principal purpose of double tax conventions is to promote, by eliminating international double taxation, exchanges of goods, services, and the movement of capital and persons. It is also a purpose of tax conventions to prevent tax avoidance and evasion.
In the world there are several so called model double tax conventions: OECD and UN models, also USA model. The relative positions of some of the Data’s and multilateral Data’s can be illustrated on a spectrum between those DTA-s that most favor capital exporting countries (and are therefore reflecting the interests of the country of residence of the income earner) and those that most favor capital importing countries (and therefore reflect the interests of the country of source of the income):
Relative positions of model and selected multilateral DTAs in residence state and source state spectrum7:
To guide tax policy in relation to FDI, policy analysts may rely on one or more economic models or frameworks to examine possible channels of influence. A selection of these includes: the OLI framework. The OCED policy framework for investment. The neoclassical investment model and models derived from the new economic geography literature8. We won’t discuss domestic tax policy of a country according to the scale of our research. After discussing the main principles of international Taxation it’s actual and interesting to review the participation of Georgia in international tax relations to analyze the countries policy which is reflected in ratified, double tax agreements’
Formation of market economy in Georgia and effort to become full member of world economy determined its active participation in international tax conventions. Because double taxation creates problems to those organizations which are operating abroad, have property or derive their income there. At the same time avoidance of double taxation we reckon as a main conductive factor in encouragement of foreign investments. Double tax agreements were introduced in independent Georgia in 1995. This model was OECD model. Based on this model was created a Georgian model.-Model Tax Convention on Income and on Capital.
According to the ministry of finance DTA are agreed with 16 EU countries, 6 CIS countries, also with china and Iran Table #1. Agreements are initiated with Turkey, Luxemburg, Swiss, Spain, Estonia, Kirgizia, Finland, and Denmark9:
International cooperation in the tax area is especially important with the countries that are main trade partners, from which are coming investments and country has economic-trade relations. According to the National Bank of Georgia in 2005-2006 years Georgia’s main trade partners were: Russia, Turkey, Azerbaijan, Germany, Ukraine, and Turkmenistan. USA, Bulgaria, Italy, United Arabia, in 2007 in the ten top partners instead of Italy in list entered China. In 2007, to the statistic department of Georgia in list of FDI countries on the top place were: Netherland’s, Czech Republic, Virgin Islands and Denmark. Table #2 II column)
As we mentioned above, in order to eliminate double taxation in practice are used both unilateral and bilateral measures. First one means: tax credit and exemptions. According to the tax code of Georgia article 192 is used tax credit. At the same time credit amount should not exceed the amount which might have been levied in Georgia by income and profit taxes.
Bilateral measures, which are determined on ratified double tax agreements, are based on source and residence principles. Nonresident’s revenues which have source in Georgia are: (Tax Code, Article 24. Income Earned from a Source in Georgia)
a) Income earned from employment
b) Income earned from supply of goods produced or purchased in Georgia and/or services rendered in Georgia;
c) Income earned from economic activities of a permanent establishment of the non-resident located on the territory of Georgia, inter alia proceeds gained by the non-resident from sale of the identical or similar goods in Georgia; income earned from services rendered in Georgia that are identical or similar to services rendered by a permanent establishment;
d) Income earned as a result of annulment of liabilities through writing off bad debts related to economic activities carried out in Georgia and sale of fixed assets or as a result of compensation.
e) Income earned in the form of dividends from resident legal person and sale of the partner’s share in such legal body;
f) Income earned in the form of interest from the resident person;
g) A pension paid by a resident
h) Income earned in the form of interest from non-resident having permanent establishment in Georgia or having a property located on the territory of Georgia if outstanding liabilities of such person are related to its permanent establishment or property;
I) Income earned in the form of royalties related to rights or property used in Georgia;
j) Income earned from lease of movable property used in Georgia and/or transfer of property use rights according to relevant agreements;
k) Income earned from Real Estate located in Georgia and used in economic activity, including income received from the sale of the partner’s share of this property;
l) Income earned from a supply of stocks or share of a partner of an enterprise, if more than 50 % of their value is directly or indirectly generated from value of Real Estate located in Georgia;
m) Other income earned from the sale of property by a resident not related to entrepreneurial activity;
n) Income earned from management, financial and/or insurance (including reinsurance) services of a Georgian enterprise or a permanent establishment of non-resident in Georgia,
o) Income earned in the form of insurance fees paid under agreements for the insurance or reinsurance of risk raised in Georgia;
p) Income earned from telecommunications or transportation services in course of international communications or transportation between Georgia and other foreign countries;
q) Other income earned from activities carried out in Georgia;
These incomes will be taxed at source without deductions at relatively lower rates than resident’s incomes.
In general the main aim of tax policy is encouragement of investments, both domestic and foreign, it’s obviously clear that high tax burden is negative factor to invest in the country, but it is important to determine in what cases and in what ways it is possible not to prevent investment by high tax rates. Georgia’s policy in this direction-taxation of income from foreign investment is quite liberal table #2
Incomes from investments are generally allocated in the form of divides, profits and interests. Thus taxation of this kind of incomes determines state’s international tax policy directions:
#There are several countries from which in flowed FDI-s in Georgia and DTA-s are not ratified in 2001-2006 years; (US $)_USA 321.250.721.39; Norway 130.063.373.56; Cyprus 126.596.830.31; Virgin Islands, Britain 61.956.177.62; Japan 61.799.810.48; Australia 28.990.696.91; Korea 27.215.964.08, Israel 10.458.513.74; Ireland 1.460.166.17; United Arab emirates 877.161.43; Libya 839.515.83 Hungary 666.487.31; Libran 620.682.95; Saudi Arabia 618.085.68; Gibraltar 554.666.62; Sweden 427.110.63; Argentina 189.303.97; India 71.315.95.
From the above data Georgia is capital importing country. Inflows of FDI for our country are the main source of macroeconomic stability. International tax policy of Georgia is directed to attract foreign direct investments and this policy is deepening. By the last changes in tax code of Georgia, tax rates on dividends and on interest payments have reduced to zero (Tax Code article 196,197)
Frequent changes in tax code reflects non stability of economic policy, at the same time all these make sense that these changes are aimed to strengthening fiscal function of taxes. At primary period encouraging of investment in certain fields of economy by zero taxation after some period will cause increase of this tax rates according to the demands of tax revenues from state; All these causes reaction from other contracting countries. But increase of tax rates and equilibrium from investments position in economy must coincide in time.
In the process of ratification of double tax treaties Georgia rely on OECD model. From the point on institutional development we reckon these processes as a positive result, because with this way country is engaged in harmonization of legal system with European and other advanced economy countries. In this way Georgia is engaged in modern international tax relations.
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