Taxing Non-Residents’ Capital Gains

Chapter III Taxation of non-residents’ capital gains Wei Cui* 1 . Introduction Designing and enforcing a legal regime for taxing non-residents on capital gains realized from domestic sources is a topic of vital importance for developing countries. The reason is that non-capital-gain income that may be derived from a given country can generally be crystalized in the form of capital gains on the disposition of the income-generating asset. 1 This is true of most important types of income, be it rent, interest, royalty, dividend or business profit. Taxing capital gains, therefore, is invariably needed to ensure that income from assets in the source country is properly subject to tax. In this sense, capital gains taxation of non-residents is inherently a measure for protecting that country’s tax base from erosion. This perspective, however, cannot be said to be clearly reflected in the prevailing international tax regime. There is a well-known principle that if the non-capital-gain income from an asset is taxable in a source country (for example, because the asset is properly viewed as being located in that country), then the capital gains from the disposition of that asset should be taxable in the same country. 2 * Associate Professor of Law, University of British Columbia Faculty of Law, Canada. 1 The intrinsic connection between income derived from an asset and capital gains realized on the disposition of the asset is grounded in a basic tenet of modern finance theory, namely, that the value of an asset simply is the present discounted value of future income that the asset can be expected to generate. 2 “It is normal to give the right to tax capital gains on a property of a given kind to the State which under the Convention is entitled to tax both the property and the income derived therefrom: ” see paragraph 4 of the Commentary on Article 13 of the United Nations Model Double Taxation Convention between Developed and Developing Countries (United Nations Model Convention), quoting paragraph 4 of the Commentary on Article 13 127 Wei Cui This principle, clearly based on the intrinsic connection between the income derived from an asset and any capital gains realized on the disposition of the asset, is commonly used to justify taxing capital gains realized by non-residents on the disposition of immovable property and assets used in a permanent establishment (PE) situated in the taxing country. Nonetheless, it has not been consistently applied to other types of capital gains realized by non-residents. The United Nations Model Double Taxation Convention between Developed and Developing Countries 3 (United Nations Model Convention), for example, provides for source-country taxation of interest, dividends, royalties and other income, in addition to the taxation of income from immovable property and business profits attributed to a PE. However, in Article 13 (Capital gains), the United Nations Model Convention follows the Organisation for Economic Co-operation and Development Model Tax Convention on Income and on Capital 4 (OECD Model Convention) in giving prominence to taxing capital gains realized on the disposition of immovable property and business assets used in a PE, but takes a weaker stance on the taxation of gains realized on the disposition of company shares, and allows other capital gains realized by non-residents to go untaxed. 5 The reason for this inconsistency is of the Organisation for Economic Co-operation and Development Model Tax Convention on Income and on Capital (OECD Model Convention). The rule that “gains from the alienation of immovable property may be taxed in the State in which it is situated … corresponds to the provisions of Article 6 and of Article 22 (1): ” see paragraph 5 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 22 of the Commentary on Article 13 of the OECD Model Convention. The taxation of gains on the business assets of a permanent establishment (PE) or fixed base “corresponds to the rules for business profits [and for income from independent personal services] (Article[s] 7 [and 14]): ” see paragraph 6 of the Commentary on Article 13 of the United Nations Model Convention, quoting and supplementing paragraph 24 of the Commentary on Article 13 of the OECD Model Convention. 3 United Nations, Department of Economic and Social Affairs, United Nations Model Double Taxation Convention between Developed and Developing Countries (New York: United Nations, 2011). 4 Organisation for Economic Co-operation and Development, Model Tax Convention on Income and on Capital (Paris: OECD, 2014). 5 See section 5 below. 128 Taxation of non-residents’ capital gains not well articulated. Adding to this, there are substantive disagreements — often between developing and developed countries — about what types of non-capital-gain income should be taxable in a country other than the resident country of the recipient of the income. 6 Both of these factors — divergent views about where non-capital-gain income should be taxed, and inconsistencies in observing the equivalence between income and gain (and therefore between the sources of income and gain)—have led to widely divergent practices in the capital gains taxation of non-residents. The first challenge facing developing countries in designing policies in this area, therefore, may be the apparent absence of an “international norm,” or confusing accounts of what such a norm consists of. The present chapter will offer a basic conceptual framework for understanding the divergent practices. It argues that there are sound conceptual justifications for taxing non-residents on capital gains in general, and that there are no compelling reasons for assuming that such taxation should be limited to immovable property. 7 Instead, the legitimacy of such a tax may depend more on its specific design—for example, its treatment of losses, and its ability to avoid arbitrary and multiple taxation of the same economic gain—than on the basic idea of its imposition. Unfortunately, both the United Nations and OECD Model Conventions — and many of the existing discussions purporting to 6 This could be a debate either about whether a source country should have a taxing right, or about what the source of the income is in the first place. 7 In this respect, the arguments of the present chapter go beyond some recent discussions of the taxation of capital gains that are intended to emphasize the interests of developing countries. See United Nations, Economic and Social Council, Committee of Experts on International Cooperation in Tax Matters, “Article 13 (Capital Gains): the practical implications of paragraph 4,” (2014), available at http://www.un.org/esa/ffd/wp-content/ uploads/2014/10/10STM_CRP13_CapitalGains.pdf (hereinafter “Committee of Experts Paper”); International Monetary Fund (IMF), “Spillovers in International Corporate Taxation,” (2014) Policy Paper, available at http://www. imf.org/external/np/pp/eng/2014/050914.pdf (hereinafter “IMF Spillovers Report”); and Richard Krever, “Tax Treaties and the Taxation of Non-Residents’ Capital Gains,” in Arthur J. Cockfield, ed., Globalization and its Tax Discontents: Tax Policy and International Investments (Toronto: University of Toronto Press, 2010), 212-238. 129 Wei Cui give guidance to developing countries —tend to be brief, or even silent, on these design issues. A second, more important challenge for taxing non-residents on capital gains lies elsewhere: namely, the tax can be difficult to enforce, and the dynamics of engagement between tax administrators and taxpayers in collecting the tax can be quite different from normal tax administration. These difficulties may provoke questions about whether the likely revenue payoff from the tax justifies the resources needed for its enforcement. The difficulty of enforcing the capital gains tax on non-residents may sound clichéd. However, some of the more familiar descriptions of the administrative difficulties may not be accurate. For example, it is unclear whether developing countries are more likely to be at a disadvantage in administering the tax. The present chapter analyses the pros and cons of the various mechanisms for administering the capital gains tax for non-residents and argues that buyer withholding is a more effective enforcement mechanism than tactics that focus on the transferred assets. Moreover, the chapter will consider ways in which voluntary compliance in this area may be improved. Tax avoidance poses the third challenge for taxing non-residents on capital gains. The typical strategies for legally avoiding a tax on capital gains imposed by a source country are neither complex nor difficult to identify. They include treaty shopping and the use of offshore holding companies. However, the incentives for taxpayers to adopt such strategies may vary as a function of the severity of the first two challenges. If there are basic inconsistencies in the rules adopted by domestic law and by tax treaties towards capital gains taxation, and if the enforcement of such tax rules is inadequate, taxpayers may have greater incentives to engage in avoidance. Moreover, the feasibility of avoidance behaviour could also depend to a substantial extent on non-tax characteristics of the business and the legal environment for investing in a country: some countries witness the use of extensive offshore markets through which investments are channelled into those countries, while others do not have to cope with such markets. The present chapter will discuss both specific and general anti-avoidance rules for maintaining the integrity of a tax on capital gains earned by foreigners, as well as how to choose among these rules in light of the circumstances that generate tax avoidance. 130 Taxation of non-residents’ capital gains Section 2 of the present chapter examines the general principles for taxing non-residents on capital gains realized on the disposition of domestic assets. It considers the relationship between capital gains and other forms of income from an asset, as well as the question why immovable property has been regarded as a special asset class for source-based taxation of capital gains. Section 3 analyses specific legal design issues for taxing capital gains, including whether to assimilate such taxation to gross- or net-income-based taxation, and issues arising from the taxation of shares of companies. Section 4 considers the fundamental administrative issues in taxing non-residents on capital gains. Whereas the issues described in sections 2 – 4 below normally need to be addressed under domestic legislation, section 5 briefly reviews Article 13 of the United Nations Model Convention—highlighting some shortcomings of the Article from the source-country perspective — as well as treaty practices among developing countries with respect to taxing capital gains. Section 6 turns to tax planning commonly adopted to avoid the tax on capital gains. It pays particular attention to policies recently adopted by a number of developing countries aimed at taxing indirect transfers of the shares of resident companies. Section 7 briefly examines the issue of departure taxes for individuals. Section 8 concludes by offering some reflections on how to view the pursuit by developing countries of capital gains taxation of non-residents. 2 . General principles for taxing non-residents on capital gains 2 .1 The economic substance of capital gains In thinking about taxing non-residents on gains realized on the disposition of domestic assets, it is useful to keep in mind what assets tend to generate capital gains in the first place and why. For instance, mass-produced durable assets (for example, machines, computers, household appliances, vehicles, ships and aircraft) generally see their values depreciate over their useful lives because of wear and tear and newer, better products becoming available on the market. Even the value of buildings as physical structures —if the value of the land they sit on is disregarded— generally declines instead of increases. By 131 Wei Cui contrast, the value of the ownership (for example, through company shares) of businesses may increase, if the businesses are successful, as may the value of land in locations that experience economic growth. Other than land, assets that are unique in some ways —for example, depletable resources and, importantly, monopoly rights (such as rights to operate in restricted industrial sectors, for instance, mining or telecommunications)—may also increase in value. Finally, modern financial markets create possibilities of speculation and arbitrage that can give rise to substantial gains (and losses). Many developing countries, for example, have become acquainted with “vulture funds” that buy up non-performing business loans or sovereign debts with high risks of default and realize substantial returns from them. Reflecting on the types of assets that are likely to give rise to capital gains is important for two reasons. First, it helps a source country to determine for which categories of assets it is important to reserve rights in terms of taxing capital gains. This issue will be discussed further in section 4 below, 8 but it is already immediately clear that immovable property, even if defined to include mining and mineral rights, is not the only type of asset that can yield substantial gain. In fact, from all that is known, it may not even be the most important class of assets. 9 Second, it enables an appreciation of the economic nature of capital gains. Essentially, in a competitive asset market, assets experience gain because of an increased expectation of the streams of income that they will generate. In effect, between the time the owner acquires the asset and the time he or she sells it, the market (that is to say, potential buyers) has come to expect the asset to generate more future income in present value terms. This increased expectation could be due to greater certainty in the future flow of income, an acceleration of the timing of the return, an increase in the absolute value of the future return or its value relative to other assets available for investment. Indeed, gain could arise due to the lack of competition 8 This issue is particularly pertinent to the interpretation of Article 13 (2) and (3) of the United Nations Model Convention. 9 In the global private equity industry, for example, where capital gains tend to be the driver of profits, funds deployed in the real estate and infrastructure sectors have been consistently and significantly smaller in comparison with funds deployed in other sectors (such as buyouts). See Bain and Company, Global Private Equity Report 2014, at 6. 132 Taxation of non-residents’ capital gains as well: an initial buyer with special access or bargaining power may be able to obtain an asset cheaply and “flip” it to other buyers. From the perspective of economic efficiency, it is in fact attractive to tax many of the types of gain described above. Increases in the value of non-reproducible assets —land, natural resources and collectibles —tend to reflect what economists call “pure rent” or “economic profit”: taxing pure rent is efficient because it does not distort economic behaviour. Taxing gains that arise because of imperfect competition is also often efficient. Finally, gains in operating businesses and speculative gains on financial markets may represent a mixture of rent, return to risk-taking and return to managerial skills. Although taxing the latter two types of return may distort economic behaviour, the magnitude of the distortions may be limited—for instance, where the managerial skills are relatively location-specific, for example, involving specific language, culture and/or political skills. Capital gains that arise in the ways just described can be contrasted with some other forms of gains. One kind of nominal capital gain results from inflation: in an inflationary context, even depreciating equipment can sell for a greater nominal amount of cash than the purchase price. Another kind of gain is income that has already been earned on the asset but that has been added to or reinvested in (capitalized into) the original asset. For example, if a corporation has retained earnings and does not distribute such earnings to shareholders, the price of its shares will go up simply because the shareholders have deferred the realization of their income, not because the corporation’s business has better prospects than before. If a shareholder sells his or her shares, the gain realized may simply be the income that he or she could have realized as dividend if the corporation had made a distribution. 10 In general, the design of an income tax may need to provide special treatment for these latter forms of nominal capital gain. In the 10 Similarly, if a zero-coupon bond with a $100 face amount is issued for two years in an environment where the market interest rate is stable at 5 per cent, no one will buy the bond initially if it is issued for more than $90.703. After a year (with the bondholder being one year closer to maturity) the bond will be worth $95.24, but the increase from $90.703 merely represents an accrual of interest, and not a change in the expectation of the bond’s yield. 133 Wei Cui case of inflation, its presence should ideally be taken into account in determining whether the taxpayer has any taxable gain. In the case of accrued earnings realized through a sale of the asset, it may be important to treat the gain from the sale similarly to other ways of realizing already-accrued earnings (for example, dividends). 11 However, it is crucial to recognize that capital gains often come about not because income has already accrued, but because of a changed expectation of what income will accrue. This conceptual discussion has a direct bearing on a common scepticism about the wisdom of taxing foreigners on capital gains. Because transfers of domestic assets by foreigners may be difficult to detect, and a tax on such transfers may be difficult to enforce, it is sometimes asked why the source country should attempt to do so. The asset itself is still located in the source country, and most of the income it generates —in the form of rent, dividends and other periodic payments — can be more easily subjected to tax (for instance through withholding). What does the source country lose by not taxing the gains non-residents derive by transferring ownership of the asset? Why tax upon transfer of ownership of an asset, and not just when income is received by the owner? 12 There is a resolution to this scepticism. As already explained, generally, the value of an asset is determined by the stream of income it is expected to generate. If such income is going to be taxed at known rates, then the value of the asset should also reflect the tax. For example, if an asset generates $10 of income in each period, and a 20 per cent tax is imposed on the $10 of income no matter who owns it, then the after-tax income generated by the asset will be $8 per period. The value of the asset to a private owner will then be determined by the $8 return, and 11 In the bond example in note 10, if the interest rate stays the same, the increases in the value of the bond in year one and year two should both be treated as interest. 12 Notably, the recent IMF Spillovers Report expresses this scepticism: “Conceptually, there are arguments as to whether or not it is appropriate to tax [capital] gains at all: they presumably reflect accumulated and expected earnings, so it may not be necessary or appropriate to tax them if those earnings have been, or will be, adequately taxed in other ways.” See IMF Spillovers Report, supra note 7, at 29. 134 Taxation of non-residents’ capital gains not the $10 return. 13 If, despite the lower price, buyers are willing to pay in view of the expected tax on income, then the seller still realizes a gain and the seller’s ownership of the asset has generated a form of income for him or her that is not captured by the tax imposed on future income. Indeed, in this example, since the burden (economic incidence) of the tax on dividends has already shifted onto the seller by being capitalized into asset value, it is clear that only a tax on capital gains can reach the additional income realized by the seller in the form of gain. Thus insofar as gains arise as a result of changes in expectations, there is a unique role for the tax on capital gains — one that cannot be played by the tax on investment income such as dividends. 14 2 .2 Why do source countries tax non-residents so little on capital gains? In light of the preceding arguments that capital gains taxation is not redundant, and, moreover, that capital gains may arise not only in connection with immovable property, it is striking how little source countries are expected to tax non-residents on capital gains under prevailing international norms. Most importantly, many developed countries do not tax capital gains realized by non-residents on the disposition of shares of domestic (that is to say, resident) companies, with the exception of companies that hold domestic real estate. There are a number of different reasons for the adoption of this policy, most of which are not necessarily relevant or persuasive in the context of developing countries. For example, developed countries generally prefer residence-based taxation, vis-à-vis themselves 15 and develop13 This reflects the idea that a tax on the income generated by an asset may be “capitalized” into the value of the asset. Economists have offered many empirical confirmations of the capitalization of different types of taxes into the value of different types of assets, for example, real estate and company shares. 14 To put it differently, a tax on dividends will tax a given amount of dividend the same way, no matter how the shares yielding the dividends are acquired. For income tax purposes, however, how the shares are acquired— with what amount of previously taxed funds — does matter. 15 If investment flows between two developed countries are roughly equal, it makes sense for them to forgo source-country taxation; thereby they will save administrative costs without losing revenue overall. 135 Wei Cui ing countries. In the European Union, there has even been a coordinated move towards residence-based taxation, removing the tax on dividends, interest and royalties derived from related companies. 16 Independently, there has also been a desire to align the treatment of shareholder capital gains with the policy of exempting dividends paid both to residents and non-residents. 17 For developing countries that are capital importers and that have decided to maintain the classic corporate income tax, the above reasons generally have been considered— and frequently found to be outweighed by other considerations. Two practices of developed countries are, however, relevant. First, some of them have historically eschewed capital gains taxation of non-residents because of its perceived administrative burden. The United States of America, for example, originally abandoned taxing non-residents on capital gains realized on the sale of United States securities in 1936 for administrative reasons. 18 Canada narrowed its range of capital gains taxation for foreigners recently, in 2010, partly for the same reason. 19 This shows that enforcing the tax may be challenging for developed and developing countries alike. Second, even in countries where the alienation of shares of domestic companies by non-residents generally goes 16 See Harry Huizinga, “Taxing Corporate Income — Commentary,” in Stuart Adams and others, eds., Dimensions of Tax Design [The Mirrlees Review] (Oxford: Oxford University Press, 2010), 894 –903. In connection with the OECD Action Plan on Base Erosion and Profit Shifting initiative, some scholars have advocated for a reversal of this trend. See, for example, Katharina Finke, Clemens Fuest, Hannah Nusser and Christoph Spengel, “Extending Taxation of Interest and Royalty Income at Source —An Option to Limit Base Erosion and Profit Shifting?” (2014), ZEW— Centre for European Economic Research Discussion Paper No. 14-073. 17 See Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation: A Structural Analysis (Alphen aan den Rijn, the Netherlands: Kluwer Law International, 2010), Part IV, chapter C, section 3. 18 See Stanford G. Ross, “United States Taxation of Aliens and Foreign Corporations: the Foreign Investors Tax Act of 1966 and Related Developments,” (1967) Vol. 22, Tax Law Review, 279, 293 –295. 19 See Jinyan Li, Arthur J. Cockfield and J. Scott Wilkie, International Taxation in Canada: Principles and Practices (Toronto: LexisNexis Canada, 2011), at 184. 136 Taxation of non-residents’ capital gains untaxed, special exceptions have been made —in Australia, Canada, Japan and the United States, for example —for companies that hold domestic real estate. In other words, taxing real estate gain is felt to be sufficiently important, from both a revenue and (perhaps more importantly) a political perspective, that the administrative costs of enforcing a tax on the transfers of shares of some resident companies are worth incurring. It is useful to reflect on this last trade-off between the importance of taxing a particular category of capital gains and its administrative costs. An often-repeated justification for taxing the gain from the dispositions of real property holding companies is that if such dispositions are not taxed, it would be too easy to avoid a tax on the capital gains realized on the disposition of the real estate itself by selling the shares of holding companies. This justification seems obvious. But it should be equally obvious that tax avoidance concerns arise not just in connection with real estate. Take, for example, an operating business the value of which has increased due to its improved prospects. It is undisputed that the disposition of a business run through a permanent establishment (PE) of a non-resident should be taxable in the country of the PE (paralleling the taxability of the business profits attributable to the PE). However, if a business is operated through the form of a domestic subsidiary and is sold through a share deal, the tax on the disposition of the business would be avoided, if share sales are not taxed. Nonetheless, this concern has not generally motivated a policy of taxing share sales despite the effort in a number of countries (for example, in Canada and the United States) to equate the tax treatment of branches and subsidiaries, for instance, through the branch profits tax. This appears to be an obvious case of inconsistency. One possible explanation for this inconsistency is that the administrative cost of taxing share transfers should be equal between a company that holds domestic real estate and a company that holds a domestic operating business. The need to tax share transfers to prevent avoidance of a tax on direct asset transfers also arises equally for immovable property and for assets of operating businesses. 20 Finally, 20 This rationale extends to the disposition of interest in other entities that are treated as legal persons. See David A. Weisbach, “The Irreducible Complexity of Firm-Level Income Taxes: Theory and Doctrine in the Corpo- 137 Wei Cui as discussed above, there is no clear difference between immovable property and business assets in their ability to generate capital gains. What is different is that foreign ownership of domestic immovable property has traditionally been politically more sensitive than foreign ownership of other domestic assets. It may be this political significance —rather than anything to do with revenue potential, the ease of tax administration or the need to rationalize tax systems —that has elevated immovable property to the status of an “especially taxable” asset class in the international tax arena. This is not to say that foreign ownership of domestic real estate is not politically sensitive in developing countries. Indeed, it may be so sensitive that it is prohibited outright—in which case the issue of taxing non-residents on capital gains from selling domestic real estate also becomes irrelevant. Although this source of political legitimacy for the taxation of non-residents on capital gains may still possess political appeal in various countries, tax systems in the twenty-first century typically rely on a wider range of justifications, having to do with budgetary needs, efficiency, fairness and administrative requirements. These justifications may well point to the taxation of a wider range of capital gains realized by non-residents. 3 . Non-administrative design issues in taxing non-residents on capital gains 3 .1 Gross-income versus net-income approaches Under their domestic laws, countries may tax income earned from sources within them by non-residents on either a net- or a gross-income basis. Under net-income-based taxation, non-resident taxpayers are treated in many ways like residents: they file income tax returns on a periodic basis; report income from different sources and of different types, as well as expenses that are associated with the various items of income and allowable as deductions; and are subject to tax rates generally applicable to domestic individuals or corporations. Under rate Tax,” (2007) Vol. 60, Tax Law Review, at 215; Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” (2014) Vol. 33, Virginia Tax Review, 649. 138 Taxation of non-residents’ capital gains gross-income-based taxation, by contrast, non-resident taxpayers may not need to file a tax return at all: the tax imposed by the source country may simply be withheld by the payer. Even when a non-resident is required to file a tax return, it may be reporting only particular items of income earned in the source country and not all such income earned in a period, and it may not be able to claim expenses or offsetting losses. Finally, the tax rate applied to income taxed on a gross basis is typically lower, in part to reflect the decision not to allow deductions of expenses and losses. Overall, gross-income-based taxation simplifies compliance and tax administration: the amount of gross proceeds is usually easily verifiable from the payer, whereas expenses and losses are more costly to substantiate and verify. The decision to tax a particular type of income either on a grossor net-income basis could depend on such administrative considerations alone. For example, if a non-resident has a sufficient physical presence in the source country that periodic contact with the country’s tax administration for purposes of filing a return and cooperating with audits is possible, then net-income taxation may be regarded as justified. Such a physical presence might be an office —possibly one that does not operate any business or at least not the business that generates the relevant taxable income — or a regular agent (even an agent that is independent). 21 However, for at least the past half century, it has been more common to tax on a net-income basis only business income attributable to a physical presence that is akin to a PE, whereas, short of a PE, income derived by a non-resident is either not taxed (if it is business income) or taxed on a gross-income basis (if it consists of particular types of investment income). Moreover, net-income taxation has become associated with active business income and gross-income taxation with passive investment income. Some of these long-standing conventions have recently come under critical scrutiny: questions have been raised especially regarding whether the concept of PE should still undergird the taxation of 21 See paragraph 6 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 27 of the Commentary on Article 13 of the OECD Model Convention (“force of attraction” approach to taxing capital gains). 139 Wei Cui business profits. 22 In any case, capital gains realized by non-residents have always fitted uneasily within the above conventions. On the one hand, capital gains are often a form of passive investment income. On the other hand, the computation of the amount of gain will almost always require the taxpayer to submit information about the original cost of the investment and not just the amount of the gross proceeds. In contrast to dividends, interest and royalties, it is difficult to collect tax on capital gains through final withholding. But once the non-resident taxpayer is already required to file a tax return (because it has crossed the administrative threshold), it can be fairly asked whether net-income-based taxation may be more sensible. This may mean allowing offsetting capital losses from the country against the capital gain; it may also mean permitting other types of expenses to be deducted. At the same time, it may require a higher tax rate to be applied. Countries differ widely in this regard in their approaches to taxing non-residents on capital gains. China and Japan, for example, require the reporting of a taxable capital gain by a non-resident, but still apply a reduced rate to such capital gains and do not allow offsetting losses. This can be viewed as being at one end of the spectrum. The United States, by contrast, treats capital gains on the disposition of certain real estate-related (FIRPTA 23 ) property realized by foreigners as though they are simply business income, and allows other losses realized in connection with a United States trade or business of the foreigner to be offset against such capital gain. This can be viewed as being on the opposite end of the spectrum from China and Japan. 24 There are important arguments in favour of allowing foreigners to reduce their taxable capital gains by their capital losses from the source country. To begin with, recognizing gains but ignoring losses may discourage investors from taking risks. Moreover, taking losses into account allows a more accurate measurement of the income of the non-resident that has been realized in the country, and imparts 22 See chapter VIII, Protecting the tax base in the digital economy, by Jinyan Li. 23 United States Foreign Investment in Real Property Tax Act (FIRPTA). 24 Canada allows the offsetting of losses from a given period from the disposition of similar investments (taxable Canadian property). 140 Taxation of non-residents’ capital gains greater legitimacy to taxing capital gains. 25 However, allowing loss offsets does reduce the revenue potential from taxing non-residents on capital gains. Moreover, because the tax on capital gains is difficult to enforce, non-residents who do not have offsetting losses might demonstrate less compliance than those who do. 26 Whether a gross- or net-income approach is taken also has consequences for the computation of the amount of capital gains on each transaction. For example, should fees paid to lawyers, accountants and investment bankers by the seller be allowed to reduce the amount recognized as the proceeds from sale, and should such fees paid by the buyer be included in the cost of their investment that can be deducted in the future? If the law treats capital gains as a form of passive income, just like dividends and interest, and applies a reduced tax rate to such income earned by foreigners, then the appropriate answer is no: any expense similar to expenses that cannot be deducted from dividends or interests should also not be deductible. This means that from the perspectives of the source country and the residence country, the amount of the capital gains realized on a sale can be very different. 27 From the residence country’s perspective, the amount of capital gains may depend on all kinds of expenses that should either be capitalized into the cost of the disposed asset or deducted from the income realized (thereby reducing the amount of capital gain), as well as on any depreciation or other allowance that has been given in respect of the investment (which may increase the amount of capital 25 Under the United Kingdom of Great Britain and Northern Ireland’s recently introduced regime of taxing non-residents on the disposal of residential properties in the United Kingdom, allowable losses may be taken into account, and for non-residents who need to file annual tax returns, they must remit tax payment only by 31 January of the following year instead of within 30 days after the disposal. See Trevor Johnson, “U.K. Tax Update: Nonresidents’ Capital Gains —The Pendulum Swings, but Too Far?” (2015) Vol. 78, Tax Notes International, 747. 26 However, a compliance culture may be fostered by taxpayers who expect to be able to claim losses, and the tax administration will be able to obtain information from such taxpayers. See section 4 below. 27 This is recognized in paragraph 4 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraphs 13-16 of the Commentary on Article 13 of the OECD Model Convention. 141 Wei Cui gains or trigger the recapture of income). From the source country’s perspective, unless the capital gains are attributable to a PE, none of the expenses and allowances may be taken into account. This need not in itself cause alarm—it should be remembered that the difference originates in the source country treating the capital gains as a form of passive investment income, subject to a simplified method of collection. 28 3 .2 Special issues in taxing transfer of interests in entities Taxing share sales creates the possibility of excessive taxation of the appreciation experienced by the assets held by the target company (whether immovable properties, operating businesses or some other type of assets): the appreciation may be taxed at both the corporate and the shareholder levels. In fact, the problem arises even for business entities (for example, partnerships) that are not themselves subject to tax: the sale of the assets of a partnership and the sale of the partnership itself are both ways of realizing a gain from the appreciation of partnership assets. Both need to be subject to tax to prevent taxpayer manipulation. 29 However, this means that the same economic gain might be taxed more than once. If such excessive taxation is to be avoided, then potentially complex measures —involving conforming the “inside” and “outside” tax cost base (or “basis”) of assets and shares —may have to be applied to ensure that a gain that has been taxed at the shareholder level is not taxed again at the entity level (and vice versa). Such measures are adopted in domestic contexts by some sophisticated tax systems (such as those implemented in Australia and the United States) within regimes for group consolidation or 28 See paragraph 4 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 12 of the Commentary on Article 13 of the OECD Model Convention, where it is stated that “as a rule, capital gains are calculated by deducting the cost from the selling price. To arrive at cost all expenses incidental to the purchase and all expenditure for improvements are added to the purchase price.” However, the same paragraph acknowledges that “the Article does not specify how to compute a capital gain, this being left to the domestic law applicable.” 29 See David A. Weisbach, “The Irreducible Complexity of Firm-Level Income Taxes: Theory and Doctrine in the Corporate Tax,” supra note 20. 142 Taxation of non-residents’ capital gains “flow-through” taxation. However, such regimes rarely extend to foreign entities. In domestic contexts, the ability of corporations to claim losses also sometimes mitigates the problem of excessive taxation of corporate assets. However, if foreign shareholders (or foreign owners of interests in other forms of business entities such as partnerships) are taxed on a gross-income basis and cannot offset losses against gains, corporate assets that are ultimately foreign-owned are again more likely to be subject to excessive taxation in this respect. In general, few countries that tax foreigners on the disposition of companies that hold domestic assets (such as immovable property) have systematically committed to mitigating potential excessive taxation. One approach suggested later in the present chapter (see section 6) in connection with the taxation of indirect share transfers is to treat such transfers as dispositions of underlying assets. That approach would go some way towards reducing the risk of excessive taxation, as it would adopt a net-income-based approach to taxing non-residents on capital gains. 3 .3 Should publicly traded shares be exempt? Enormous gains may be realized on stock markets, raising the question of whether such gains realized by foreigners on domestic stock exchanges, for example, under “qualified foreign institutional investor” regimes operated in countries like China and India, should be taxed. It used to be said that because trading on stock exchanges tends to have very high volume and frequency, it would be impossible to keep track of the gains and losses realized by investors on exchange trades. But with advancing technology and increasing uses of such technology by financial intermediaries, tracking information on gains or losses realized by investors (including foreign investors) may become less difficult. 30 Moreover, it is possible to require such financial intermediaries, and not the sellers, to act as withholding agents. Therefore, the decision whether to tax stock exchange gains may hinge more on policies regarding attracting foreign investment than on administrability. 30 See United States Internal Revenue Service, Notice 2012-34, “Basis Reporting by Securities Brokers and Basis Determination for Debt Instruments and Options.” 143 Wei Cui In addition, trading gains are more likely to reflect risk-taking rather than economic rent, and the case for allowing offsetting losses is thus rather strong. For gains realized on shares of resident companies listed and traded abroad, it is obviously difficult to secure cooperation from foreign stock exchanges to collect tax, even if such taxation is otherwise legitimate. For foreign listed companies, there is an important argument against source-country taxation of the transfers of their publicly traded shares, even if the companies hold substantial assets in the country. The argument is that listed companies are unlikely to be formed for tax avoidance purposes, but will almost invariably possess economic substance. The distinction between publicly traded and non-publicly traded companies is thus obviously relevant to the policy of taxing share sales, when that policy is motivated by anti-avoidance considerations. But this implies a criticism of the United Nations Model Convention, which, like the OECD Model Convention, does not distinguish between listed and non-listed companies among companies that hold substantial immovable property in the source country: 31 the source country is allowed to tax the capital gains realized on the sale of all such companies in accordance with Article 13 (4). 32 3 .4 Whether to tax foreign exchange gains Measurements of capital gains or losses are sometimes affected by foreign exchange gains or losses. 33 For example, local assets purchased 31 Article 13 (4) of the United Nations Model Convention. See further discussion in section 5 below. 32 The United Nations Committee of Experts Paper surveyed a number of countries regarding how Article 13 (4) was implemented, and one set of questions posed to the countries related to how shareholders can learn that the companies they own derive their values principally from immovable property in a given country. These questions seem to be pertinent mostly for publicly traded companies, and it seems debatable whether the sale of shares of these companies should be taxed in the source country. 33 See paragraph 4 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 11 of the Commentary on 144 Taxation of non-residents’ capital gains with US$ 1 million may sell later for more than that amount, not because the assets have appreciated within the local market (they may even have suffered a slight loss), but because the local currency has appreciated against the United States dollar. Conversely, a real capital gain may be hidden by a foreign currency loss. In designing the rules of taxing capital gains, a country will want to consider how to deal with foreign currency gains or losses. For example, if a country is expecting a steadily appreciating domestic currency against the foreign currency in which the investment is initially denominated, it will collect more revenue by measuring gain in the foreign currency than in the domestic currency (thereby capturing some of the gain of currency speculators). Conversely, if a country is expecting a steadily depreciating domestic currency against the foreign currency in which the investment is initially denominated, it will collect more revenue by measuring gain in the domestic currency. It is worth mentioning in this connection that any capital control regime adopted by a country may create problems for non-residents in paying tax on capital gain. If the amount realized on the disposition is in foreign currency, but tax must be paid in domestic currency, then the non-resident taxpayer must be allowed to exchange the currency for purposes of the tax payment. This issue does not normally arise in connection with passive income, such as dividends, interest or royalties, which has a domestic payer: the payer in these cases should be able to furnish the local currency required. 4 . Administering the tax on capital gains of non-residents Administering a tax on capital gains realized by non-residents faces three fundamental challenges. First, if the sale and purchase of the asset occur between two non-residents, the execution of the transaction and the flow of funds may all take place outside the source Article 13 of the OECD Model Convention. (“The Article does not distinguish as to the origin of the capital gain … . Also capital gains which are due to depreciation of the national currency are covered. It is, of course, left to each State to decide whether or not such gains should be taxed.”) See also paragraph 4 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraphs 16 and 17 of the Commentary on Article 13 of the OECD Model Convention. 145 Wei Cui country, making such transactions difficult to detect. 34 Second, even if a transaction is detected, if the non-resident seller refuses to pay the tax and becomes delinquent, unless such a seller has other assets in the source country, it could be very difficult to complete tax collection. Third— and this is a point that has received little discussion in the existing literature —it may be difficult to organize tax administration around taxing capital gains. The non-resident taxpayers typically have little or no interaction with the tax authority of the source country. The timing and volume of transactions may be unpredictable, as may be the revenue intake from levying the tax. Such irregularity may be felt to be especially severe if tax administration in the source country is decentralized. However, none of these challenges need be insuperable. 4 .1 Detection 4.1.1 Reporting by transacting and third parties Generally, there are three legal mechanisms that enable tax authorities to detect offshore (direct or indirect 35 ) transfers of domestic assets or shares: self-reporting by the transferor, reporting by the transferee (whether or not accompanied by withholding) and reporting by third parties. As regards transferor self-reporting, the source country may impose penalties on non-reporting transferors to foster compliance. However, if the chances of detection of taxable transactions are very low, the expected cost of a penalty for non-reporting may also be too low to be effective. If most taxpayers do not comply and the tax authority fails to detect most instances of non-compliance, imposing a heavy penalty on the few detected cases will also seem unfair. It thus seems surprising that, at least until recently, many countries have solely or 34 It should be noted that this is a potential problem for all taxable transfers among non-residents, and not just for the type of indirect transfers discussed in section 6 below (that is to say, transfers of foreign entities that hold, directly or indirectly, domestic assets). 35 Indirect transfers are discussed more extensively in section 6 below. 146 Taxation of non-residents’ capital gains largely relied on seller reporting for taxing capital gains. 36 In response to a recent survey conducted by the United Nations Committee of Experts on International Cooperation in Tax Matters, a number of countries, both developed and developing, confirmed the relevant challenges for detection of taxable transfers. 37 For this reason, the Australian government has announced that “to further improve the integrity of the foreign residents’ regime in relation to the disposal of Australian real property interests … a 10 per cent non-final withholding tax [will] apply to the disposal by foreign residents of certain taxable Australian property from 1 July 2016.” 38 As to transferee reporting, if the transferee is a non-resident as well, the failure of such reporting would be just as hard to detect as the failure of transferor reporting. A sanction imposed upon a transferee’s failure to report would, in a way, be similar to increasing the penalties on a transferor’s failure to report—in both cases, the aggregate penalties on non-reporting are increased. The difference is that the transferee usually has a lot less to lose by reporting, since it is not the party paying the tax. This may be sufficient to create compliance by transferees. Interestingly, however, no government seems to have instituted transferee reporting alone (without further requiring withholding) for taxing either direct or indirect transfers. This points to the magnitude of the collection problem: simply having information that a non-resident engaged in a taxable transaction is of little value; the 36 As recently as 2015, when the United Kingdom amended the Finance Act to subject non-residents to tax on the disposal of residential properties in the United Kingdom, the Government eschewed a proposed system of deduction at source whereby the solicitor for the seller would deduct the amount of tax. Instead, the amended Finance Act only required the transferor individual to file a non-resident capital gains tax return within 30 days of the completion of the disposal. See Trevor Johnson, “U.K. Tax Update: Nonresidents’ Capital Gains —The Pendulum Swings, but Too Far?” supra note 25. 37 See Committee of Experts Paper, supra note 7, at 36-39. The countries confirming difficulties with detection include Australia, Azerbaijan, China, Japan, Malaysia, Mexico, Norway, Russia, South Africa and Zambia. India and the United States, by contrast, did not report such problems because they require transferee withholding. 38 Ibid., at 45. Withholding will apply to both capital and revenue transactions and the withholding obligation will rest with the purchaser. 147 Wei Cui government still has to make all the efforts to collect the tax. 39 Besides explicit sanctions, market dynamics may also create incentives to comply with transferee reporting requirements. 40 For example, when taxing capital gain, the source country generally needs to keep track of the tax cost or basis of the assets transferred. If the capital gains realized on a transfer have been subject to tax, the cost basis of the shares transferred should be adjusted (“stepped up” in the case of gain) for purposes of future source-country taxation. Conversely, one can imagine a rule that provides that if a transfer has not been taxed (other than in a case where the capital gains on a transfer are affirmatively exempted from tax, for example, under an applicable treaty), then the basis of the transferred shares would, for the purpose of source-country taxation, remain the same. That is to say, the transferee would not obtain a basis in the shares it acquires equal to the consideration it pays unless the acquisition has been taxed. This is different from the normal use of the concept of cost basis: the cost basis of an asset is normally determined in respect of a particular owner of the asset. However, the notion can be modified so as to keep track of the relationship of the asset to the taxing authority: which portion of the value of the asset has been subject to tax by the source country (in whomever’s hands)? With such a rule in place, the failure to report a taxable transfer would result in the risk that the transferee, in the future when it acts as a transferor, would be taxed on gain that accrued to and was realized by previous owners. Of course, for this to have an incentive effect, there must be an expectation that the future transfer itself will be reported or detected. Another complication is that both the tax authority and the non-resident taxpayer may also have difficulty determining what the original basis was in 39 Canada, India and the United States are some of the countries that already impose withholding obligations on purchasers. While China nominally “requires” transferees or other payers of consideration (whether domestic or foreign) to withhold on the capital gains realized on a transfer, when withholding is infeasible, the transferee or payer has no information reporting obligation. 40 See Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20. 148 Taxation of non-residents’ capital gains the hands of previous owners. 41 Nonetheless, the risk of the conversion of a seller tax liability into a potential tax liability of the buyer (as a future seller) may well be unacceptable to many buyers. They would then either seek indemnity from the seller, or require, as a matter of contract, the seller to report the sale to the tax authorities and, in addition, to pay tax if required by law. 42 With regard to third-party reporting, for certain types of property, such as immovable property, shares in companies, mineral and other licences, and sometimes even ships and aircraft (because of regulatory requirements), the country in which they are located may operate ownership registration systems. The transfers of ownership will be recorded in such systems and tax authorities may require those who maintain the systems to report the transfers. 43 In addition, third parties in the transfers of financial claims, that is to say, lessees, borrowers and companies issuing shares, often receive notice of the transfers under either legal or contractual requirements. It may be possible to enlist such parties in reporting taxable transfers, even if they are not party to the transfer. However, such a requirement could have limits if third-party contractual rights to notice are not always required in the market. 44 Moreover, should both the purchaser/transferee and third parties be required (in the sense of having an obligation backed up by penalties) 41 The future transfer might also itself be exempt from tax (for example, under treaty protection). 42 Dynamics in the tax service market may also contribute to compliance. For further discussion, see Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20, at 680-681, 690-691 and 694. Because the penalties for non-reporting under China’s policy of taxing indirect transfers of domestic company shares are very low, most compliance with that policy that has taken place in China since 2009 may have resulted from buyer and adviser monitoring. 43 It should be noted, however, that the mere transfer of legal ownership may not be sufficient to constitute an ownership change for income tax purposes under the tax laws of many countries. 44 Nonetheless, a government requirement for third-party reporting may induce changes in contractual terms, such that third parties will demand contractually (and receive) notice of transfers. 149 Wei Cui to report a transaction? Third-party reporting requirements often will call upon market participants to share information which they would not otherwise share. 45 Finally, third-party reporting will not by itself solve the collection problem. 46 Therefore, where it is possible to rely on transferee/buyer reporting, third-party reporting should arguably not be used, unless such reporting (for example, to a regulatory authority) would take place in any case. 4.1.2 Exchange of information among tax authorities Some recent discussions of the detection problem refer optimistically to the exchange of information among tax authorities. 47 It seems exceedingly unlikely, however, that the seller’s resident country will have more information about an isolated transaction than the source country where the transferred asset is located. The question can also be raised whether the new country-bycountry (CbC) reporting regime promoted by the OECD project on Base Erosion and Profit Shifting (BEPS) is relevant to the detection of taxable transfers among non-residents. The OECD Final Report on BEPS Action 13 provides a template for multinational enterprises (MNEs) to report annually, and for each tax jurisdiction in which they do business, supplies information to help assess “high-level transfer pricing risks and other base erosion and profit shifting related risks.” 48 45 For example, shareholders may have reasons to withhold information about a share sale from the managers of the company sold, because these managers may soon be fired. To enlist the assistance of these same managers in notifying tax authorities of the sale could be awkward. 46 See discussion below regarding objections to imposing a substantive liability on third parties (other than the seller and buyer). 47 See Committee of Experts Paper, supra note 7, at 36-39; IMF Spillovers Report, supra note 7, at 71; and Lee Burns, Honoré Le Leuch and Emil Sunley, “Transfer of an Interest in a Mining or Petroleum Right,” in Philip Daniel and others, eds., Resources without Borders (Washington: International Monetary Fund, 2014), section 4.1. 48 See OECD, Transfer Pricing Documentation and Country-by-Country Reporting, Action 13 —Final Report (Paris: OECD, 2015), available at http:// dx.doi.org/10.1787/9789264241480-en. As at October 2016, 49 countries had signed the Multilateral Competent Authority Agreement (MCAA) for the automatic exchange of CbC reports. 150 Taxation of non-residents’ capital gains Under the CbC reporting regime, each MNE group required to file CbC reports needs to provide a “master file” depicting (among other things) the MNE group’s organizational structure as well as its intercompany financial activities. In addition, “local files” for each country in which the MNE does business would furnish “information relevant to the transfer pricing analysis related to transactions taking place between a local country affiliate and associated enterprises in different countries and which are material in the context of the local country’s tax system.” 49 While the primary aim of the CbC reports is to expose risks of profit shifting through whatever intercompany transactions there are within an MNE group, changes in corporate structures and intragroup financial claims may indirectly reveal taxable asset transfers (including indirect transfers, discussed in section 6.2 below). However, there are various reasons to believe that the impact of CbC reports on the practice of taxing capital gains realized by non-residents will be of secondary significance (at best). First, only MNEs with an annual consolidated group revenue equal or exceeding €750 million or equivalent are required to file CbC reports. Source countries may directly receive “master files” and “local files” only from MNEs that have consolidated subsidiaries in their countries. It is far from clear that this framework captures a population of taxpayers who routinely realize the kinds of capital gains that source countries may want to tax. For instance, although investment funds are not automatically exempt from CbC reporting requirements, how to apply the annual revenue threshold and the accounting consolidation requirement to investment funds remains unclear. 50 Moreover, the CbC reports that countries may exchange under the Multilateral Competent Authority Agreement contain only aggregate information and would not be informative with respect to particular transactions, whereas capital gain taxation crucially depends on the identification of particular transactions. Finally, information on corporate structures (including offshore holding structures) is the type of information that many countries’ tax administrations are already able to obtain from 49 Ibid., paragraph 22. See OECD, Guidance on the Implementation of Country-by-Country Reporting: BEPS Action 13 (Paris: OECD, 2016). Investee entities may generally not be included in the consolidated group of a fund if ordinary financial accounting practice does not require such inclusion. 50 151 Wei Cui taxpayers directly, either pursuant to domestic legislation or in administrative practice, and it is not clear that the leverage provided by the CbC reporting regime is really needed. 4 .2 Collection From a collection and revenue protection perspective, transferee withholding is clearly a more powerful tool than transferee reporting. Canada, India and the United States each require the transferee in a taxable direct (and, in the case of Canada and India, indirect) transfer to withhold from gross proceeds paid to the transferor, regardless of whether the transferee is domestic or foreign. 51 Each also makes the amount required to be withheld the personal tax liability of the transferee if it fails to withhold. Note that when the transferee is made personally liable for failing to withhold a tax that was in the first instance imposed on the transferor, the implicit penalty of the no-basis-step-up treatment (which is possible even under transferor reporting) has merely been made explicit. In countries with weak legal norms, a view may be held that the failure of the transferor to pay tax on a transfer creates a de facto personal liability for the transferee anyway, as the tax authority could always “go after” the asset located in the country and therefore expropriate its value from the present owner of the asset. Unless the transferee (new owner) is legally made liable for the tax that the transferor fails to pay, however, this kind of expropriation is against the rule of law, and is both unnecessary and unproductive for tax administration. Moreover, even when transferees are made liable for failures to withhold, it is important to observe legal distinctions. For example, if it is the tax on the capital gains realized on the alienation of 51 The United States rule, Internal Revenue Code section 1445, requires withholding of 10 per cent from gross proceeds. IRC § 1445 (2013); the Canadian rule, Income Tax Act section 116, requires a significantly higher (25 per cent) rate of withholding, but allows the transferor to prepay or post collateral with the government based on the amount of capital gains. See Income Tax Act, R.S.C. 1985, c. 1. The Indian rule, Section 195 (1) of the Income Tax Act, 1961, requires withholding simply of the amount of the tax owed, without addressing the issue of how the transferee would know how much tax is owed. See Income Tax Act (195/1961) (India). 152 Taxation of non-residents’ capital gains a domestic company’s shares that is at stake, it makes little sense to demand payment from the domestic company itself. To do so would erase the distinction between shareholder and corporate liabilities that lies at the core of an indefinite range of transactions (for example, with creditors, customers and employees) that the company may be engaged in. This would clearly be counterproductive. 52 Several limitations of the withholding approach should be noted, however. First, if the transferee is a non-resident, the imposition of a withholding obligation alone does not necessarily enhance the transferee’s likelihood of compliance. And delinquent non-resident transferees create collection problems similar to those encountered in respect of delinquent non-resident transferors. 53 Second, withholding on capital gains also cannot generally be expected to be accurate with respect to the ultimate tax liability and therefore is likely to trigger either an application for refund or examination by a tax authority. The overall compliance burden for taxing capital gains, therefore, will be increased by withholding. It also bears mentioning that any obligation to withhold could only sensibly be formulated with respect to the gross amount paid and not the capital gains realized by the payee, because it is only infrequently that a seller would tell a buyer how much profit the seller has made. 54 4 .3 Voluntary compliance In other areas of tax administration, a key to success in collection, beyond adequate sanctions and effective enforcement powers, is the inducement of voluntary compliance among taxpayers. It would be surprising if this were not the case in levying tax on non-residents. 52 For these reasons, several suggestions regarding collection techniques made in the IMF Spillovers Report (for instance, treating the target resident company as the agent of the non-resident, so that it will be liable if the tax is not paid by the non-resident, or deeming the resident company to have made the transfer, so that it is liable for the tax) should be viewed with caution. See IMF Spillovers Report, supra note 7. 53 Nonetheless, for the reasons discussed in the previous paragraph, it rarely makes sense to make the target of the transfer liable for tax. 54 See, however, the Indian withholding requirement, Income Tax Act (195/1961) (India). 153 Wei Cui However, there has been little government or scholarly research on voluntary compliance on the part of non-residents. For example, while, intuitively, a lower rate of tax should produce greater voluntary compliance, it is not known how low the tax rate would need to be to produce sufficient compliance. Another suggestion is to increase the contact of non-residents with the tax authority and with other compliant taxpayers. For example, allowing losses and expenses to be taken into account in computing taxable gain may make the contact of non-residents with the source country less “one-shot” in character. Finally, it may be useful to focus on improving compliance among multinationals and foreign investors that deal with the source country on a regular basis. A culture of compliance among such taxpayers (and their advisers) may be an important step towards creating a culture of compliance among non-resident taxpayers in general. 4 .4 Organization of tax administration The occurrence of taxable transfers of domestic assets among non-residents can be erratic, which makes the decision to assign dedicated tax administration personnel to collect tax on such transfers difficult. At the same time, non-reporting non-residents —whether they are transferors or transferees — are like domestic taxpayers who do not file tax returns: special efforts have to be made to detect them and bring them into compliance. It is not clear that any country’s tax authority has developed well-articulated strategies for dealing with this predicament. In many OECD countries, where both tax administration and the study of tax administration are generally more developed than elsewhere, the scope of capital gains taxation on non-residents tends to be limited. They therefore offer limited expertise insofar as taxing capital gains of non-residents is concerned. In the United States, for example, an Internal Revenue Service (IRS) publication from 2010 states that a study of the collection of FIRPTA tax was only “planned” and data was “not yet available.” 55 Moreover, the “planned” study was based only on returns filed by 55 Melissa Costa and Nuria E. McGrath, “Statistics of Income Studies of International Income and Taxes,” (2010) Vol. 30, No. 1 Statistics of Income Bulletin, available at http://www.irs.gov/pub/irs-soi/10intertax.pdf, at 192. 154 Taxation of non-residents’ capital gains transferees who had withheld tax from the gross proceeds of sales of United States real estate interest (including shares of United States companies that hold United States real estate) by foreigners. 56 No data seems to be separately available to the IRS on transferor self-reporting of sale of United States real property interests, and there is no sign of any data on audits (if any) of transferors or transferees. In fact, the United States did not attempt to measure non-resident taxpayer compliance until 2008, and even the new attempt to do so is designed only for individual taxpayers. 57 For developing countries that aim to preserve their tax base consisting of income belonging to non-residents to a greater extent than OECD countries, effective tax administration strategies may therefore have to be developed indigenously. One possible approach is to centralize tax administration in this area so as to allow specialization and economy of scale: the number of taxable transactions as well the revenue outcome will diminish if averaged over too many tax administrators, whereas a small number of specialized tax administrators may be able to deal with a relatively large number of taxable transactions because of the one-shot nature of the taxpayers involved. 58 56 Ibid. The most recent IRS Bulletin on Foreign Receipts of United States Income, relating to the year 2010, also reports only FIRPTA withholding information and no information about transferor self-assessment. See Scott Luttrell, “Foreign Recipients of U.S. Income, 2010,” (2013) Statistics of Income Bulletin, available at http://www.irs.gov/pub/irs-soi/13itsumbulforrecip.pdf. 57 See United States Internal Revenue Service, “The Tax Gap and International Taxpayers,” (2008), available at http://www.irs.gov/Businesses/TheTax-Gap-and-International-Taxpayers. See also, United States Government Accountability Office, “IRS May Be Able to Improve Compliance for Nonresident Aliens and Updating Requirements Could Reduce Their Compliance Burden,” GAO-10-429 (2010), available at http://gao.gov/products/GAO-10429. The IRS has not developed estimates for the extent of non-resident alien tax non-compliance. 58 However, in China, where enforcement of the tax on capital gains of non-residents realized on transfers of domestic company shares (including indirect transfers, as discussed in section 6 below) has intensified in recent years, a decentralized approach seems to have emerged: tax administration staff in local offices take initiatives to find offshore share transfers (which is not hard to do if listed companies are involved and material transactions 155 Wei Cui 5 . Article 13 of the United Nations Model Convention and treaty practices among developing countries with respect to taxing capital gains Article 13 of the United Nations Model Convention allocates non-exclusive taxing rights to the source country in respect of gains on immovable property (paragraph 1), business assets forming part of a PE (paragraph 2), ownership interest in entities that derive value principally from immovable property (paragraph 4) and shares that represent substantial participation in a resident company (paragraph 5). It assigns exclusive taxing rights to the place of effective management in respect of gains on ships or aircraft operated in international traffic and boats engaged in inland waterways transport (paragraph 3). 59 It then provides that the gain from the alienation of other property not specifically enumerated shall be taxable only in the residence State of the alienator (paragraph 6). The threshold decisions of whether capital gains should be taxed and, if so, of how they are to be taxed, are left to the domestic law of each contracting State. 60 The United Nations Commentary on Article 13 repeatedly refers to the “correspondence” between the taxation of gain and the taxation of income, and uses this correspondence to explain the purpose are required to be disclosed by stock exchanges), and sometimes collect revenue that is sizeable for that particular office, even if not for the country’s tax administration as a whole. There is no systematic study of this practice, but a sense of it can be gleaned from practitioners’ reports. See, for example, Jinji Wei, “Chinese Tax Implications of Indirect Share Transfers,” (2014) Vol. 23, No. 7 Tax Management Transfer Pricing Report. 59 The practical significance of Article 13 (3) is unclear. Ships, aircraft or boats as physical vehicles should generally decline in value during their useful lives, even if the rights to use them may change in value due to fluctuations in demand and supply in shipping and aviation markets. Moreover, the paragraph is limited to alienation by owners who also operate the ships, aircraft or boats; such vehicles operated by parties other than such owners (for example, under dry lease) fall outside the scope of the paragraph. See paragraph 7 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 28 of the Commentary on Article 13 of the OECD Model Convention. 60 Paragraph 3 of the Commentary on Article 13 of the United Nations Model Convention. 156 Taxation of non-residents’ capital gains of paragraphs 1 and 2 of the Article. 61 Nonetheless, in the restrictions it imposes on source-country taxing rights, the United Nations Model Convention does not generally adhere to this correspondence: instead of being a consistent implementation of the principle of similar taxation of income and gain (given their economic equivalence), Article 13 of the United Nations Model Convention is very much a compromise. The most salient symptom of this compromise is the structure of the Article. While the language of the United Nations Model Convention, following Article 13 of the OECD Model Convention, proceeds to delineate source-country taxing rights for specific types of property, and then to provide for exclusive resident-country taxation for properties not specifically enumerated, the United Nations Commentary on Article 13 acknowledges that “[most] members from developing countries advocated the right of the source country to levy a tax in situations in which the OECD reserves that right to the country of residence.” 62 It therefore mentions an alternative provision allowing source-country taxation of gains “from the alienation of any property other than those gains mentioned in paragraphs 1, 2, 3 and 4.” 63 This alternative language, adopted with modification in many actual treaties, leads to some obvious interpretive tensions surrounding the Article, as discussed below. The following aspects of the language of Article 13 are especially relevant to understanding the restrictions that the Article imposes on source-country taxing rights, as well as the anti-avoidance principles the Article acknowledges. 5 .1 The definition of “immovable property” “Immovable property” for purposes of Article 13 is defined by reference to Article 6, which, in the United Nations Model Convention, has “the meaning which it has under the law of the Contracting State in which the property in question is situated.” Article 6 (2) of the United 61 See section 3 above. Paragraph 2 of the Commentary on Article 13 of the United Nations Model Convention. 63 Paragraph 18 of the Commentary on Article 13 of the United Nations Model Convention. 62 157 Wei Cui Nations Model Convention explicitly states that the term “immovable property” “shall in any case include … rights to which the provisions of general law respecting landed property apply, usufruct of immovable property and rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources.” This broad formulation is likely to capture the rich variety of “bundle[s] of infinitely divisible rights” 64 that may be associated with immovable property and transferred at a gain. 65 5 .2 Movable property part of a permanent establishment Article 13 (2) gives the source country taxing rights on gains from the alienation of movable property forming part of the business property of a PE (or pertaining to a fixed base available for the purpose of performing independent personal services). The United Nations Commentary explicitly notes that “the term ‘movable property’ means all property other than immovable property … . It includes also incorporeal property, such as goodwill, licenses, etc. Gains from the alienation of such assets may be taxed in the State in which the permanent establishment [or fixed base] is situated.” 66 This is an important observation, because tangible movable properties — such as machines and equipment—tend to experience depreciation and thus have limited 64 Richard Krever, “Tax Treaties and the Taxation of Non-Residents’ Capital Gains,” supra note 7, at 224. 65 Nonetheless, Professor Richard Krever has argued that “there are remarkably wide variances in the different definitions” used in different jurisdictions, and that “civil law jurisdictions with limited [natural] resources” tend to adopt the narrowest definitions. He warns that “treaties often fail to operate as broadly as domestic legislation, and domestic legislation itself may struggle to keep up with new and innovative forms of de facto property owners, including the use of rights, options, or derivatives.” Therefore, he suggests that “countries seeking to retain domestic taxing rights through Article 13 must ensure, first, that domestic law is sufficiently robust to capture all gains related to real property realized by resident and non-resident taxpayers and, second, that Article 13 in their tax treaties is equally broad.” Ibid., at 223 –224. 66 Paragraph 6 of the Commentary on Article 13 of the United Nations Model Convention, quoting paragraph 24 of the Commentary on Article 13 of the OECD Model Convention. 158 Taxation of non-residents’ capital gains potential for capital gain. It is instead the intangible components of a business, including contracts with customers, employment contracts with skilled personnel, brand names, know-how (whether patented or not) and so forth, that give rise to capital gains on the sale of a business. This broad definition of movable property under Article 13 (2) raises a crucial interpretive issue: is movable property that does not form part of the business property of a PE of a non-resident thereby carved out from the scope of taxation under Article 13? Consider the vulture fund that has sold a portfolio of non-performing loans at a handsome gain. The loans may be viewed as movable property for the purpose of the fund business, or depending on the fund’s structure, they may be held as investment assets but nonetheless are “movable property” in the sense defined above. The fund may have no PE in the country where the business borrowers are located. Does Article 13 (2) imply that the vulture fund’s gain is not taxable in the country of the debtors? 67 Since whatever is not immovable property will be regarded movable property, unless there is a subsequent paragraph in Article 13 that prescribes a specific rule (for example, for ships, aircraft and shares), one might infer that capital gains taxation (without PE) is precluded by paragraph 2. If under the same treaty, interest on loans (and rent or royalty from leases, licences and other agreements covered by the “Royalties” article) remain taxable in the source country, a sharp inconsistency between the treatment of income and of gain from the same asset would result. As discussed below, this difficulty is not necessarily resolved even when the contracting States agree to retain residual taxing rights for the source State over gains not otherwise enumerated in Article 13. 5 .3 Entities holding immovable property directly or indirectly Article 13 (4) of the United Nations Model Convention provides taxing rights over “gains from the alienation of shares of the capital stock of a company, or of an interest in a partnership, trust or estate, the 67 Similar questions can be raised for transfers of lease contracts with domestic lessees, or of licences with domestic licensees, and so on, where the lessor, licensor, etc., has no PE in the source country. 159 Wei Cui property of which consists directly or indirectly principally of immovable property situated in a Contracting State” to that State. 68 The United Nations Commentary notes that the provision: is designed to prevent the avoidance of taxes on the gains from the sale of immovable property. Since it is often relatively easy to avoid taxes on such gains through the incorporation of a company to hold such property, it is necessary to tax the sale of shares in such a company … . In order to achieve its objective, paragraph 4 would have to apply regardless of whether the company is a resident of the Contracting State in which the immovable property is situated or a resident of another State … . In order to fulfil its purpose, paragraph 4 must apply whether the company, partnership, trust or estate owns the immovable property directly or indirectly, such as, through one or more interposed entities. 69 However, it does not appear that countries have generally enacted the anti-avoidance measures permitted by Article 13 (4). For example, as discussed in section 6.2 below, surprisingly few countries — in the OECD 70 or in the developing world—have enacted domestic 68 Article 13 (4) (b) defines “principally” in relation to ownership of immovable property to mean “the value of such immovable property exceeding 50 per cent of the aggregate value of all assets owned by the company, partnership, trust or estate.” 69 Despite the anti-avoidance intent of Article 13 (4), it has been argued that it may not encompass all the ways in which non-residents may employ tax structures to avoid taxation. “A convertible debt or option, for example, may not be viewed by a court to constitute an interest in a company, but merely a claim to a company’s property in the former case or a right over a shareholder or the company in the latter.” See Richard Krever, “Tax Treaties and the Taxation of Non-Residents’ Capital Gains,” supra note 7, at 229. It has therefore been suggested that a source country may want to subject such claims against a company holding immovable property situated in it to capital gains taxation also. Canada defines taxable Canadian property (that is to say, property whose gain realized by a non-resident is taxable in Canada) as including “an option in respect of” other taxable Canadian property. See Income Tax Act, RSC 1985, c. 1 (5th Supp.), s. 248. 70 The OECD Model Convention contains a somewhat similar provision for source-country taxation of the shares of real estate holding companies, including shares of non-resident companies. 160 Taxation of non-residents’ capital gains law for taxing transfers of foreign companies (indirect transfers). The mere language of Article 13 (4), therefore, sheds little light on the practice of anti-avoidance legislation. Finally, Article 13 (4) of the United Nations Model Convention carves out from source-country capital gains taxation transfers of interests in entities whose property consists directly or indirectly principally of immovable property used by them in their business activities (but not an immovable property management company, partnership, trust or estate). The reason for this carve-out, presumably, is that entities that use immovable property in their business activities are not formed for purposes of avoiding the tax on the sale of immovable property. However, relatively few treaties involving developing countries have adopted this carve-out; nor has Article 13 of the OECD Model Convention adopted a similar one. An obvious reason is that there are important types of companies which derive their value predominantly from real property, for example, hotel and resort operators, operators of shopping malls and even of restaurants and cinemas, and, of course, companies that extract natural resources. The appreciation in the value of the shares of such companies is likely to reflect the appreciation of the underlying real property, and it is not at all obvious why the source country should give up taxing rights over such shares. This carve-out can also be regarded as a special case in the inconsistent treatment between PEs and subsidiaries of non-residents, mentioned in section 2.2 above and further discussed in the next section. 5 .4 Substantial participation in a company The Commentary on Article 13 of the United Nations Model Convention notes that “some countries hold the view that a Contracting State should be able to tax a gain on the alienation of shares of a company resident in that State, whether the alienation occurs within or outside that State.” It then claims that “for administrative reasons the right to tax should be limited to the alienation of shares of a company in the capital of which the alienator at any time during the 12-month period preceding the alienation, held, directly or indirectly, a substantial participation.” 71 This position is reflected in Article 13 (5) of the United 71 Paragraph 9 of the Commentary on Article 13 of the United Nations Model Convention. 161 Wei Cui Nations Model Convention, where the percentage deemed to constitute substantial participation is to be established through bilateral negotiations. Article 13 (5) allows that the substantial holding (which leads to taxability) may be “indirect,” partly as an anti-avoidance device. 72 Under the OECD Model Convention, the alienation of shares of companies other than those holding domestic real property assets is not taxable in the country of residence of the companies. As noted earlier, this produces differential treatment between PEs and subsidiaries, and ignores the anti-avoidance argument for taxing both asset and share sales. Article 13 (5) of the United Nations Model Convention can be viewed as constituting an improvement in this regard. What is less clear, especially in view of the analysis of enforcement and compliance in section 4 above, is why administrative considerations dictate a percentage ownership approach to having a threshold for taxing the alienation of shares. For example, if it is the burden of filing a tax return by the non-resident that is at issue, a monetary amount (that is to say, exclusion of small gains) would seem more appropriate. The Commentary on the United Nations Model Convention also points out arguments against taxing listed shares (that it is “costly,” and that “developing countries may find it economically rewarding to boost their capital markets by not taxing gains from the alienation of quoted shares.” 73 ) It goes on to suggest language for carving out traded shares from the scope of taxation under paragraph 5. The cost of taxing exchange-traded shares and the policy of boosting domestic stock markets, however, seem to be issues better addressed through domestic law. There seems to be little need or justification for negotiating a reciprocal agreement with individual treaty partners. 72 According to paragraph 11 of the Commentary on Article 13 of the United Nations Model Convention, “It will be up to the law of the State imposing the tax to determine which transactions give rise to a gain on the alienation of shares and how to determine the level of holdings of the alienator, in particular, how to determine an interest held indirectly. An indirect holding in this context may include ownership by related persons that is imputed to the alienator. Anti-avoidance rules of the law of the State imposing the tax may also be relevant in determining the level of the alienator’s direct or indirect holdings.” 73 Paragraph 13 of the Commentary on Article 13 of the United Nations Model Convention. 162 Taxation of non-residents’ capital gains 5 .5 Residual taxing power Article 13 (6) of the United Nations Model Convention, like Article 13 (5) of the OECD Model Convention, gives the residence State exclusive taxing rights over assets not covered by the preceding paragraphs of the Article. However, as mentioned, the Commentary has noted the preferences of developing countries to retain taxing power over assets not specifically enumerated. Such preferences are also reflected in the treaty practice of many countries — and not just developing ones. 74 This is not surprising insofar as the previous paragraphs of Article 13 do not capture all the important elements of the capital gains tax base for the source country (see the discussion at the beginning of section 2 above), and insofar as ceding such residual taxing rights would create disparate treatment between income and gain from the same asset. However, the way in which residual taxing power is preserved under Article 13 remains a problematic issue. The Commentary on Article 13 of the United Nations Model Convention proposes the language: “Gains from the alienation of any property other than those gains mentioned in paragraphs 1, 2, 3 and 4 may be taxed in the Contracting State in which they arise according to the law of that State.” The question can be raised as to what constitutes a gain “mentioned” in a previous paragraph. For example, consider the gain from the alienation of shares that fall below the ownership threshold set by the contracting State in a provision similar to Article 13 (5) of the United Nations Model Convention. Article 13 (5) states only that the gain realized on the alienation of shares above the threshold is taxable in the source State. Is gain realized on the alienation of shares below the threshold thereby “mentioned”? If the position is taken that it is not, then the residual taxing power paragraph essentially erases the line drawn in Article 13 (5): it is 74 A recent study of Article 13 offers as examples of tax treaties that permit the source State to tax gains from the alienation of property that is not otherwise covered by Article 13, those concluded by Australia (1989 to 2003), Argentina, Brazil, China (the tax treaties with Australia, Canada, the Czech Republic, Germany, Hungary, India, Japan, Malaysia, the Netherlands, New Zealand, Nigeria and Thailand), India (the tax treaties with Canada and the United States) and Turkey (the tax treaties with Canada, Italy, Singapore and Spain). Jinyan Li and Francesco Avella, “Article 13: Capital Gains,” Global Tax Treaty Commentaries (Amsterdam: International Bureau of Fiscal Documentation, 2014), section 3.1.6.2, “Other cases dealt with by domestic law.” 163 Wei Cui almost as though Article 13 (5) is deleted in its entirety. 75 Interpreted in this way, the approach to drafting in Article 13 would strike many readers as unusual (and unnatural). Even source-country tax authorities want to refrain from “overlooking” distinctions made in the previous paragraphs of Article 13 if residual taxing power is reserved under Article 13 (6). An alternative approach to applying Article 13 (6) is to deem what is reserved to be taxing rights over types of property (as opposed to types of gain) not referred to in a previous paragraph. 76 Thus, shares of resident companies are a type of property already covered by Article 13 (5), and the alienation of shares below the threshold would not be taxable even under Article 13 (6). The question is then what is the “type of property” previously referred to in the Article. For example, does Article 13 (2) refer to all movable property, or only movable property used in a business, or, even more narrowly, only movable property used in a business conducted by a PE? Here, one faces an interpretative dilemma. On the one hand, the reading of Article 13 (2) as referring to all movable property would render the class of “property other than that referred to” in a previous paragraph nearly empty. On the other hand, reading it as referring to “movable property used in a business conducted by a PE” would mean erasing the distinctions drawn in (and therefore the point of) that paragraph. Therefore, the uneasy compromise that the United Nations Model Convention has tried to delineate between Article 13 of the OECD Model Convention and the positions of developing countries seems to have led to an interpretive impasse. 6 . Preventing avoidance of the tax on capital gains by non-residents Section 4 of the present chapter identified detection of taxable transfers and enforcement against delinquent taxpayers as the main challenges 75 A similar question can be raised about the 50 per cent-of-assets threshold for real property holding entities in Article 13 (4). 76 This interpretation is made explicit in some treaties, through such language as: “Gains derived by a resident of a Contracting State from the alienation of any property other than that referred to in paragraphs 1 through 5 and arising in the other Contracting State may be taxed in that other Contracting State.” 164 Taxation of non-residents’ capital gains for administering the tax on capital gains of non-residents. These are the types of challenges more frequently discussed in connection with tax evasion, but for non-residents and for taxing capital gains, the line between tax avoidance and tax evasion is especially blurry: it takes little effort for the taxpayer to hide the relevant taxable transactions and to dodge enforcement— efforts whose undertaking normally distinguishes the tax evader. This may be one reason why tactics for avoiding the tax on capital gains are generally fairly crude. Another reason is that, as discussed in sections 2 and 5 above, both domestic laws of various countries and tax treaties may sometimes give the impression that ceding source-country taxing rights over capital gains (for example, from company shares and from the transfer of other financial claims or intangibles) is normal. But once such concessions are made, taxpayers can be expected to exploit them. 6 .1 Treaty shopping One obvious strategy for avoiding the capital gains tax is to set up holding companies that otherwise serve little or no business purpose in jurisdictions with treaties that contain favourable provisions on the taxation of capital gains. 77 Even for countries that generally tax transfers of shares of domestic companies (whether all transfers or transfers of substantial ownership, in accordance with Article 13 (5) of the United Nations Model Convention), some of their treaties may exempt such transfers. Still fewer treaties may exempt the transfer of shares of real estate holding companies (contrary to the provisions of Article 13 (4) of the United Nations Model Convention). 78 Moreover, a 77 It was recently reported that in 2010, a non-resident company (Heritage Oil) sold a 50 per cent stake in two oil exploration blocks in western Uganda to a Ugandan company. Evidence from the Panama Papers leak shows that Heritage Oil not only knew of the impending tax but had planned aggressively to avoid it, by redomesticating the holding company from the Bahamas to Mauritius to take advantage of the latter’s tax treaty with Uganda (which lacks any indirect transfer provision for real estate assets). Ajay Gupta, “Taxing Indirect Transfers of Real Estate Assets,” (2016) Vol. 82, Tax Notes International, 820. 78 The carve-out for companies that use domestic real property in their businesses contained in Article 13 (4) of the United Nations Model Conven- 165 Wei Cui developing country may not always be able to negotiate the retention of residual taxing rights under Article 13 (6). Since a separate chapter in this publication deals with the abuse of treaties, there is no need to dwell on the issue here. 79 However, one comment is worth making in connection with Article 13. Unlike some of the other distributive articles in tax treaties (regarding, for example, interest, dividends, royalties and, increasingly frequently, other income), which generally deploy the concept of beneficial owner as a way of preventing treaty abuse, the capital gains article generally does not refer to beneficial owners. This by no means implies that a more permissive attitude towards treaty shopping is intended with respect to capital gains. Instead, it merely reflects the fact that the drafting of the article uniformly refers to capital gains “derived by” residents of a contracting State, and never employs the phrase “paid to.” It is indeed this latter phrase that led to the (perceived) need to stress the qualification of the payee as a beneficial owner in the other distributive articles. 80 6 .2 Indirect transfers 81 6.2.1 The growing prevalence of taxation of indirect transfers As discussed in section 2.2 above, if the transfer of an asset is taxable, but the transfer of ownership interest in an entity that holds tion is not often adopted, but where it is, it also gives rise to incentives for treaty shopping. 79 See chapter VI, “Preventing tax treaty abuse,” by Graeme S. Cooper. 80 A rare anti-avoidance provision specifically addressing capital gains is found in Article 14 (6) of the Convention between the Government of the Italian Republic and the Government of the Republic of Ghana for the Avoidance of Double Taxation with Respect to Taxes on Income and the Prevention of Fiscal Evasion, of 19 February 2004: “The provisions of this Article shall not apply if the right giving rise to the capital gains was created or assigned mainly for the purpose of taking advantage of this Article.” 81 The present section is based on Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20. 166 Taxation of non-residents’ capital gains the asset is not taxable, then the tax on the transfer of the asset can be indefinitely deferred (thus essentially avoided) by using a holding entity. This logic applies no matter how many layers of holding entities are involved and regardless of whether the holding entity (or entities) is (are) domestic or foreign. This is why Article 13 (4) of the United Nations Model Convention permits the country where immovable properties are located to tax foreigners even on transfers of foreign entities, if such entities principally hold, directly or indirectly (for example, possibly through multiple layers of holding companies), the immovable properties. However, it is relatively uncommon for countries to adopt domestic law provisions for taxing non-residents on the disposition of shares of foreign companies, whether generally or for real estate holding companies. There are several possible explanations for this. First, many developed countries where anti-tax-avoidance policies are most established have chosen not to tax non-residents on capital gains, on grounds unrelated to tax avoidance. 82 Second, using offshore holding companies to make an investment in a given country may be tax-inefficient for investors from that country (unless domestic investors can evade home-country taxes by going offshore). Thus for any asset market where domestic investors are dominant, it may be unlikely for that asset market to move offshore. This is probably the reason why the United States (unlike Australia, Canada and Japan) has not adopted rules for taxing indirect transfers of United States real property interests: any foreigner investing in United States real estate will want to use investment structures that future United States buyers would not reject. 83 Third, and more generally, there may be other legal factors that either pull the legal structures for foreign investment onshore or push them offshore. 84 Where such other considerations favour using onshore structures, the attraction of offshore structures (in terms of helping to avoid the capital gains tax) may be outweighed. 82 See supra note 15; and Stanford G. Ross, “United States Taxation of Aliens and Foreign Corporations: the Foreign Investors Tax Act of 1966 and Related Developments,” supra note 18. 83 See Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20, 664-666. 84 Ibid., 666-671. 167 Wei Cui In the past few years, a number of non-OECD countries, including Chile, China, the Dominican Republic, India, Indonesia, Mozambique, Panama and Peru, adopted the policy of taxing foreigners on the sale of interests in foreign entities that hold, directly or indirectly, the shares of resident companies. 85 While the background to these policy developments may be very diverse, 86 what is likely common among them is the use of active offshore markets to channel investments into these jurisdictions, making tax avoidance through indirect transfers a natural strategy. 6.2.2 Specific and general anti-avoidance rules in taxing indirect transfers The current approaches to taxing indirect transfers illustrate a well-known dichotomy in legal design for anti-avoidance, namely the use of specific anti-avoidance rules (SAARs) versus general anti-avoidance rules (GAARs). The crucial distinction is that under a SAAR, the content of the legal rule applicable to the relevant circumstances is specified ahead of time, so that it is clear what the outcome of applying the rule will be. By contrast, GAARs tend to be statements of principle, and how the legal standard is applied can be known only after the fact. India’s policy illustrates the SAAR approach. The 2012 amendment of the Income Tax Act of India provided that “any share or interest in a company or entity registered or incorporated outside India shall be deemed to be … situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.” Therefore, the transfer of such shares would result in the realization of income accruing or arising in India and taxable to a non-resident transferor. 87 In contrast, China determines the taxability 85 For Mozambique, see IMF Spillovers Report, supra note 7, at 70; for the other countries, see Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20, 654-656. 86 In India, for example, the policy developed as a consequence of the Vodafone case, adjudicated by India’s Supreme Court and provoking parliamentary action. In China, by contrast, the taxation of indirect transfers was launched by a piece of informal administrative guidance. 87 It has been proposed that “substantially” be defined to mean 50 per cent or more of the total value of a company’s assets. 168 Taxation of non-residents’ capital gains of an indirect transfer on the basis of an ex post determination. Under the relevant administrative guidance, 88 in cases where “an offshore investor makes abusive uses of organizational forms or arrangements indirectly to transfer the equity interest in a Chinese resident enterprise, and such arrangements are without a reasonable business purpose and entered into to avoid enterprise income tax obligations,” tax agencies are authorized to “re-characterize an equity transfer according to its business substance, and disregard the existence of the offshore holding company which is used for tax planning purposes.” That is to say, only a tax authority can determine the taxability of an indirect transfer, and such determination is to be made explicitly on the basis of a finding of tax avoidance motives. 89 The statutory basis of this determination has been attributed to the GAAR in China’s Enterprise Income Tax Law. 90 Using the GAAR to deal with potentially abusive indirect transfers has turned out to be unsatisfactory in China in many respects, for 88 Guoshuihan [2009] No. 698 (often referred to as “Circular 698”), Notice on Strengthening the Management of Enterprise Income Tax Collection on Proceeds from Equity Transfers by Non-resident Enterprises (promulgated by State Administration of Taxation (SAT), China, 2009). Circular 698 has largely been supplanted by SAT Public Notice [2015] 7, issued on 6 February 2015. Public Notice No. 7, relying on the statutory GAAR, extends China’s policy of taxing indirect transfers to non-resident companies’ gains on indirect transfers of movable property and immovable property, in addition to ownership interests in Chinese resident companies. 89 This, ironically, implies that there is no legal basis for requiring transferors to report indirect transfers. Circular 698, a piece of informal administrative guidance, purported to impose such a legal obligation. The SAT changed this position when it issued Public Notice No. 7 in 2015, which eliminated the obligation of transferors to report indirect transfers to the Chinese tax authorities. 90 Enterprise Income Tax Law, Article 47 (2008) (China). The statutory language provides: “Where an enterprise enters into [an] arrangement without reasonable commercial purpose and this results in a reduction of taxable gross income or taxable income, tax agencies shall have the authority to make adjustments using appropriate methods.” An “arrangement without a reasonable commercial purpose” has been defined as one “the primary purpose of which is to reduce, avoid or defer tax payments.” See regulation on the Implementation of the Enterprise Income Tax Law, Article 120 (2008) (China). 169 Wei Cui the fundamental reason that indirect transfers of shares of Chinese companies occur too often. Many of the entities used in offshore structures for investing into China neither serve substantial functions nor display a bona fide, operational business purpose. In this context, the determination that many of the holding companies serve no genuine business purpose, or that whatever business purpose they serve pales in comparison to the potential tax savings through indirect transfers, can be made in a much more routine fashion than case-by-case examinations permit. 91 Furthermore, overreliance on GAARs creates too many opportunities for negotiation between taxpayers and authorities. An industry of tax advisers on indirect transfers has emerged, whose routine tool of trade is to persuade foreign parties who have made indirect transfers first to hire them to report the transfers, and then to pay them literally to “negotiate” with Chinese tax authorities on the taxability of the transfers, often regardless of whether the position of non-taxability has any merit. These phenomena are consistent with the theory that, when a type of transaction which the law wishes to regulate occurs often, it is socially optimal to spell out the content of the law ahead of time, thus minimizing the costs of interpreting the law for regulated subjects, legal advisers and enforcement personnel. 92 Thus SAARs are likely to be a superior way of dealing with the majority of indirect transfers, while a GAAR should be reserved for the relatively rare cases that are not properly dealt with by SAARs. However, the existing SAARs adopted by various countries for taxing indirect transfers —in Australia, Canada and Japan for real property holding companies, and in India for all companies that hold sufficient assets in India— are subject to several objections. One is that many of them do not exempt publicly traded companies, even though such companies are unlikely to be formed for tax avoidance purposes 91 There are reports of a backlog of indirect transfer cases across China, in which foreign entities have reported indirect transfers already carried out, are prepared to make tax payments, but are kept waiting indefinitely by local tax authorities who have yet to make the determination that the transfers are taxable. 92 See Louis Kaplow, “Rules versus Standards: An Economic Analysis,” (1992) Vol. 42, No. 3 Duke Law Journal, at 557. 170 Taxation of non-residents’ capital gains (and therefore taxing the transfers of their shares are unnecessary for maintaining the integrity of source-based taxation). 93 Another objection is that, typically under these rules, transfers of shares of foreign entities by non-residents are treated as giving rise to items of per se taxable income: any capital gains on such transfers are explicitly stipulated to have a domestic source. In Canada, for example, if foreign company A derives more than 50 per cent of the fair market value of its shares directly or indirectly from real or immovable property situated in Canada, then the shares of A constitute “taxable Canadian property,” and any capital gains realized on the disposition of shares of A are deemed to arise in Canada. Assuming that A is wholly owned by another foreign company, B, and B has no assets other than the shares of A, the shares of B would also constitute “taxable Canadian property.” Any capital gains realized on the disposition of the shares of B are therefore also taxable income in Canada, and are legally distinct from the capital gains that have accrued to or been realized on the shares of A. If the capital gains on the disposition of the shares of A (by B) have been taxed in Canada, that does not prevent the capital gains realized on the disposition of the shares of B (by its shareholder(s)) from being taxed in Canada (or vice versa). Interestingly, neither Australia, Canada or Japan, nor the Commentaries to the United Nations and OECD Model Conventions has addressed this problem of multiple taxation arising from the taxation of indirect transfers of real estate. Nor do they (or the United States, in its law taxing the transfer of United States companies that hold United States real property) deal with the issue of proportionality: if the shares of a holding company derive only 50 per cent of their fair market value from domestic assets, under most of the existing SAARs, all of the capital gains realized on the sale of the shares are taxable in the country of the location of the underlying assets. Although the recent “Shome Report” in India recommends that any gain realized on a taxable indirect transfer should be taxed only in proportion to the value of the Indian assets relative to the entity’s global assets, this 93 See section 3.3 above. China’s policy of taxing indirect transfers was refined in 2015 to exempt the transfers of shares of publicly traded non-resident companies as a result of SAT Public Notice No. 7. See supra note 88. 171 Wei Cui is still different from taxing the gain on the transfer only to the extent attributable to gains realized on the underlying Indian assets. 94 6.2.3 Multiple taxation and other implementation issues Are governments justified in their indifference to these problems? One view is that the decision on how many layers of intermediate companies are interposed between the domestic asset and ultimate investors is in the control of the taxpayers, as are decisions to make dispositions at different levels. If governments are wary of convoluted and opaque offshore structures to begin with, they will have no motivation to go out of their way to make sure that tax is neutral with respect to the choice of organizational structure in offshore corporate groups. 95 While this argument is probably correct in itself, there is an important competing consideration. As discussed in section 4 above, taxing foreigners on capital gains raises significant challenges for enforcement. If the tax on indirect transfers leads to arbitrary tax consequences because of unmitigated multiple taxation, taxpayers may respond not by simplifying offshore corporate structures, but by non-compliance and evasion. If a government wants to maintain the credibility of its anti-avoidance regime without committing indefinite resources to enforcement, it should try to maximize voluntary compliance. Rationalizing the rules for taxing indirect transfers —including by mitigating the multiple taxation of the same economic gain—would seem to be one strategy for increasing voluntary compliance. Notably, China’s policy for taxing indirect transfers, though problematic in terms of adopting an approach of case-by-case determination, in fact suggests a solution to the problems characterizing the existing SAARs. In China, indirect transfers become taxable only after they have been determined by tax authorities to be, in economic substance, direct transfers. The layers of offshore holding companies, 94 Expert Committee (2012) (India), Draft Report on Retrospective Amendments Relating to Indirect Transfer, available at http://www.incometaxindia.gov.in/Lists/Press%20Releases/Attachments/21/Draft_Report.pdf. 95 Advanced income tax systems tend to aim to be neutral with respect to such choices when the structures are domestic or “onshore,” adopting special regimes such as corporate consolidation and disregarding intragroup transactions. 172 Taxation of non-residents’ capital gains instead of creating separately and distinctly taxable assets under Chinese law, must be disregarded. This implies that if the shares of a Chinese company are treated as having been disposed of indirectly through the transfer of an offshore entity, the fact that the indirect transfer has been subject to tax should be reflected by adjusting the tax cost or basis for the Chinese company’s shares. 96 This eliminates the possibility of taxing the same economic gain multiple times as a result of multiple layers of indirect transfers. Moreover, the tax on an indirect transfer would necessarily always be proportional. The source country will get to tax only any gain represented by the excess of: (a) the portion of the purchase price paid on the indirect transfer that is allocable to the shares of the target company in the source country regarded as transferred indirectly; over (b) the tax basis, for purposes of the source country, of such shares of the target company. 97 Overall, it seems possible to improve on all existing practices for taxing indirect transfers by taking the SAAR approach (if indirect transfers occur frequently), while modifying it to incorporate the Chinese approach of treating all indirect share sales as sales of the underlying domestic assets. 98 To implement this approach consistently can be technically complex, and adjusting the tax basis of assets held by an entity to reflect the transfers of interests in the entity by its owners (so as to avoid multiple taxation of the same economic gain) has only recently become feasible for entities with a large number of 96 For example, suppose that foreign investor S forms an offshore company P with equity capital of 200. P, in turn, contributes 200 of equity capital to Chinese company Q. When the value of Q shares grows from the initial value of 200 to 250, S sells the shares of P for 250 to buyer B. If China decides to disregard the existence of P to tax S on the sale, and S is liable for tax on the gain of 50, then the tax basis or cost of Q shares in the hands of P, and of B, should each be adjusted to 250. If either P disposes Q shares now for 250, or B disposes of P shares for 250, there should be no further tax for either P or B. 97 In more technical terms, disregarding an offshore entity and taxing an indirect transfer is essentially a matter of treating a sale of shares (of the offshore entity) as a sale of underlying assets (that is to say, the shares of a target resident company). 98 This is discussed as the “ex ante, look-through” approach in Wei Cui, “Taxing Indirect Transfers: Improving an Instrument for Stemming Tax and Legal Base Erosion,” supra note 20, section V. 173 Wei Cui owners in the United States through specialized accounting software. 99 However, if publicly listed entities are excluded from a tax on indirect transfers, such that most taxable indirect transfers involve only entities with few owners, the complexity may be manageable. And the exclusion of shares of publicly listed entities from a tax on indirect transfers is independently justifiable, as they are unlikely to be used mainly for tax avoidance purposes. One final issue that deserves mention is that the policy of taxing indirect transfers, when implemented by a number of source countries, increases the likelihood that a single share transfer may be taxable in multiple source countries, for example, because subsidiaries in different countries are indirectly transferred when a holding company is sold. The tax authorities in the different source countries may have different assessments of the amount of gain attributable to their country, which may lead to taxation of the same gain by multiple source countries. 100 Notably, there is currently no international arrangement for source countries to coordinate their taxes in such situations 101 — not even in a post-BEPS environment, given that the OECD project on BEPS did not identify taxation of non-residents’ capital gains as being an important factor in dealing with base erosion. 6 .3 Issuance of new shares and corporate reorganizations Sometimes, taxpayers may try to avoid a tax on the sale of shares (whether direct or indirect) by having the target company issue new shares to new investors. This may or may not be accompanied by a distribution of the proceeds from the new share issuance to existing shareholders. When it is, there is a barely disguised share sale. But even when it is not, there can be an effective transfer of the value of the company 99 The author gratefully acknowledges Mr. Ameek Ashok Ponda, adjunct professor at Harvard Law School, for providing this information. 100 This problem is worsened if, as is likely under traditional practice in taxing indirect transfers, the source country taxes the entire gain in the transfer even if only a portion of the gain is attributable to it. 101 The author is grateful to Mr. Peter Barnes, Senior Fellow, Duke University, for providing this information. 174 Taxation of non-residents’ capital gains from existing to new shareholders. 102 Such tax planning tactics may be used within purely domestic contexts as well, and they need to be dealt with whether used domestically or in cross-border transactions. Many developed countries adopt tax-deferral regimes for corporate reorganizations, and businesses are accustomed to using such regimes to reduce their tax liabilities in mergers and acquisitions. However, to protect the domestic tax base, developed country corporate reorganization rules tend to impose more stringent requirements when ownership of domestic assets is transferred to or among non-residents. Developing countries should be equally cautious in granting deferral treatment for purported reorganizations carried out among non-residents. 7 . Taxing former residents on capital gains The present chapter has mainly focused on capital gains taxation from a source-country perspective. This section briefly touches on an issue that properly belongs to the topic of resident country taxation. 103 When the residence of a taxpayer changes on emigration, the taxing rights of the former residence State are reduced to those of a source State. In order to preserve the right to tax gains accrued while the taxpayer is a resident, many countries impose an “exit tax” (also referred to as a “departure tax”) and/or a “trailing tax.” Under an exit tax, assets owned by an emigrant are deemed to be alienated at market value and reacquired at a cost equal to that value. For instance, under the Australian domestic law exit tax rules, a person ceasing to be resident is deemed to dispose of assets other than taxable Australian assets (on which even non-residents are taxed) at market value. The last few years have witnessed an expansion in the adoption of exit taxes in OECD countries. In Japan, a law became effective 102 This issue is highlighted in Lee Burns, Honoré Le Leuch and Emil Sunley, “Transfer of an interest in a mining or petroleum right,” in Philip Daniel and others, eds., Resources without Borders, supra note 47. 103 For a more detailed discussion, see Jinyan Li and Francesco Avella, “Article 13: Capital Gains,” supra note 74, section 2.1.8; Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation: A Structural Analysis, supra note 17, Part IV, chapter A, section 2.1. 175 Wei Cui on 1 July 2015, to require permanent residents with Japanese-source financial assets of at least 100 million yen (US$ 840,000) to pay an exit tax on any appreciation of the assets if they leave Japan to take up residence elsewhere. 104 The legislation was driven by concerns that wealthy Japanese individuals were moving to countries with no capital gains tax and selling assets that had experienced significant appreciation while they were held in Japan. Similarly, Spain introduced an exit tax at the beginning of 2015, applicable to taxpayers who have been Spanish tax residents for at least 10 out of the 15 years prior to their departure from the country, and who hold large fortunes — specifically, substantial shareholdings the market value of which exceeds €4,000,000 (or €1,000,000, if the total shareholdings exceed 25 per cent of the relevant company). Unrealized gain on such holdings is subject to tax, regardless of the location of the investments. In the absence of coordination between the treaty States, a problem regarding the potential double taxation of the accrued gain may arise. This occurs when the property is actually alienated and the current residence State taxes the entire gain, computed by reference to the historical cost basis, which includes the gain that has been subject to the exit tax in the former residence State. Countries with exit taxes, such as Australia, Canada, the Netherlands and the United States, may include special provisions in their tax treaties to resolve the problem of double taxation. This is usually realized by allowing the taxpayer to use a tax cost for the asset in the new residence State equal to its market value at the time of the change in residence. 105 Trailing taxes are taxes levied after a change of residence on assets that would normally not otherwise be taxed in the hands of a non-resident, but that are usually taxed under domestic law if alienated within a given period following the change of residence (generally five to ten years). A country may provide for both a trailing tax 104 William Hoke, “Cabinet Proposes Exit Tax on Departing Permanent Residents,” (2015) Vol. 77, Tax Notes International, 317. Persons subject to the exit tax include anyone who has been a resident of Japan for at least 5 years during the 10 years immediately before the date of departure. 105 Indeed, under its domestic law, Australia deems a person who becomes a resident to acquire assets other than taxable Australian assets at market value on becoming a resident. Canadian rules are largely similar. 176 Taxation of non-residents’ capital gains and an exit tax if a taxpayer has an election to be subject to the exit tax or remain liable to tax for the full gain realized on actual alienation following the change of residence. 106 Special treaty provisions may also be needed to preserve the taxing rights of the former residence State and prevent double taxation. 8 . Conclusion Throughout the discussion in the present chapter, it has not been assumed that revenue from taxing non-residents on capital gains is indispensable to many developing countries. 107 Such an assumption could very well turn out not to be true. For example, in many of the developing countries that recently led efforts to combat base erosion by taxing indirect transfers —for example, China, India, Indonesia, Peru and others —revenue from international taxation in general (not to mention from capital gains taxation of non-residents in particular) is likely to represent a very small portion of overall tax revenue. The pursuit of such base protection measures is thus likely to be motivated by other policy considerations, for example, for maintaining the integrity and fairness of the tax system. Insofar as the administrative apparatus of a developing country can handle such taxation in the normal course of its operation, there should be little that is out of the ordinary. A core contention of the present chapter is that many of the conventional arguments for limiting the taxation of non-residents 106 The exit tax introduced in Spain in 2015 has this feature. Taxpayers can request to defer their exit tax liability if they move to any country which has a double taxation agreement with Spain and an information exchange clause. Moreover, if the taxpayer moves, for any reason, to another country in the European Union or the European Economic Area, the gain will be declarable and taxable in Spain only if they either sell the shares within 10 years of leaving Spain, or if they discontinue residency in the European Union or the European Economic Area. 107 This can be contrasted with a view expressed in the recent IMF Spillovers Report, whose discussion of capital gains taxation— and the taxation of indirect transfers in particular—was motivated by its technical assistance experience, which “provides many examples in which the sums at stake in international tax issues are large relative to overall revenues [of developing countries].” See IMF Spillovers Report, supra note 7, at 1. 177 Wei Cui on capital gains are weak. The conceptual case for generally taxing non-residents on such gains is essentially as strong as for any other form of source-based taxation. For example, the claim that only immovable property has enough of an “economic connection” with the source country is hard to comprehend, except as an unconstructive attempt to gloss over the traditional political sensitiveness of foreign ownership of domestic land. Just as significantly, as discussed in section 5, even Article 13 of the United Nations Model Convention may have started with a baseline too close to the non-taxation of capital gains, such that source countries either are allocated taxing rights over only a few enumerated categories of capital gains or, when they claim broader taxing rights, must struggle against the textual interpretation of the model convention. Insofar as the norms expressed by the United Nations Model Convention matter, one needs to be aware of this special bias against source-country taxation on capital gains. However, there is obviously little point in declaring a taxing right over capital gains of non-residents if the tax cannot be enforced. Because many developed countries have abandoned taxing non-residents on capital gains, they cannot be viewed as experts in implementing the tax. Whether developed countries can succeed in enforcing the tax— and more importantly, foster a culture of compliance with it—is yet to be seen. But it is worth stressing that the conventional assumption that capital gains of non-residents should not be taxed is surely not conducive to producing compliance. Moreover, too much of the international tax discussion over recent decades has been centred on whether non-residents should be taxed on capital gains, rather than on how they are to be taxed. Yet the question of how to tax capital gains (discussed in section 3 above) should arguably matter just as much to the legitimacy of such a tax as the question of whether to tax. 178