Have the source and residence principles become redundant?

How typical. You only just get your head round a concept that you learn it’s no longer useful. So it seems to be with the principles of source and residence, based on a thought-provoking conference at the Oxford Centre for Business Taxation last week.

To recap. The fundamental problem of international tax is to allocate between countries the right to tax income earned in one country by a company or person who is a resident of another. Under the source principle, the income is taxed where it arises, for example the country in which a road is built; under the residence principle, it’s taxed where the person earning the income resides, for example the home country of the road building company. This is lecture 1 in any international tax course, and it’s still the basis on which tax treaties divide up taxing rights. I’m interested in it because, in general, developing countries are “source countries” – investees – and developed countries are “residence countries” – investors.

I would already have said that tax havens confound this categorisation, because they’re often neither the country of source nor residence, but rather somewhere off to the side that allowing exploits the definitions of source and residence while actually being neither. But it seems there are at least two more ways in which the source/residence distinction doesn’t work any more, according to some of the speakers.

Identity crisis

As little as 20 years ago, you could quite easily conceive of source and residence in terms of power relations. In the interwar period when the foundations of the international tax regime were laid, powerful economies the US and UK were the big residence countries, and continental Europe was more on the source side. As time went on, with the growth of multinational companies, the divide became a North-South one: the OECD was predominantly a bloc of residence countries whose multinationals invested abroad (although some members, like Canada and Australia, had a bit more of a source characteristic because their big mining industries, and their historical position as former colonies).

But now things are all messed up. In e-commerce, for example, almost everyone is a source country apart from the United States, which is home to most of the big internet firms. In other areas, big countries outside the OECD are increasingly become capital exporters, not just towards less developed countries, but even in some instances towards the OECD. And of course the growth of sovereign wealth funds means that countries that were recipients of investment by oil and gas extractive industries are now starting to use the wealth this generated to become huge sources of investment into OECD countries.

At the Oxford conference, the OECD’s Pascal Saint Amans said something very interesting about this. Some countries, he said, are “in denial” about the fact that they’re no longer predominantly residence countries. “It’s a psychological issue,” he said. This leaves open the possible that countries might continue to defend the residence emphasis in international tax standards against their own economic interests, because it’s part of their national identity to do so.

So source and residence are down, but are they out? Not so far, I’d say. Rather, all this means that they are best understood as relative concepts, not absolute ones. With respect to a particular pair of countries, or a particular industry, it still makes sense to talk about source and residence. But there are no pure source or residence countries now – if there ever were.

The end of the world as we know it

That was all fine, until Philip Baker QC tried to land the killer blow. In his argument, the concepts source and residence principles are essentially based on administrative practicalities. This is certainly how many accounts of the development of the international tax system have it. It’s easier to tax some kinds of income in the country of residence, because you have the person there, you can force them to pay, and you can build a more complete picture of their total income. But their overseas income, say from property they own there, is rather harder to tax, because you rely on them to tell you that it exists. Much better to leave that to be taxed on a source basis, in the country where the property is, because it’s easy for that tax authority to see that it exists and to get its hands on it. Indeed, if the source country decides to tax that income, there’s little you can do to stop it.

But according to Baker, the growth of information exchange and mutual assistance agreements has rendered this distinction redundant. Increasingly, tax authorities are going to find out about their residents’ overseas income automatically, and they’re going to be legally empowered to collect taxes on each other’s behalf. So why not go back to the drawing board entirely, to find something more satisfactory?

It’s a good question, and one that merits quite a lot of thought!


  1. Compliment for your Blog and for your ‘ brio ‘ and broad and open thought, on tax matter. Usually so obsure and dry. Mainly, at international level. Thanks, and hope later to be able to contribute, in a some way. Mainly interested to Tax and development subject.

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