Source of Income in Globalizing Economies: Overview of the ... · Moris, “Limitation of the national power of taxation by the fundamental freedoms and non-discrimination clauses

Source of Income in Globalizing Economies:Overview of the Issues and a Plea for

an Origin-Based ApproachProf. Dr Eric C.C.M. Kemmeren*

© 2006 IBFD

430 BULLETIN NOVEMBER 2006

Professor of International Tax Law, Fiscal InstituteTilburg, Tilburg University, the Netherlands. The author isalso a member of the board of the European Tax College;of counsel at Ernst & Young, Tax Advisers, Rotterdam;and Senior Fellow, Taxation Law and Policy ResearchInstitute, Monash University, Australia.

This article derives from a paper presented at theseminar on “The Source of Income in a GlobalizedEconomy: Developing Source Rules for the 21st Century”on 14-15 June 2006. The seminar was organized by theCentre for Tax Law at the Stockholm School ofEconomics and sponsored by TOR/Skattenytts Stiftelse,the Swedish Branch of IFA, Skeppsbron Skatt AB,Deloitte Sweden, Öhrlings PricewaterhouseCoopers, andMannheimer Swartling AB.

The other articles based on papers presented at thisseminar are:

Halkyard, Andrew, “Source of Profits Rules in HongKong – Analysis of a ‘Troublingly Successful System’”, inthis issue of the Bulletin; and

Rosenbloom, H. David, “US Source Rules: BuildingBlocks of Cross-Border Taxation”, and Andersson,Krister, “An Economist’s View on Source versusResidence Taxation – The Lisbon Objectives andTaxation in the European Union”, both in the October2006 issue of the Bulletin.

Contents1. INTRODUCTION2. SOURCE OF INCOME: A MULTITUDE OF

MEANINGS2.1. Source as legal justification for income and

capital tax jurisdiction2.2. Source: a motley collection of justifications2.3. Origin-based interpretation of source

2.3.1. Source interpreted as origin for incometax purposes2.3.1.1. Origin of income: only human

activities2.3.1.2. Originator of income2.3.1.3. State of origin2.3.1.4. Origin limited to substantial

income-producing activity2.3.1.5. Major benefits of an origin-

based interpretation of source2.3.2. Source interpreted as economic

location for capital tax purposes3. GLOBALIZING ECONOMIES NEED CAPITAL AND

LABOUR-IMPORT NEUTRALITY AND A SOURCE-BASED APPROACH3.1. Economic policies in globalizing economies

and tax jurisdiction3.2. CLIN versus CLEN economic policies3.3. CLIN needs to replace CLEN3.4. CLIN supports an origin-based interpretation of

“source”4. EU LAW: CASE LAW SUPPORTS SOURCE-BASED

TAXATION, DIRECTIVES DO NOT4.1. Towards a common market

4.2. CLIN best satisfies the EC Treaty4.3. Substantial income-producing activity means

“economic activity” in the EC Treaty4.4. Case law supports source-based taxation4.5. Directives support residence-based taxation4.6. EC Treaty does not determine “source”

5. THE OECD MODEL: RESIDENCE-BASED FLAWSTRIGGER SOURCE-BASED CORRECTIVEACTIONS

6. ALTERNATIVE ORIGIN-BASED TAX SYSTEM: TAXTREATIES, EC DIRECTIVES AND DOMESTIC LAW6.1. Eligible treaty subject6.2. Business income: profits, dividends and capital

gains on shares6.3. Interest and capital gains on debt claims6.4. Royalties and capital gains on underlying

intangible property6.5. Pensions6.6. Personal circumstances

7. SUMMARY AND CONCLUSIONS

1. INTRODUCTION

The allocation of tax jurisdiction with respect toincome, including capital gains, has traditionally beenbased on the principles of residence and source. Well-supported doctrine has demonstrated that the sourcestate should have the primary right to tax. Neverthe-less, the residence state has traditionally claimed tohave the better rights, and this is also reflected indouble taxation treaties. Applications of the residenceprinciple have created flaws in tax systems which offeropportunities for tax planning but also trigger govern-mental (re)actions, e.g. limitation on benefits provi-sions. Such (re)actions may also be considered as anattempt to strengthen the application of the sourceprinciple. But what is a source of income?

Over the last decades, economies have increasinglybecome globalized and business models have changedas a consequence of, inter alia, the intense growth ofthe service sector and international capital markets andthe development of electronic business. The two fun-damental systems used to identify the source of incomefor tax purposes – statutory source rules and the com-mon law “facts and circumstances” doctrine – wereboth developed in an era of simpler commercial trans-actions. Are these traditional source rules still appro-priate, or should new rules for the 21st century bedeveloped? In this context, the starting points are thatincome should be taxed and that, conceptually, incomeshould constitute comprehensive income.

* © Eric C.C.M. Kemmeren, 2006.

This article presents a general overview of the issuesand advocates an origin-based interpretation of theterm “source”. The issues are discussed at a more gen-eral level. First, the concept of source of income isaddressed from a juridical perspective. The authoridentifies a multitude of meanings used in source rulesin international tax law and also specifies what, in hisopinion, source of income should mean. In this respect,the author advocates ranking the source principle overother principles like the residence principle. Second,economic policy is addressed. Considering the global-ization of economies, states should rethink the eco-nomic policy underlying their tax system. As pointedout, capital and labour-import neutrality fits best withthe changed economic environment and, as a conse-quence, also with a source-based tax system. Third, EUlaw must be dealt with when transnational situationsare addressed. In the field of direct taxation, the caselaw of the European Court of Justice (ECJ) regardingthe fundamental freedoms plays an important role. Thecase law supports a source-based tax system, but thedirectives adopted in this field point in another direc-tion. Fourth, tax treaties are discussed. The residence-based OECD Model Tax Convention has flaws whichoffer opportunities for tax planning and also result ingovernmental (re)actions. Finally, alternative origin-based source rules are outlined for some classes ofincome and deductions, such as business income (busi-ness profits, dividends and capital gains on shares),interest and capital gains on debt claims, royalties andcapital gains on the underlying intangible property andpensions as well as personal allowances, reliefs anddeductions. A summary concludes this article.

2. SOURCE OF INCOME: A MULTITUDE OFMEANINGS

2.1. Source as legal justification for income andcapital tax jurisdiction

The legal justification for the right to tax and, there-fore, the assignment of tax jurisdiction among states, isgenerally considered to be the principle of sovereignty,i.e. jurisdiction, and thus also tax jurisdiction, is anattribute of statehood or sovereignty.1 Basically, a stateitself determines its taxing rights, but in internationalrelationships, the imposition of tax is limited, on theone hand, by the limited possibilities of a state toenforce its taxing rights as a practical matter and, onthe other hand, by international law.2 The injunctionagainst arbitrariness in international law must be takeninto consideration. Arbitrariness is considered to bepresent if there is no sufficient relationship with thestate concerned and that state nevertheless imposes tax.In general, a sufficient relationship is considered toexist on the basis of e.g. citizenship, incorporation of acompany under national law, domicile, residence,statutory seat of a company, place of effective manage-ment of an enterprise, permanent establishment, situsof land, and place of labour.3 A relationship can, there-fore, reveal itself through a political and/or economicconnection with the state concerned.4

Tax jurisdiction is based in particular on the economicrelationship with the state concerned;5 at least the taxjurisdiction with respect to income and capital should,

in the author’s opinion, be based on it.6 Income is pro-duced only if a person utilizes the production factor(s)of labour or, in addition to labour, capital. The taxationof income should be linked, as much as possible, withthis utilization and therefore also with the place (terri-tory) where these factors are utilized (territory prin-ciple). Mere political allegiance is, in the author’sview, an insufficient basis for tax jurisdiction withrespect to the production of income and the possessionof capital because political allegiance does not produceincome, nor does it establish or preserve capital.7

To determine whether a sufficient connection forassigning tax jurisdiction is present, a linkage shouldbe made between the territory principle and the directbenefit principle, i.e. taxes should be considered as acontribution for the benefits provided to an individualthrough state activities.8 It should be noted that thedirect benefit principle is used here merely as an under-lying principle for allocating tax jurisdiction amongstates. Whether a state’s internal tax system should bebased on this principle is beyond the scope of this art-icle. The relevance of the direct benefit principle in thecontext of assigning tax jurisdiction was pointed out asearly as 1892. With respect to “wirtschaftliche Zuge-hörigkeit”, Schanz wrote: “Jeder, der wirtschaftlich andie Gemeinschaft gekettet ist, d.h. jeder, dem aus derErfüllung der Aufgaben des Gemeinwesens Vorteile

© 2006 IBFD

1. See e.g. Bühler, Ottmar, Prinzipien des Internationalen Steuerrechts(Amsterdam: Internationales Steuerdokumentationsbüro, 1964), at 260.2. See e.g. id. at 130-137; Martha, R.S.J., The Jurisdiction to Tax inInternational Law (Deventer, the Netherlands: Kluwer Law and Taxation,1989), at 23-41; and Commissie Internationale belastingvlucht vanlichamen, Internationale belastingvlucht van lichamen, Geschriften van deVereniging voor Belastingwetenschap, No. 196 (Deventer, the Netherlands:Kluwer, 1994), at 15.3. See e.g. Schanz, Georg, “Zur Frage der Steuerpflicht”, in Finanz -archiv: Zeitschrift für das gesamte Finanzwesen (Stuttgart: Mohr, 1892),Vol. IX at 368; Bühler, supra note 1, at 148-149; Crezelius, G.,“Beschränkte Steuerpflicht und Gestaltungsmißbrauch”, Der Betrieb 1984,at 533; Wuster, H.J., Die ausländische Basisgesellschaft, steuerrechtlicheQualifikation und finanzielle Vorteilhaftigkeit (Frankfurt a.M.: Deutsch,1984), Sec. 6.1.1; and Grossfeld, B., Basisgesellschaften im internationalenSteuerrecht (Tübingen, Germany: Mohr, 1974), at 171-173.4. See e.g. Rosembuj, Tulio, “Personal and Economic Allegiance underthe Personal Income Tax and Corporate Tax in Spain”, 26 Intertax 4 (1998),at 4-6.5. See Martha, supra note 2, at 22 and 183; Hinnekens, Luc, De territo-rialiteit van de inkomstenbelasting op nieuwe wegen en grondslagen(Deurne, Belgium: Kluwer Rechtswetenschappen België, 1993), at 28;Kaufman, Nancy H., “Fairness and the Taxation of International Income”,29 Law and Policy in International Business 145 (1998); and Lehner,Moris, “Limitation of the national power of taxation by the fundamentalfreedoms and non-discrimination clauses of the EC Treaty”, 9 EC TaxReview 5 (2000), at 12.6. See e.g. Schanz, supra note 3, at 372-380; and Endriss, Horst Walter,Wohnsitz- oder Ursprungprinzip? (Cologne: Verlag Dr. Otto Schmidt,1967), at 71. For a different opinion, see e.g. Easson, Alex, “Fiscal deroga-tion and the inter-nation allocation of jurisdiction”, 5 EC Tax Review 112(1996); and Graetz, Michael J. and Michael M. O’Hear, “The ‘OriginalIntent’ of U.S. International Taxation”, 46 Duke Law Journal 1021 (1997),at 1092-1093.7. See Profs. Bruins, Einaudi, Seligman and Sir Josiah Stamp, Report onDouble Taxation, submitted to the Financial Committee, League of Nations,Geneva, 5 April 1923, E.F.S. 73 (F. 19), at 19. Disagreeing: Martha, supranote 2, at 69, 71, 79 and 99. 8. See e.g. Meyer, Heiko, Die Vermeidung internationaler Doppel- undMindestbesteuerung auf der Grundlage des Ursprungsprinzips (diss. 1970,Georg-August-Universität, Göttingen), at 36-37; Vogel, Klaus, “Worldwidevs. source taxation of income – A review and re-evaluation of arguments(Part III), Intertax 393 (No. 11, 1988), at 394-395; Martha, supra note 2, at19-21; and Rosembuj, supra note 4, at 4. Disagreeing: e.g. Kaufman, supranote 5.

NOVEMBER 2006 BULLETIN 431

erwachsen, trägt zu den Lasten bei.”9 Another exampleis Bruins et al., who discussed the direct benefit prin-ciple as part of the faculty principle or the principle ofthe ability to pay:

So far as the benefits [conferred by a state on a person]connected with the acquisition of wealth increaseindividual faculty, they constitute an element not to beneglected. The same is true of the benefits connectedwith the consumption side of faculty, where there isroom even for a consideration of the cost to the govern-ment in providing a proper environment which rendersthe consumption of wealth possible or agreeable ....10

A person’s wealth gives him the ability to pay tax, eco-nomic faculty, or faculty. These terms are used heresynonymously.

Based on the direct benefit principle, a person whobenefits from the public expenses incurred by a stateshould also contribute to those expenses.11 Thisimplies, in the author’s view, that a person who pro-duces income, including capital gains, i.e. increases hisindividual faculty, or who possesses capital, i.e. main-tains his individual faculty, benefits from the publicexpenses incurred by a state which enable him to pro-duce income or to establish and preserve capital andshould, therefore, also contribute to those expenses.This principle is further elaborated by the principles ofnationality/citizenship, incorporation/siège réel, domi-cile/residence, source, origin and functionality. Theseprinciples are more of a qualitative nature, i.e. theyindicate whether there is any justification to make aperson subject to an income or capital tax in a state.Justification, or at least equity, is the most importantlegal principle regarding the allocation of tax jurisdic-tion.12 Besides these qualitative principles, the univer-sality principle and a more limited application of theterritory principle (territoriality principle) play a partwith regard to the allocation of tax jurisdiction. Theseprinciples are more of a quantitative nature, i.e. if aqualitative principle applies, they determine more orless the magnitude of the taxing rights.

In a comprehensive tax system, the taxes on the pro-duction, possession, consumption and disposal ofwealth need to be harmonized because an individual’sfaculty as a whole should be taxed only once. If taxesare levied at these four occasions, the tax system in factspreads the obligation to contribute to the publicexpenses based on the ability to pay principle over aperson’s entire faculty time line, whereas, in theory atleast, in a fully autarkic community, it would also bepossible to tax a person’s faculty only at one time. Amore open economy needs, in the author’s view, moreoccasions for taxation due to a desirable allocation oftax jurisdiction between the states connected with suchan economy. For example, a person’s wealth might beproduced in State A, after which it is transferred andkept for a while in State B, and finally consumed inState C. Allocating tax jurisdiction to all three states isjustified, but needs to be balanced. This is especiallytrue in the current era of globalizing economies.13

From the above, it follows that the principle of sourceis one of the basic principles on which the taxation ofthe production of income and the possession of wealthis/should be allocated to states. The interpretation ofthe term “source of income” is discussed in more detailbelow.

2.2. Source: a motley collection of justifications

The principle of source is commonly used by tax legis-latures, judges and scholars, but the term “source” isnot always clearly defined, and it is used in variousmeanings.14 For example, it is referred to as the state inwhich the tangible or intangible property in question islocated15 or used,16 in which the services are per-formed, which is affected by the services, in which thecontract is signed, in which the contract is executed,whose laws govern the contract,17 with which the iden-tity of the payer is linked, in which the payer islocated,18 from which the payment was made,19 orwhich bears the expenses.20 Thus, the term “source” isused for a motley collection of justifications for allo-cating tax jurisdiction. This often makes discussionburdensome because people use the same term toexpress different concepts.

The author considers the principle of source as an elab-oration of the principle of location of wealth (situs): aperson who receives income from a person or propertysituated in a state has such a close relationship with thestate in which that person or property is physicallylocated that the relationship justifies an obligation tosupport that state.21 The taxation of income in the

© 2006 IBFD

9. Schanz, supra note 3, at 372.10. Bruins et al., supra note 7, at 18.11. See e.g. Vogel, supra note 8, at 394-395; van Soest, J., Belastingen(Arnhem, the Netherlands: Gouda Quint, 1995), at 20; and Romyn, M.,Internationaal Belastingrecht (Tilburg: Gianotten, 1999), at 3. According toEasson (supra note 6, at 112), notions such as economic allegiance or thedirect benefit principle are unable to provide satisfactory answers to thequestion of how tax jurisdiction should be shared between states.12. See e.g. Vogel, Klaus, “Worldwide vs. source taxation of income – Areview and re-evaluation of arguments (Part I)”, Intertax 216 (Nos. 8/9,1988); and Kaufman, supra note 5, at 145, 152 and 157.13. See Kemmeren, Eric C.C.M., Principle of Origin in Tax Conventions,A Rethinking of Models (diss. 2001, Katholieke Universiteit Brabant,Tilburg), at 18-26.14. See e.g. Valdés Costa, Ramón, “The Treatment of Investment Incomeunder the Andean Pact Model Convention – The Andean View, 29 Bulletinfor International Fiscal Documentation 2 (1975), at 91, 92; Rosembuj,supra note 4, at 9-13; and Avery Jones, John F., et al., “Tax Treaty ProblemsRelating to Source”, 38 European Taxation 3 (1998), at 78, 79.15. See e.g. Endriss, supra note 6, at 61, using the German term Ursprungin the meaning of “source” and not of “origin”, as discussed below. See alsoe.g. Pires, Manuel, International Juridical Double Taxation of Income(Deventer, the Netherlands and Boston: Kluwer Law and Taxation Publish-ers, 1989), at 122.16. See e.g. Pires, id. at 121: “Producing source or in an economic sense.According to this, source is located in the territory of the State where thefactors of production are used.”17. See e.g. the title passage rule. See also Pires, supra note 15, at 122-123; Martha, supra note 2, at 109; Forst, David L., “The ContinuingVitality of Source-Based Taxation in the Electronic Age”, 15 Tax NotesInternational 1455 (1997); and Sweet, John K., “Formulating InternationalTax Laws in the Age of Electronic Commerce: The Possible Ascendancy ofResidence-Based Taxation in an Era of Eroding Traditional Income TaxPrinciples”, 146 University of Pennsylvania Law Review 1949 (1998).18. These categories include “the paying state principle”. The assignmentof tax jurisdiction is then justified because the income is paid by a state orone of its departments or because of the payer’s location. In the author’sopinion, neither the fact that a state or department makes the payment northe fact that the payer is located in a state reflects the cause of the produc-tion of income.19. See e.g. Endriss, supra note 6, at 61; and Pires, supra note 15, at 122:“Paying source or in a financial sense. Source is located in the territory ofthe State where income is made available, where costs corresponding to thatincome are incurred.”20. See e.g. Endriss, supra note 6, at 80-81.21. See e.g. Bruins et al., supra note 7, at 1. See also Martha, supra note 2,at 101 and 109; van der Geld, J.A.G., De Herziene Deelnemingsvrijstelling(Deventer, the Netherlands: Kluwer, 1990), at 68; and Vanistendael, Frans,


source state is then justified because the income arisesfrom a person or property situated within that state,22

i.e. the income physically arises in the territory of thatstate. The discussion below elaborates on the differ-ence between the principle of source and the principleof origin. See 2.3.

The principle of source may also play a part in justify-ing the allocation of tax jurisdiction with respect tocapital. If so, the state in which the property is physi-cally situated is entitled to levy a capital tax on theproperty. In that case, the physical location of the prop-erty is decisive, e.g. the state in which the immovableproperty is situated or the bond deposited. This loca-tion (situs) should, however, be distinguished from theeconomic location. This issue is also discussed furtherbelow.

In the author’s view, it is not self-evident that the prin-ciple of source may serve to justify a tax on incomesince the income may be produced or the property maybe established and preserved in a state other than thestate in which the person from whom the income wasreceived or the property is physically situated. Forexample, the fact that a state or department makes apayment or that the payer is located in a state does notreflect per se the cause of the production of income.For instance, in Appeal of Estate of L. McKinnon,Betram W. Burtsell, and Norman Parsons ClementExecutors, 6 B.T.A. 412 (1927), the US Board of TaxAppeals decided that the United States was not entitledto tax the interest paid on a foreign bond that was heldin the US as security for a loan to a non-resident alien.The Board of Tax Appeals held that it was immaterialthat the bond itself was temporarily or permanentlywithin the jurisdiction of the United States: the incomeflowed from its origin outside the United States to anon-resident alien.23 With regard to a capital tax, it ismerely mentioned here that a state other than the statein which e.g. a share is physically present may providethe (legal) framework to establish and preserve prop-erty (possession of wealth).24 Furthermore, as concernsimmovable or movable tangibles or intangibles evi-denced by paper (e.g. a certificate), it is possible todetermine the physical location. Regarding intangiblesnot evidenced by paper (e.g. goodwill), however, it isimpossible to determine the physical location.25 Forthis reason alone, the principle of source might not beadequate (enough) to assign tax jurisdiction withrespect to income and capital.

In relation to the principles of nationality/citizenship,incorporation/siège réel and domicile/residence, how-ever, it follows from the closer connection of thesource principle to economic allegiance and the pro-duction and possession of wealth aspects of the facultyprinciple that the source principle should take prece-dence over the other principles mentioned.26

2.3. Origin-based interpretation of source

From the above, it is clear that the term “source ofincome” is not defined unambiguously and that itcauses confusion. Therefore, the author suggests that“source of income” be interpreted only as the origin ofincome in respect of income taxes. In respect of capitaltaxes, “source of capital” should be interpreted as the

economic location of capital. If this approach isadopted, source and origin would be identical inrespect of income taxes, whereas currently origin isonly one of the various meanings of the term “source”.In respect of capital taxes, the same would be truemutatis mutandis for the terms “source” and “eco-nomic location”. Both “origin” and “economic loca-tion” are explained in more detail below. The idea isthat (future) source rules should be based on the con-cepts of origin and economic location, as discussedbelow. This way, an unambiguous system of sourcerules can be developed by virtue of which income andcapital tax jurisdiction will be allocated to the states inwhich income is actually produced and capital is actu-ally established and preserved. Such source rules willenhance not only inter-individual equity but also inter-nation equity.

2.3.1. Source interpreted as origin for income taxpurposes

Taxation based on the principle of origin justifies astate taxing income that is created within the territoryof that state, i.e. the cause of the income is within thatstate.27 That state makes the yield or acquisition ofwealth possible.28 Whereas the causal relationship

© 2006 IBFD

“Reinventing source taxation”, 6 EC Tax Review 152 (1997). A broaderapproach is taken in Doernberg, Richard and Luc Hinnekens, ElectronicCommerce and International Taxation (The Hague: Kluwer Law Interna-tional, 1999), at 14-15: “Source jurisdiction in taxation is generally claimedwith respect to items of income that have a reasonable nexus with the terri-tory of the state concerned. These are economic activities and capital inter-ests that are substantively connected with that state”; the authors used theterms “source” and “origin” as equivalents. See also e.g. Endriss, supranote 6, at 73-78; and Pires, supra note 15, at 121 and 140-163.22. See e.g. Newton III, William H., International Income Tax and EstateTax Planning (International Business & Law Series, West Group, UnitedStates, loose-leaf), Vol. 1, Chap. 5, Sec. 5.04; Davies, David R., Principlesof International Double Taxation Relief (London: Sweet & Maxwell, 1985),at 62; Pires, supra note 15, at 120; O’Donnel, Thomas A. and Paul A.DiSangro, “United States Tax Policy on Electronic Commerce”, 25 Inter-tax 429 (1997), at 431-432; and Ault, Hugh J., Comparative Income Taxa-tion (The Hague, London and Boston: Kluwer Law International, 1997), at 431.23. Discussed in Martha, supra note 2, at 107-108 (also referring toAppeal of Ethel M. Codrington, 6 B.T.A. 415 (1927), decided on the sametheory, which was equally valid for dividends paid on the shares of a foreignlegal person).24. Disagreeing: Martha, supra note 2, at 105-106 (see 104 for an exam-ple). In the UK case Winans v. Attorney General (1910) A.C. 27, the justifi-cation for levying the UK estate tax was based only on the physical locationof the bonds and certificates in the UK.25. See e.g. Bühler, supra note 1, at 181-186; Martha, supra note 2, at 106-107; and Ring, Diane M., “Exploring the Challenges of ElectronicCommerce Taxation through the Experience of Financial Instruments”, 51Tax Law Review 663 (1996), at 665.26. See Kemmeren, supra note 13, at 27-35.27. See e.g. International Chamber of Commerce, Avoidance of DoubleTaxation: Exemption versus Credit Method, Resolution of the ICC Counciland Report of the Commission on Taxation (Tokyo, 1955) (“that the countryof origin, that is, the country from which the income is derived ...”); At -chabahian, Adolfo, “The Andean Subregion and Its Approach to Avoidanceor Alleviation of International Double Taxation”, 28 Bulletin for Interna-tional Fiscal Documentation 8 (1974), at 309, 315 (using the term “source”where this author uses the term “origin” since he defined “the principle ofsource” as follows: “That is, the taxing power rests with the country inwhose territory such income originates or is generated.” See also Vogel,supra note 12, at 223 (also using the term “source” and defining it as “theplace of the income-generating activity”). According to the US Treasury,the source of income is generally located where the economic activities cre-ating the income occur. See US Treasury, Selected Tax Policy Implicationsof Global Electronic Commerce (1996), at 18. 28. See e.g. Bruins et al., supra note 7, at 23-24, Meyer, supra note 8, at 26-28; and Graetz and O’Hear, supra note 6, at 1021.


between the production of income and the territory of astate is predominant under the principle of origin,29 thecausal relationship is of minor or no importance underthe principle of source. Therefore, the principle of ori-gin and the principle of source as currently used are notidentical.30 If the income in question is not generated ina state but nevertheless physically appears from thatstate, tax jurisdiction may be allocated to that statebased on the principle of source, but not the principleof origin. An example may illustrate the difference. InState O, income is generated by means of an enter-prise, and the income is transferred via a corporation inState S as a dividend to a person resident in State R.Applying only the principle of origin, only State Omay tax the income, but applying the principle ofsource, both States O and S may tax the income. Theprinciple of source reinforces State O’s right to taxbased on the principle of origin.31

The principle of origin is most strongly related to taxa-tion based on “wirtschaftliche Zugehörigkeit”, eco-nomic allegiance, the direct benefit principle, and theproduction of wealth aspect of faculty. Therefore, inthe author’s view, it is the primary,32 if not the exclu-sive,33 principle on which the allocation of tax jurisdic-tion among the contracting states in a bilateral taxtreaty on income and capital should be based.34 Bruinset al. thought that the principle of origin could not bethe only test because “residents owe duty to the placewhere they live, even if ... their income [is] derivedelsewhere”.35 This author agrees that a resident shouldcontribute to the public expenses of his residence state,but disagrees that this should be done through a tax onthe production of income. As mentioned above, thefaculty principle also has a consumption aspect. Sinceresiding is a way of consuming income but not produ -cing income, the residence state should be entitled tolevy a consumption tax, but not an income tax.36 In acomprehensive tax system in an international context,it is appropriate, in the author’s opinion, to allocate taxjurisdiction with respect to income merely on the prin-ciple of origin; at least this principle should be rankedfirst on the list of principles on the basis of which suchtax jurisdiction is assigned.37

2.3.1.1. Origin of income: only human activities

The origin of income does not seem to be self-evi-dent.38 The US Treasury concluded that the nature ofan item of income is generally important for determin-ing its source because the source of income flows fromits nature.39 According to Vogel, the only positive state-ment that can be made is that “origin”, in his wording“source”, “refers to a state that in some way or other isconnected to the production of the income in question,to the state where value is added to a good. In contrast,the type of connection that establishes that ‘source’ ofincome cannot be defined generally”.40 In the AndeanPact Double Taxation Conventions (1971), the term“source” is defined in Art. 2(e): “The word ‘source’means the activity, right, or property that generates, ormay generate, the income.”41 According to Bruins etal., however, “the origin of income is where the intel-lectual element among the assets is to be found .... Theyield or acquisition [of wealth] is due ... not only to theparticular thing but to the human relations which mayhelp creating the yield”.42 In the US case Commis-sioner v. Piedras Negras Broadcasting, 127 F.2d 260

(5th Cir. 1942), affirming 43 B.T.A. (1941), the courtstated: “We think the language of the statutes clearlydemonstrates the intendment of Congress that thesource of income is the situs of the income-producingservice. The repeated use of the words within and with-out the United States denotes a concept of some physi-cal presence, some tangible and visible activity.” AndBühler stated: “Wir nennen hier den Staat, in dem dieVermögenserträge erarbeitet werden, Ursprungstaatoder Quellenstaat.”43 Finally, Graetz and O’Hearargued that “[i]ncome ... is an attribute of individuals...”. 44

In the author’s view, it is true that only individuals cancreate income and that things in themselves cannot.The intellectual element is the key component in theproduction of income. Through the action of an indivi-dual, whether or not a device is used, value may beadded to things.45 Some of the above quotes reflect thisidea with the words: “the intellectual element” and“human relations” (Bruins et al.), “a concept of somephysical presence, some tangible and visible activity”(Piedras Negras Broadcasting), and “erarbeitet”(Bühler). It is even possible, of course, that addedvalue is created without adding value to things, butthrough personal services. In this case, the added valuemay be created without using a device, but merelythrough labour, e.g. a porter carrying a person’s lug-gage with his bare hands. The place of origin of a per-son’s income is the site of his income-producing activ-ity.46

© 2006 IBFD

29. See e.g. van der Geld, supra note 21, at 68.30. Disagreeing: e.g. Meyer, supra note 8, at 29.31. Disagreeing: Martha, supra note 2, at 108-110.32. See e.g. Schanz, supra note 3, at 372-380; Bühler, supra note 1, at 184;Meyer, supra note 8, at 24-49; and Graetz and O’Hear, supra note 6, at1102-1105. The Mexico Draft Model Tax Convention (1943) of the Leagueof Nations also highly favoured the principle of source. See e.g. Meyer,supra, at 31-33; and Bunders, E. and J.A.C.A. Overgaauw, “Terugblik opeen eeuw Nederlandse belastingverdragen. Wat zal de nieuwe eeuw bren-gen?”, MBB 2000/1, at 27. 33. See e.g. International Chamber of Commerce, supra note 27; Endriss,supra note 6, at 71-78; and Atchabahian, supra note 27, at 315-317.34. See e.g. Meyer, supra note 8, at 238-339; and Vogel, supra note 12.35. Bruins et al., supra note 7, at 20.36. See e.g. Meyer, supra note 8, at 34-36; Boyle, Michael P., et al., “TheEmerging International Tax Environment for Electronic Commerce”, 28Tax Management International Journal 357 (1999), at 366-367. In Bühler,supra note 1, at 175-176 and 184-185, Bühler mixed up, in the author’sview, the production and consumption aspects when using the term“Ursprungsland” for the state in which products are sold without the pro-ducer/seller having a permanent establishment or any physical entrepre-neurial activity there.37. See e.g. Endriss, supra note 6, at 79-82. See also Kemmeren, supranote 13, at 35-37.38. See e.g. Endriss, supra note 6, at 67 and 82; and Atchabahian, supranote 27, at 317.39. US Treasury, supra note 27, at 18.40. Vogel, supra note 12, at 223-228.41. In both the Convention for the Avoidance of Double Taxation BetweenMember Countries and the Model Convention for the Avoidance of DoubleTaxation Between Member Countries and Other Countries Outside the Sub-region, as reproduced in an unofficial English translation in 28 Bulletin forInternational Fiscal Documentation 8 (1974), Supplement D.42. Bruins et al., supra note 7, 20 and 23.43. Bühler, supra note 1, at 181. See also Endriss, supra note 6, at 77and 79.44. Graetz and O’Hear, supra note 6, at 1034.45. See e.g. Pires, supra note 15, at 143; and Boyle et al., supra note 36,at 374.46. See e.g. Forst, supra note 17, at 1455; and Kemmeren, supra note 13,at 37-39.


2.3.1.2. Originator of income

An important issue that remains to be resolved iswhether the intellectual element may be found only inthe activities of the income recipient himself or his per-sonnel, agents, etc., or whether the intellectual elementmay also be found in the activities of an individual whois independent of the income recipient.47 The authorthinks that, in many cases, the income recipient and theincome originator coincide, e.g. the porter mentionedabove or the personnel of an enterprise who are identi-fied with the enterprise. It is also possible, however,that they do not coincide. If the income received is to asubstantial extent produced through the activities of anindependent person (i.e. he is the person who adds theintellectual element) and the benefits from the activi-ties do not regard this person but are passed on toanother (i.e. the income recipient), the income does notoriginate with the recipient but with the independentperson (i.e. the originator). In the author’s view, suchan independent person with respect to the incomepassed on can, in substance, be put on a par economi-cally with a person dependent on the income recipient,e.g. an employee.48 For example, C, a person residentin State R, granted an interest-bearing loan to an entre-preneur, E, in State O, who is active only in State O.The interest paid was then created through E’s entre-preneurial activities within State O, i.e. the cause of theinterest is within State O. That state made the yield onthe loan or the acquisition of interest possible. Theintellectual element added to the loan granted by Cmust be located in E’s “sweat and tears” activities inState O. The interest was produced because E utilizedthe loan in his organization of labour and capital (hisenterprise). The origin of the interest is in State O. C’sactivities concerning the interest received may havebeen very limited, e.g. a phone call to his bank from hisswimming pool in order to know whether the interestwas paid. The taxation of income should be linked, asmuch as possible, with the utilization of the productionfactor of labour and, therefore, also with the place (ter-ritory) where this factor was utilized (territory prin-ciple) (see 2.1.), which might often be combined withthe production factor of capital; nevertheless, the bilat-eral tax treaty between States O and R should allocatethe tax jurisdiction with respect to the interest toState O.49

2.3.1.3. State of origin

Within the framework of an enterprise, activities maybe carried on in various tax jurisdictions, i.e. variousplaces of origin, and various states of origin might bedistinguished in the chain of business activities.50 Forexample, product Y is produced in a plant in State P. Yis subsequently transported through State T to State M,where it is warehoused and from which the marketingis done. Finally, Y is sold by a sales department in StateS to a client in State C, who picks Y up at the ware-house. Five states are involved but, in the author’sview, in only four states (States P, T, M and S) maysome value have been added.51 It might be true thatState C offers the enterprise a market to sell Y,52 but theintellectual element, the human activity carried on bythe persons in the enterprise’s sales department, isfound in State S, not in State C. Therefore, State Cshould not be entitled to tax any part of the income pro-

duced by the enterprise.53 It is possible that activities ina state create a negative added value, e.g. because ofbad marketing in State M. This should be taken intoaccount as well when tax jurisdiction is allocated basedon the principle of origin because the negative addedvalue is caused by the activities of persons in the salesdepartment in State M. The allocation of tax jurisdic-tion with respect to business profits based on the arm’slength principle flows prima facie from the principle oforigin.

Because the intellectual element is considered the keycomponent in the production of income, it might alsobecome easier to find answers to questions regardingelectronic commerce. The (key) intellectual element ina digital service, e.g. the advice of a tax lawyer, is, inthe author’s view, found in the state where the taxlawyer prepared his advice. The (key) intellectual ele-ment, his labour, has added value by means of assets,e.g. the firm’s databases situated in other states.54 Thetax lawyer does not add the intellectual element withinthe territory of the states in which the firm’s serverswere established.55

© 2006 IBFD

47. Under the US national source rules regarding services income, it wasruled as early as 1939 that the activities of an individual other than theincome recipient may be attributed to the income recipient. In Helvering v.Boekman, 107 F.2d 388 (2d Cir. 1939), the court stated: “It can hardly bethat when an alien employs agents in this country to do things from whichhe collects a profit, Congress intended to escape him, though it meant to taxhim, if he came here to do them himself.”

None of the court decisions, however, purported to set forth any rulesof general application regarding the attribution of activities from agents orcontractors to principals for sourcing purposes. And it is not obvious whatprinciples can be derived from case law. See e.g. Boyle et al., supra note 36,at 376, which nevertheless tried to deduce the relevant criteria from caselaw: (1) perhaps a distinction can be made between activities that are inte-gral to the services that are consumed by the customer or client and activi-ties that are merely ancillary or incidental to those services; (2) perhaps theindependence of the agent is important; (3) alternatively (or in addition), thesubstantiality and distinctiveness of the services provided directly by theprincipal may be relevant; even if the principal acquires inputs that are inte-gral, or even essential, to his rendering of services, there would seem to bea point where the principal renders enough value directly that the source ofthe ultimate services should not be influenced by the fact that some inputswere acquired from others; and (4) it may be important to distinguishbetween activities that are preparatory rather than part of the delivery of theservices.48. The compensation paid to the independent person and the dependentperson for their respective activities might deviate because of, for example,differences in the risks concerning continuation of the activities.49. See Kemmeren, supra note 13, at 39-40.50. See e.g. Endriss, supra note 6, at 67.51. See e.g. Boyle et al., supra note 36, at 377-378.52. According to Schaumburg, Harald, Internationales Steuerrecht:Aussensteuerrecht, Doppelbesteuerungsrecht (Cologne: Verlag Dr. OttoSchmidt, 2nd ed., 1998), at 878, because of this argument, a state like StateC should be entitled to tax part of the income of the enterprise. See alsoAlexander Hemmelrath in Vogel, Klaus, Klaus Vogel on Double TaxationConventions (London: Kluwer Law International, 3rd ed., 1997), at 400(Art. 7, marginal number 6).53. State C might impose a consumption tax if Y is consumed in that state.54. In Doernberg and Hinnekens, supra note 21, at 316-317 and 319, theauthors underlined this result based on international income tax principles,but thought that such an outcome would not be politically and financiallyacceptable to many states. Especially State C might have a problem inaccepting the result, but State C should, in the author’s view, admit that noincome was produced in its territory. The client did, however, consumewealth within its borders and therefore, in a comprehensive tax system,State C should levy a consumption tax. Although Doernberg and Hinnekensreferred to different entitlements of states regarding an income tax and con-sumption tax, they did not here use the complementary function of a con-sumption tax to an income tax as an argument that may convince State C.55. But see id. at 317, where the authors seem to argue that these statescall upon the principle of origin (“source” in their words) to extend their tax


The report of Bruins et al. was rather negative onassigning tax jurisdiction with regard to, what wetoday call, passive income based on the principle oforigin. It was believed that the undesirable phenome-non of international juridical double taxation wascaused by the state of origin, not by the state of resi-dence.56 Taxation based on the principle of originwould impede the free movement of capital.57 Theexclusive right of the residence state to tax passiveincome would result in taxation being neutral to invest-ment decisions under the assumption that all incomeand capital would be taxed in the residence state at thesame level, thereby neutralizing the different levels oftaxation in the states of origin. Although this reasoningseems to be convincing, the author thinks it is not.58

First, income from capital is not produced in the resi-dence state of the creditor, but in the state of the debtor,the state of origin. Second, double taxation may also beavoided under tax treaties if the state of origin is giventhe exclusive right to tax. The report of Bruins et al. leftthis option completely untouched.59 Third, the differentlevels of taxation in the residence states of creditorsmay affect the capital markets as well. A creditor resi-dent in a low-tax state will offer his money on thedebtor’s market at a lower interest rate than a creditorresident in a high-tax state, all other factors being iden-tical for the two creditors. The debtor’s choice will,therefore, not be tax neutral.60 Considering these argu-ments, it is the author’s opinion that the state of originhas the strongest, if not the exclusive, right to taxincome from capital.61

2.3.1.4. Origin limited to substantial income-producing activity

If the principle of origin regarding the allocation of taxjurisdiction to states via tax treaties is applied broadly,a problem might be that a person who produces incomeas a globetrotter may be taxed by numerous states inwhich he carries on income-producing activities,although the taxation by each state will be restricted tothe income created by an activity within that state.After all, each income-producing activity in a state,even an occasional one, seems to justify that state’sright to tax the income produced in that state. Thisresult should be considered undesirable, both from atheoretical and a practical point of view. It is strikingthat, regarding the allocation of tax jurisdiction withrespect to dependent personal services, an occasionalactivity can create a taxing right for the state in whichthe activity is exercised,62 whereas regarding businessprofits and independent personal services, a merelyoccasional relationship with a state is considered to beinsufficient.63 In that case, a more durable relationshipis generally required.64 Such a limitation does not seemto be compatible with the principle of origin. Theauthor thinks, however, that the activity of a personwho only hops in and out of a state and producesincome in that state generally lacks a sufficient nexus,a sufficient economic relationship with that state, tojustify taxation.65 The Commentary (Para. 3) on Art. 7of the OECD Model also defends this position withrespect to entrepreneurial activities:

... an enterprise of one State shall not be taxed in theother State unless it carries on business in that otherState through a permanent establishment situated

therein. It is hardly necessary to argue here the merits ofthis principle. It is perhaps sufficient to say that it hascome to be accepted in international fiscal matters thatuntil an enterprise of one State sets up a permanentestablishment in another State it should not properly beregarded as participating in the economic life of thatState to such an extent that it comes within the jurisdic-tion of that other State’s taxing rights.

If this reasoning is valid for the activities of enter-prises,66 the author does not see why this should be dif-ferent for other activities, for example, dependent per-sonal services. The author thinks that, for allocatingtax jurisdiction with respect to income from activities,a substantial relationship between the activity and thestate concerned is required.67 From a theoretical per-spective, the author thinks that the requirement of asufficient economic relationship as a consequence ofthe direct benefit principle, and thus also the facultyprinciple, implies that an occasional activity is not sig-nificant enough to be considered a sufficient relation-ship with a state, even though an occasional activity

© 2006 IBFD

jurisdiction with respect to the production of income if the client is in thesame state as the server.56. See e.g. Para. 1 of the Commentary on Art. 11 of the OECD Model;Valdés Costa, supra note 14, at 94-95 and 98; and Pires, supra note 15,at 141. Within this framework, see Bühler, supra note 1, at 181, preferringEmpfangstaat to Wohnsitzstaat.57. See Para. 2 of the Commentary on Art. 11 of the OECD Model.58. See e.g. VerLoren van Themaat, P., Internationaal Belastingrecht(Amsterdam: Uitgeverij H.J. Paris, 1946), at 14-15; Meyer, supra note 8,at 45-46; and Pires, supra note 15, at 137-140.59. An origin-based tax introduced unilaterally may impede the freemovement of capital. In Cnossen, S. and A.L. Bovenberg, “Vermogensren-dementsheffing: vondst of miskleun”, Weekblad voor Fiscaal Recht2000/6369, at 9, the authors considered such a tax an indirect tax on labourbecause the higher expenses on capital will result in lower real labourincome.60. See e.g. Atchabahian, supra note 27, at 331.61. See VerLoren van Themaat, supra note 58, at 28 and the referencescited there; and Graetz and O’Hear, supra note 6, at 1058 and 1071-1072(illustrating that, within the International Chamber of Commerce, even theUnited States in the early 1920s advocated the source-state taxation of div-idends and interest based on the benefit principle of taxation, administrativeadvantages, the desire to avoid antagonizing debtor nations and the interna-tional balance of payments. See also Kemmeren, supra note 13, at 40-42.62. For example, Art. 15 of the OECD Model, UN Model 2001, USModel 1996 and Netherlands Model 1987 (dependent personal services)may in substance result in such taxation if the 183-day rule is not satisfied.63. See e.g. Para. 2 of the Commentary on Art. 5, second indent: “thisplace of business must be ‘fixed’, i.e. it must be established at a distinctplace with a certain degree of permanence” (emphasis added); and Para. 4of the Commentary on Art. 14 of the 1997 OECD Model: “But if there is inanother State a centre of activity of a fixed or a permanent character, thenthat State should be entitled to tax the person’s activities” (emphasis added).The linkage to the “place of effective management of the enterprise” inArt. 8 of the OECD Model in substance expresses the same idea because theplace of effective management of a material enterprise, i.e. not an enterprisecreated by a legal fiction, implies by the nature of an enterprise a certaindegree of durability.64. See e.g. Art. 7 (requiring a permanent establishment) and Art. 8 (refer-ring to the place of effective management of the enterprise) of the 2005OECD Model, and Art. 14 (requiring a fixed base) of the 1997 OECDModel, 2001 UN Model, 1996 US Model and 1987 Netherlands Model.65. This view seems to be confirmed by e.g. Para. 1 of the Commentary onArt. 7 of the OECD Model: “The permanent establishment criterion is com-monly used in international double taxation conventions to determinewhether a particular kind of income shall or shall not be taxed in the countryfrom which it originates ...” (emphasis added).66. The author refrains here from taking a position on whether the require-ment of a permanent establishment is the most desirable criterion orwhether it should be replaced by another factor expressing a sufficientlydurable relationship with a state. The author discusses this below. See 6.2.67. See e.g. Ault, supra note 22, at 431.


creates an economic relationship with a state. Theactivity is not “an die Gemeinschaft gekettet”. A suffi-cient relationship with a state should be consideredpresent if a substantial income-producing activity isexercised in that state. Such a restrictive application ofthe principle of origin is not only rooted in theory, butis also very attractive from a practical perspective, e.g.because of the reduction in the number of states inwhich the globetrotter mentioned above may betaxed.68

Both legal security and the principle of equality requirethat it be determined which activities are considered“substantial”. With respect to the exclusion of perma-nent establishments of a preparatory or auxiliary char-acter, Para. 24 of the Commentary on Art. 5 of theOECD Model provides: “The decisive criterion iswhether or not the activity of the fixed place of busi-ness in itself forms an essential and significant part ofthe activity of the enterprise as a whole.” Inspired bythis exclusion, the author thinks that the following def-inition of “substantial” could serve as a general crite-rion: An income-producing activity is considered to besubstantial if the activity forms an essential and signif-icant part of the activity as a whole.

For those who think that the term “substantial” needsfurther specification, former Art. 26(2)(c) of the 1992Netherlands–United States tax treaty may offer usefulelements for inspiration. The first sentence read:“Whether the trade or business of the income recipientis substantial will generally be determined by refer-ence to its proportionate share of the trade or businessin the other State, the nature of the activities performedand the relative contributions made to the conducttrade of business in both States.”69

While it is necessary to adapt this phrase to income-producing activities in general, the author’s position isthat whether an income-producing activity is substan-tial is generally determined by reference to:(1) the proportionate share of the activity in a state

compared to the activity as a whole by which thequantity and quality of the production factors oflabour and capital are taken into account, e.g. therelative scale of the exploitation activities ofimmovable property in a state other than the statein which the property is physically situated;

(2) the nature of the activity performed, e.g. the pro-duction of goods is different from the performanceby an artist; and

(3) the relative contributions made to the activity inboth states, e.g. the share in the gross income fromor expenses of an activity in one state compared tothe gross income from or expenses of the activityas a whole.

The relevance of each of these factors might differfrom case to case. In one case, there might be moreemphasis on the nature of the activity whereas, inanother case, the proportionate share of an activity in astate compared to the activity as a whole might beemphasized. For practical reasons, the introduction ofsafe harbours could be considered, e.g. ratios based ongross income, payroll expenses and days of physicalpresence relating to the activity concerned on the basisof which both the contracting states and the taxpayersconcerned have (more) certainty regarding the inter-

pretation of the term “substantial”. If the relevant ratiosexceed fixed levels, the activity in a state is deemed tobe substantial, and tax jurisdiction must therefore beallocated to that state.70

2.3.1.5. Major benefits of an origin-basedinterpretation of source

In the author’s view, the principle of origin willenhance the principle of justice, the economic facultyprinciple (ability to pay), the direct benefit principleand inter-nation equity (especially between developingstates), which might have all kinds of other beneficial(side) effects,71 such as an increasing inter-nation sta-bility. Furthermore, the principle of origin will reduceinternational tax avoidance, and therefore also abuse oftax treaties as part of it, since taxation will then belinked with a substantial income-producing activityand not with a place of residence. Nationality, place ofresidence, place of signing the contract, etc., can easilybe established, changed or transferred without affect-ing the production of income. Under the principle oforigin, to avoid taxation in a state, there may be no sub-stantial income-producing activity in that state or itmust be transferred elsewhere. This will, however,actually affect the base on which the tax at issue wasfounded: income. According to this standard, the key-words are: no (production of) income, no income tax.Besides, whether a person will start a substantialincome-producing activity, stop the activity or transferit depends on more factors than the income tax.72

Applying the principle of origin might also be moreeffective and efficient in combating international taxfraud73 since the relevant information might be moreeasily disclosed by the state of origin than by the resi-dence state. For example, it will probably be easier forthe state in which the business activities are carried onto locate the recipient of interest paid by an entrepre-neur on a loan used in his enterprise to finance businessactivities. This state could make the deduction of the

© 2006 IBFD

68. This is attractive for the potential taxpayer, e.g. less paperwork andfewer compliance costs, and can also be beneficial for states, e.g. the per-ception costs might exceed the tax revenue from income from an occasionalactivity.69. As the sentence read until 1 January 2005. The treaty was amended bythe protocol of 8 March 2004, but a similar rule was included in Art.XXII(2) of the memorandum of understanding of 8 March 2004.70. See Art. 22(3)(a)(iii) of the 1996 US Model and Technical Explana-tion to the United States Model Income Tax Convention, 20 Septem-ber 1996, Art. 22, Paras. 319-323 (all the facts and circumstances are takeninto account). For a critical analysis of Art. 22 and its technical explanation,see e.g. Doernberg, Richard L. and Kees van Raad, The 1996 United StatesModel Income Tax Convention (The Hague: Kluwer Law Interna-tional, 1997), at 182-184. The author thinks that, as a starting point, all therelevant facts and circumstances should be taken into account, but it shouldalso be noted that the three conditions mentioned will likely cover the mostprominent elements and offer more guidance; thus, those conditions couldbe incorporated rather than the general phrase. See Kemmeren, supranote 13, at 42-44.71. See e.g. Vogel, Klaus, Taxation of Cross-Border Income, Harmoniza-tion, and Tax Neutrality under European Community Law, An InstitutionalApproach (Foundation for European Fiscal Studies Erasmus UniversityRotterdam/Kluwer Law and Taxation Publishers in Deventer, the Nether-lands, 1994), at 30.72. See e.g. Report of the Committee of Independent Experts on CompanyTaxation (Ruding Committee) (Brussels/Luxembourg: European Commis-sion, 1992), at 93-119.73. Following the Ruding Committee (id. at 138), the author prefers “taxfraud” to “tax evasion” because, in France, “evasion” has the same meaningas “avoidance”, whether legitimate or not.


interest by the entrepreneur conditional on the entre-preneur disclosing all the relevant information aboutthe creditor. Thus, the entrepreneur clearly has aninterest in making the disclosure. The recipient cansubsequently be effectively taxed.74

2.3.2. Source interpreted as economic location forcapital tax purposes

In the context of a capital tax, “origin” might not be themost appropriate term because a capital tax is not jus-tified by the production of wealth, but by the posses-sion of wealth. In this respect, the term “economiclocation” is preferred.75 If a state provides the legalframework and/or physical infrastructure for establish-ing and preserving property, the state is justified in tax-ing the possession of property. If real estate is situatedin State S, allocating the right to tax the mere posses-sion of it is justified because State S, among otherthings, provides a legal framework for enforcing therights to the real estate and has created a physical infra-structure for preserving it. To the author, this principleseems to be valid not only regarding immovable prop-erty, but also regarding movable property and intangi-ble property. If movable property, e.g. equipment, issituated in State S, it benefits from the legal frameworkand other public services provided by State S. Becauseof the nature of intangible property (e.g. shares, debtclaims and patents), its possession is more closelyrelated to the legal system under which the propertywas established and will be preserved than to the placewhere it is physically present. Intangible property cangenerally be moved around the world quickly and eas-ily without affecting its preservation. Therefore, taxjurisdiction with respect to the possession of intangibleproperty should be allocated to the state under whoselegal system the property was established and will bepreserved. The economic location should, therefore, bedistinguished from the physical location (situs).76 Thetemporary situs might be distinct from the true eco-nomic location. For example, a bond or a mortgage ona piece of land estate may be kept in a deposit box out-side the state under whose legal system the bond ormortgage was established and is preserved. The physi-cal situs is in substance only important in economicallegiance to the extent it reinforces the economic loca-tion.77

3. GLOBALIZING ECONOMIES NEED CAPITALAND LABOUR-IMPORT NEUTRALITY ANDA SOURCE-BASED APPROACH

3.1. Economic policies in globalizing economiesand tax jurisdiction

Economic political considerations determine the mag-nitude of a state’s tax jurisdiction.78 In this respect, taxneutrality should prevail, i.e. taxation should not influ-ence an efficient allocation of the production factors oflabour and capital, or at least should do so as little aspossible.79 The concept of efficiency is based on theassumption that productivity will be highest when theproduction factors are distributed by a market mecha-nism without public interference, or at least with as lit-tle as possible. A given economic arrangement is effi-cient if there can be no rearrangement that will leave

someone better off without worsening the position ofothers.80 Economic considerations, not tax motives,should determine the behaviour of economic opera-tors.81 Complete neutrality is probably not possible but,from an efficiency perspective, the highest possiblelevel of neutrality should be pursued.82 Other values,like equity, may justify a deviation from this rule inspecific situations. Efficiency is used here in the con-text of worldwide efficiency83 and in a narrow sense,i.e. an optimal allocation of the production factorsshould not be unintentionally thwarted by taxation. Itshould be noted that, in globalizing economies, theactions of governments are greatly limited by theactions of other governments. Spillover effects acrossfrontiers generated by taxation have become veryimportant.84 The efficiency of the world economyshould be maximized by allocating the production fac-

© 2006 IBFD

74. See e.g. Endriss, supra note 6, at 64-65 and 67-70; Pires, supranote 15, at 144; Graetz and O’Hear, supra note 6, at 1097-1105; and Kem-meren, supra note 13, at 44-45.75. This term was mentioned in 2.2. and 2.3. See also Bruins et al., supranote 7, at 24; Atchabahian, supra note 27, at 317; and Martha, supra note 2,at 104-108 (using the term “situs”, but also giving an example of economiclocation when referring to the US case De Ganay v. Lederer, 250 U.S. 376(1919), at 382).76. According to Bruins et al., supra note 7, the economic location ofproperty means “the place where are to be found the successive instalmentsof earnings which are capitalised into the fund of wealth that we call capitalor, more popularly, property”.77. Id. at 24-25. See Kemmeren, supra note 13, at 45-46.78. See e.g. Owens, Jeffrey, “Taxation within a Context of EconomicGlobalization”, 52 Bulletin for International Fiscal Documentation 7(1998), at 290.79. See e.g. Ault, Hugh J., “Colloquium on Corporate Income Tax: Corpo-rate Integration, Tax Treaties and the Division of the International Tax Base:Principles and Practices”, 47 Tax Law Review 565 (1992), at 572; Hufbauer,Gary Clyde and Joanna M. van Rooij, U.S. Taxation of InternationalIncome, Blueprint for Reform (Washington, D.C.: Institute for InternationalEconomics, 1992), at 50; Rädler, Albert and Jens Blumenberg, “Harmo-nization of Corporate Income Tax Systems within the European Commun-ity”, in Ruding Committee, supra note 72, at 441; Utz, Stephen G., “Taxa-tion Panel: Tax Harmonization and Coordination in Europe and America”, 9Connecticut Journal of International Law 767 (1994), at 785; Cnossen, S.,“Om de toekomst van de vennootschapsbelasting in de Europese Unie”,Weekblad voor Fiscaal Recht 1996/6203, at 876 and 889-890; and Cnossen,Sijbren, “Tax Policy in the European Union, A Review of Issues andOptions”, Valedictory Address, Erasmus University Rotterdam, 2001, at 3.80. See Musgrave, Richard A. and Peggy B. Musgrave, Public Finance inTheory and Practice (New York: McGraw-Hill Book Company, 1989),at 60.81. See e.g. Gandenberger, Otto, “Die Einfluß der Einkommen- und Kör-perschaftsteuer auf die internationalen Wirtschaftströme”, in Vogel, Klaus,Grundfragen des Internationalen Steuerrechts (Cologne: Verlag Dr. OttoSchmidt, 1985), at 36-37; Doernberg, Richard, International Taxation in aNutshell (St. Paul, Minnesota: West Group, 1999), at 3-6; and U.S. JCT(Joint Committee on Taxation), “Reports on International Taxation”, 19 TaxNotes International 69 (1999), at 92. Disagreeing: e.g. Juch, D.,”Interna-tionaal fiscaal (verdragen)recht”, MBB 1999/3, at 116. Considering thereports on harmful tax competition, some states seem to pursue a policydeviating from this concept of tax neutrality. See e.g. OECD, Harmful TaxCompetition, An Emerging Global Issue (Paris: OECD, 1998); and the EUreport from the Code of Conduct Group (Business Taxation), Brussels, 23November 1999 (SN4901/99) to ECOFIN Council on 29 November 1999. 82. See e.g. Vogel, supra note 71, at 27-28; and Brands, Johan, “Com-ment: Trade-Off between Subsidiarity and Neutrality”, in Vogel, supranote 71, at 38.83. See e.g. Vogel, supra note 12, at 216; and Vogel, Klaus, “Worldwidevs. source taxation of income – A review and re-evaluation of arguments(Part II), Intertax 310 (No. 10, 1988).84. See e.g. Ruding Committee, supra note 72, at 93-109, 143-151and 439-460; Ross, Stanford G., “National versus International Approachesto Cross-Border Tax Policy Issues”, 4 Tax Notes International 719 (1992);and Tanzi, Vito, “The Impact of Economic Globalization on Taxation”, 52Bulletin for International Fiscal Documentation 8/9 (1998), at 338, 339.


tors to the location where “they” earn the highestreturn.85 This will enhance worldwide prosperity,86

although it depends, of course, on more than the effi-cient creation of income, e.g. on the distribution of theincome earned. Such issues are of paramount impor-tance for a well-functioning world society, but arebeyond the scope of this article.

3.2. CLIN versus CLEN economic policies

With respect to the tax effects on the international allo-cation of the factors of production, the focus is mostlyon the movement of capital87 and, consequently, on thedifference between the principles of capital-importneutrality (CIN) and capital-export neutrality (CEN).88

Both CIN and CEN and their definitions disregard theproduction factor of labour provided by individuals,which is considered the classical production factorbesides capital. As stated above (see 2.3.1.1.), onlyindividuals can create income; things in themselvescannot. Therefore, an individual’s activities, the pro-duction factor of labour, should not be disregarded inassessing tax neutrality. Furthermore, not only is cap-ital increasingly mobile, but personal mobility is alsoincreasing in globalizing economies,89 although thedegree of capital mobility will be, and will likelyremain, far greater than labour mobility. However,since tax neutrality is considered to be a valuableobjective, it should not be restricted to capital.Although the difference in the degree of mobility mayexplain why the factor of labour has usually been dis-regarded in the discussion on tax neutrality, the authorthinks that it should now be included in the discussionsince tax neutrality with respect to labour also con-tributes to the efficiency of the world economy. Theauthor thinks, therefore, that the terms CEN and CINand their definitions need to be supplemented. At leastthe factor of labour should be included. Consideringthe factor of labour as the origin of all income, it mighteven be argued that the factor of capital should bereplaced by the factor of labour in both the terms andtheir definitions. If only because of the traditional useof CIN and CEN, the author supplements only the fac-tor of labour. Capital and labour export-neutrality(CLEN) is then defined as follows: an income recipientshould pay the same total (domestic plus foreign) taxirrespective of whether he derives a given amount oflabour or investment income from foreign or fromdomestic sources. The definition of capital and labour-import neutrality (CLIN) should then be: labour andcapital funds originating in various states should com-pete on equal terms in the labour and capital markets ofa state irrespective of the place of residence of theworker or investor. This way, the role of individuals ineconomics is valued (more) equally to its relevance.

From an economic perspective, applying the universal-ity principle, and thus taxing a resident’s (accrued)worldwide income and granting a (full) foreign taxcredit, is generally viewed as consistent with the over-all policy of CLEN.90 In contrast, the territoriality prin-ciple, as a more restricted application of the territoryprinciple, implies that the magnitude of a state’s taxingrights is determined only by the income earned or cap-ital situated in that state. This results in exempting for-

eign income and capital, which is considered to be con-sistent with the overall policy of CLIN.91

The emphasis here is on inter-nation neutrality. Com-plete neutrality is not possible because tax systems andtax levels vary too much.92 Neutrality can be achievedto a certain extent if every state respects the degree andform of non-neutrality that have arisen in another stateas a result of that state’s tax law. This implies that nei-ther state will attempt to use its taxing powers tochange the relative prices in the other state, i.e. theallocation should not be influenced by a state, eithernegatively or positively. Inter-nation neutralityrequires that a taxpayer who carries on substantialincome-producing activities, e.g. an enterprise, inanother state and thus uses the other state’s facilities(public goods and services) can be sure of not beingtaxed more heavily than anyone else who, under thesame circumstances, uses the facilities to the sameextent. As a consequence, taxation on the basis of theuniversality principle must be rejected, and taxationbased on the territoriality principle and the principle oforigin should be accepted.93

© 2006 IBFD

85. See e.g. Hufbauer and van Rooij, supra note 79, at 55.86. See e.g. Vogel, supra note 71, at 28; Utz, supra note 79, at 786; andKemmeren, supra note 13, at 69-71. For a different view, see e.g. Roin,Julie, “The Grand Illusion: A Neutral System for Taxation of InternationalTransactions”, 75 Virginia Law Review 919 (1989), at 963-969. 87. See e.g. Vogel (Part II), supra note 83, at 311; and Capellen, AlexanderW., “National and International Distributive Justice in Bilateral TaxTreaties”, Finanzarchiv N.F., Bd. 56 (1999), at 424-442.88. See e.g. U.S. JCT (Joint Committee on Taxation), supra note 81, at 92-93. See also e.g. Hufbauer and van Rooij, supra note 79, at 49-61;Doernberg, supra note 81, at 3-6; Forst, David L., “The U.S. InternationalTax Treatment of Partnerships: A Policy-Based Approach”, 14 BerkeleyJournal of International Law 239 (1996), at 241-249; and Graetz andO’Hear, supra note 6, at 1042-1043. According to Easson (supra note 6), theCIN and CEN principles do not help a great deal in providing answers to thequestion of how tax jurisdiction should be shared between source and resi-dence states. Easson favoured source-state taxation for two reasons. First,capital-importing states tend, on balance, to be poorer than those that exportcapital. Considerations of inter-nation equity would, therefore, seem tofavour source-state taxation. The second and, in his opinion, more com-pelling argument lay in the difficulty of taxing international capital income.According to Easson, in reality, the choice may be between source-statetaxation or no taxation at all.89. See e.g. Tobin, James, “A Proposal for International MonetaryReform”, Eastern Economic Journal 153 (1978), at 154; Tanzi, supranote 84, at 340; and Juch, supra note 81, at 115.90. CLEN could also be achieved by taxation in the residence state andexemption in the source state or by taxation in the source state and exemp-tion in the residence state as long as the tax bases and tax rates in all statesare the same. See e.g. van Raad, Kees, Nondiscrimination in InternationalTax Law (Deventer, the Netherlands: Kluwer Law and Taxation Publishers,1986), at 264-265; and Ault, supra note 79, at 572.91. See e.g. Vogel (Part II), supra note 83, at 311; OECD, Taxing Profits ina Global Economy, Domestic and International Issues (Paris: OECD,1991), at 177-181; Wattel, Peter, “Capital Export Neutrality and FreeMovement of Persons”, Legal Issues of European Integration 1996/1,at 116-119; Ault, supra note 22, at 381; Schaumburg, supra note 52, at 606-608; and U.S. JCT (Joint Committee on Taxation), supra note 81,at 92.92. See e.g. Ruding Committee, supra note 72, at 194-199; Cnossen, “Omde toekomst van de vennootschapsbelasting in de Europese Unie”, supranote 79, at 880-885 and 894; and de Bont, G., P. Essers and E. Kemmeren(eds.), Fiscal versus Commercial Profit Accounting in the Netherlands,France and Germany (Amsterdam: IBFD Publications, 1996).93. See e.g. Vogel (Part II), supra note 83, at 313-314; Ault, supra note 79,at 576; Vito, supra note 84, at 342; Kemmeren, supra note 13, at 71-74; andVlaanderen, Paul, “Why Exempt Foreign Business Profits”, 22 Tax NotesInternational 1095 (2002), at 1098-1100.


3.3. CLIN needs to replace CLEN

From the perspective of an optimal allocation of theproduction factors, investments should be made in theplace(s) where production is the cheapest and shouldbe carried out by the person(s) who can do so mostcheaply. Economic considerations, not tax motives,should be decisive in this respect. This would, in thefirst place, apply to direct investments (enterprises).While CLEN is generally regarded as fostering effi-ciency, CLIN is generally regarded as fostering com-petitiveness.94 In the author’s view, however, CLINfosters efficiency and a CLEN-based system does not.It is argued in favour of CLEN that, if a perfect capitalmarket is presupposed, a tax system based on CLENwould not disturb competition in the state in which aninvestment is made.95 As long as the investment is prof-itable, a competing enterprise that is taxed more heav-ily in its residence state would always be able to com-pensate its reduced supply of after-tax capital byfinancing through external funds. By contrast, theauthor thinks that taxation based on the universalityprinciple creates a non-neutral and therefore inefficientsystem due to the differences in the residence-statetaxation of the competitors on the relevant market.Residents of high(er)-tax states will be deterred frominvesting in low(er)-tax states because the residents ofthe low(er)-tax states who have a higher after-taxreturn will have a competitive advantage.96 In thisrespect, it should be emphasized that the level of taxa-tion and the level of public goods and services, likeinfrastructure, are often correlative.97 Allocating taxjurisdiction based on the territoriality principle shouldtherefore be favoured. It enables enterprises to com-pete on a level playing field with their foreign competi-tors.98 “Business competes with business, not ownerswith owners.”99 In such a case, economic decisionswould not be distorted by differences in taxationbecause all competitors are presumably subject to thesame tax treatment. A tax system based on the territo-riality principle would contribute to an efficient alloca-tion of the production factors worldwide.100

CLEN has also been advocated because it prevents theshift of investment capital from high-tax to low-taxjurisdictions. Consequently, enterprises in low-taxstates might increase their market share through lowerprices to the detriment of enterprises resident in high-tax states, even though the latter are more efficient.Capital is then considered to be diverted from its moreproductive uses, and worldwide income and efficiencyare considered to suffer.101 The same line of reasoningcould be applied with regard to labour. In the author’sview, this reasoning is not valid under tax treatiesbecause the overall general policy of states is to con-clude tax treaties with bona fide states, i.e. states witha “decent” tax rate and tax base.102 Furthermore, if anactivity can most profitably be carried on in a low-taxlocation, some firms will exploit the opportunity.Directly or indirectly, the production factors will flowfrom high-tax states to low-tax states. The real trade-off is whether the activity will be carried on by foreign-based firms or domestic-based firms.103 Besides, parentcompanies could minimize the tax on their worldwideincome by shifting their legal residence from a high-tax state to a low-tax state.104 In globalizing economies,where globalization is accelerated by IT developments,

many enterprises become or have become multina-tional. This might be easier to pursue because enter-prises will increasingly lose their original nationalidentity.105 The argument that the owners of servicesare much less mobile internationally than the servicesthey supply106 has become or is becoming more andmore obsolete. As a result, neither neutrality nor CLENwould be achieved in the long run. There would also bea reduction in the global profit tax revenues.107 This istrue not only regarding direct investments, but alsoregarding portfolio investments, operational leases andindependent and dependent personal services(labour).108

3.4. CLIN supports an origin-basedinterpretation of “source”

Neutrality, and thus tax neutrality as well, is by defini-tion a relative issue because the question must beanswered: Neutrality to whom or to what? Should thetax positions of entrepreneurs, portfolio investors,lessors, professionals and employees with foreignincome be equal to the tax positions of their fellowresidents with only domestic income, or should theirtax positions be equal to those of their competitors onthe local foreign markets. Whether a state choosesCLEN or CLIN seems to depend largely on the sizeand structure of its economy and the place of its econ-omy within the globalizing economies.109 Economiesof a more autarkic nature, like the United States, will

© 2006 IBFD

94. See e.g. Forst, supra note 88, at 242.95. See e.g. OECD, supra note 91, at 39-40.96. See e.g. Gandenberger, supra note 81, at 42; Ault, supra note 79,at 572; Hufbauer and van Rooij, supra note 79, at 57-61; Vogel, supra note12, at 222; Cnossen, “Om de toekomst van de vennootschapsbelasting in deEuropese Unie”, supra note 79, at 872; and Langbein, Stanley I., “TheFuture of Capital Export Neutrality: A Comment on Robert Peroni’s Path toProgressive Reform of the U.S. International Tax Rules”, 51 University ofMiami Law Review 1019 (1997).97. See e.g. Gandenberger, supra note 81, at 44.98. Vlaanderen, supra note 93, at 1103. 99. Graetz and O’Hear, supra note 6, at 1036, citing Adams, Thomas S.,“Fundamental Problems of Federal Income Taxation”, 35 Quarterly Jour-nal of Economics 527 (1921), at 542.100. See Kemmeren, supra note 13, at 74-77.101. See e.g. U.S. JCT (Joint Committee on Taxation), supra note 81, at 92;Bird, Richard M., Shaping a New International Tax Order (Erasmus Uni-versity Rotterdam, 1988), at 11; Hufbauer and van Rooij, supra note 79,at 50-51; Green, Robert A., “The Future of Source-Based Taxation of theIncome of Multinational Enterprises, 79 Cornell Law Review 18 (1993),at 21-22, 30-32 and 70-86; and Peroni, Robert J., “Back to the Future: APath to Progressive Reform of the US International Income Tax Rules”, 51University of Miami Law Review 975 (1997), at 978 and 980-983.102. See e.g. OECD, International Tax Avoidance and Tax Evasion, FourRelated Studies (Paris: OECD, 1987), at 23; the memorandum of theNetherlands Under-Secretary of Finance, “Fiscaal verdragsbeleid”, 2 Octo-ber 1996, No. IFZ96/741, V-N 1996/51, at 4011; and Wattel, supra note 91,at 119.103. See e.g. Hufbauer and van Rooij, supra note 79, at 58.104. See e.g. OECD, supra note 91, at 179; and Graetz and O’Hear, supranote 6, at 1060. The tax considerations are, of course, only one factor thatinfluences the location of a parent company.105. See e.g. Tanzi, supra note 84, at 339-340. 106. See e.g. Graetz and O’Hear, supra note 6, at 1034. 107. See OECD, supra note 91, at 179.108. See e.g. Kemmeren, supra note 13, at 74-83.109. See e.g. Cnossen, S., Het verrekeningsstelsel in opmars: Wat doetNederland? (Deventer, the Netherlands: Kluwer, 1979), at 101-102; Vogel(Part II), supra note 83, at 316; OECD, supra note 91, at 176 and 271-281;Nooteboom, A. and J.N. Bouwman, Wegwijs in de Vennootschapsbelasting(Lelystad, the Netherlands: Koninklijke Vermande, 1994), at 29-32; andWattel, supra note 91, at 118.


likely incline more to CLEN, and a more open econ-omy, like the Netherlands, to CLIN, if these qualifica-tions still hold in a globalizing environment: the USeconomy has also become a more open economy.Political economic power might be the decisive factorfor the ultimate choice. As argued above, a CLIN-based system will promote an efficient allocation of theproduction factors. However, even if CLEN isembraced as the leading policy, and thus a tax creditsystem is applied, it would still be possible to promotethe principle of origin more than is done today. Thiscould be done by (re)drafting the distributive rules intax treaties based more on this principle.110 For exam-ple, the primary right to tax interest could be assignedto the state of origin, but the residence state couldimpose an additional tax if the income tax in the stateof origin is below the residence state’s level.

As developed states are wealthy and developing statesrelatively poor, it is assumed that developed statesexport capital, which is imported by developingstates.111 Furthermore, it is assumed that capital flowsbetween developed states tend to be more or less bal-anced.112 These assumptions are by nature veryabstract, and day-to-day practice may very well deviatefrom them. For example, a specially tailored offshoreregime in a developed state to attract finance com-panies or to promote its exports113 may cause an imbal-ance in the capital flows between developed states.114

Nevertheless, the assumption regarding imbalancedcapital flows between developed and developing stateswas generally accepted a long time ago. A residence-based system promoting CLEN would, therefore,favour the position of developed states. In contrast, anorigin-based system promoting CLIN would favourdeveloping states.115 The author concluded in 2. that atax treaty system based on the principle of origin issuperior to a residence-based system from the perspec-tive of legal principles. Residing means consumingincome; it does not produce income. Therefore, a sys-tem whose aim is to distribute tax jurisdiction withrespect to the creation of income should not be basedon residence. Furthermore, as discussed above, an ori-gin-based system does not result in an inefficient allo-cation of economic resources. By contrast, in theauthor’s view, an origin-based system promotes anefficient allocation of economic resources. In such asystem, the income originating in one state should beexempt, i.e. not included in the tax base, in the otherstate. In such a system, the principle of origin canachieve its full potential. Besides, the tax sovereigntyof the state of origin will be most respected. Further, itmight enable developing states to reduce the gap ineconomic development with developed states.116 Underan origin-based allocation of tax jurisdiction, there isan immediate connection between substantial income-producing activities carried on within a developingstate and its tax proceeds. If such activities increased,the state’s budget would also increase. Consequently,that state has an incentive to promote the growth ofsubstantial income-producing activities by enhancingits infrastructure. As a result, the state’s economic wel-fare would increase even more. Such a system mightalso have other beneficial (side) effects,117 such as pro-moting inter-nation stability. Therefore, in the author’sview, an origin-based interpretation of “source” is sup-

ported not only by legal principles, but also by eco-nomic principles.118

4. EU LAW: CASE LAW SUPPORTS SOURCE-BASED TAXATION, DIRECTIVES DO NOT

4.1. Towards a common market

The EC Treaty contains a broadly phrased declarationof the Community’s purposes (see Arts. 2, 3 and 4).The most important means to reach these mixed, andeven contradictory, purposes119 are the establishmentof a common market and of an economic and monetaryunion (EMU).120 The terms “common market” and“internal market” are considered to be synonyms.121

The internal market is characterized by the abolition,as between the Member States, of obstacles to the freemovement of goods, persons, services and capital.122 Acommon market requires, inter alia, a common com-mercial policy, a system ensuring that competition inthe internal market is not distorted, and the approxima-tion of the Member States’ laws to the extent necessary

© 2006 IBFD

110. See e.g. Pires, supra note 15, at 136; and Sweet, supra note 17,at 1995.111. See e.g. Commentary on the 2001 UN Model, Introduction at vii, andArt. 11 at 168.112. See e.g. Bühler, supra note 1, at 186; and Capellen, supra note 87,at 435-436.113. See e.g. Wijnen, Willem F.G., “Towards a New UN Model?”, 52 Bul-letin for International Fiscal Documentation 3 (1998), at 135, 136.114. This will also affect a state’s budget. A residence-based allocation oftax jurisdiction, e.g. with respect to interest, reduces the tax revenue of thedebtor’s state, whereas an origin-based system would prevent this. Espe-cially when interest is deductible in the debtor’s state and not taxed or onlylightly taxed by that state in the hands of the creditor (this is the most com-mon pattern), an origin-based allocation of tax jurisdiction is also in thebudgetary interests of developed states. How much revenue a developedstate will lose or gain under an origin-based allocation of tax jurisdiction isan interesting question, but beyond the scope of this article. It should benoted, however, that a switch to an origin-based allocation of tax jurisdic-tions in tax treaties will not per se cause a loss of revenue for developedstates. Furthermore, if desired, the possible negative budgetary conse-quences could be countered by, for example, raising and/or extending con-sumption taxes.115. See e.g. Atchabahian, supra note 27, at 316; Piedrabuena, Enrique,“The Model Convention to Avoid Double Income Taxation in the AndeanPact”, 29 Bulletin for International Fiscal Documentation 2 (1975), at 51,52; Bird, supra note 101, at 16; Capellen, supra note 87, at 436-437and 439-441; and Vlaanderen, supra note 93, at 1099-1100. 116. See e.g. Bühler, supra note 1, at 186; Endriss, supra note 6, at 62-63and 70; and Meyer, supra note 8, at 37-40 and 44-49.117. See e.g. Vogel, supra note 71, at 30.118. See e.g. Endriss, supra note 6, at 75; Vogel, supra note 8, at 399; andKemmeren, supra note 13, at 110-112.119. See e.g. Beaumont, Paul and Gordon Moir, European Communities(Amendment) Act 1993 with the Treaty of Rome (as amended) (London:Sweet & Maxwell, 1994), at 32-37 and 32-38; and Mortelmans, Kamiel,“The Common Market, the Internal Market and the Single Market, What’sin a Market?”, 35 Common Market Law Review 101 (1998), at 118-119. 120. See e.g. Terra, Ben J.M. and Peter J. Wattel, European Tax Law(Deventer, the Netherlands: FED, 2005), at 1-2; and Kapteyn, P.J.G. and P.VerLoren van Themaat (edited by Laurence W. Gormley), Introduction tothe Law of the European Community (London: Kluwer Law Interna-tional, 1998), at 114-125.121. See e.g. ECJ, 17 May 1994, Case C-41/93, France v. Commission. Seealso e.g. Kapteyn and VerLoren van Themaat, supra note 120, at 116, 123and 779-780; and van der Woude, A.M., Belastingen begrensd, de door -werking van het discriminatieverbod en de richtlijnen van de EG opnationale belastingen (Delft: Eburon, 2000), at 9-10. The term “single mar-ket”, which is also frequently used e.g. by the ECJ, is considered to be syn-onymous with both terms. See e.g. Mortelmans, supra note 119, at 107. 122. See Art. 3(1)(c) of the EC Treaty.


for the functioning of the common market.123 The ECTreaty itself, in Art. 14(2), defines the “internal mar-ket” as “an area without internal frontiers in which thefree movement of goods, persons, services and capitalis ensured in accordance with the provisions of thisTreaty”.

For operations within the EC, it is essential that thecommon market be analogous in nature to the domesticmarket of a single state.124 It should be emphasized,however, that a genuine internal market still does notexist.125 At best, we are moving towards a commonmarket. This situation is evidenced by e.g. the fact thatall 25 Member States still have their own system ofdirect taxation, including tax treaties. The concept ofthe market is reflected in the basic principle of “anopen market economy with free competition” men-tioned in Arts. 4 and 98 of the EC Treaty, on which thepolicy concerning the EMU and the Member States’and Community’s economic policies must be based.An “open market economy” means a market economycharacterized by a liberal commercial policy.

4.2. CLIN best satisfies the EC Treaty

As argued above, an open economy will likely inclinemore towards CLIN. Economies become increasinglyopen as a result of globalization. For the EuropeanCommunity, the concept of an open market economy isone of the fundamental principles. Therefore, theauthor finds strong support to base tax treaties on theCLIN principle. The EC Treaty certainly does not pro-hibit doing so. In the author’s opinion, CLIN best sat-isfies the objectives and principles of the EC Treaty.Regarding the efficiency of the common market, taxneutrality should prevail (see 3.1.) The common mar-ket is analogous in nature to the domestic market of asingle state although, as mentioned above, a genuineinternal market still does not exist. CLIN underscoresin the best way possible the operation of such a marketestablished by the Member States by creating a levelplaying field in them; labour and capital originating inthe Member States will compete on equal terms in thelabour and capital markets of any state irrespective ofthe worker’s or investor’s place of residence. The con-cept of such a level playing field is also reflected in thebasic principle of “an open market economy with freecompetition” mentioned in Arts. 4 and 98 of the ECTreaty.

Regarding direct investments, the author agrees, asstated above (see 3.3.), that business competes withbusiness, not owners with owners. Allocating tax juris-diction based on the territoriality principle shouldtherefore be favoured. It enables enterprises to com-pete on a level playing field with their foreign competi-tors because, presumably, all competitors are subject tothe same tax treatment. This way, the freedom of estab-lishment, and thus the internal market, will be pro-moted. Taxation based on the universality principlewould also not be neutral with respect to cross-borderindependent and dependent personal services. From aneconomic perspective, the decision to work in a foreigncountry, to contract with a foreign professional or toemploy a foreign employee could be hindered by sucha system. A CLIN-based system, however, will be neu-tral with respect to the labour market in the state where

the labour income is produced. The free movement ofworkers and the freedom of establishment, and conse-quently the internal market, will benefit from it.Regarding income from portfolio investments, in theauthor’s view, the taxation of interest will be neutralonly if it does not change the market conditions underwhich the debtor operates. Assuming that the creditor’stax burden is passed on to the debtor, the differences intaxation by the various (potential) creditor states willaffect the market conditions under which the debtoroperates. A territoriality and origin-based system,however, will be neutral with respect to the debtor’sposition because the interest will be subject only to thetax imposed by the debtor’s state. The same appliesmutatis mutandis to dividends. The taxation of interestand the corporate income tax, whether or not supple-mented with a dividend withholding tax, should be har-monized. Such taxation will promote both the freemovement of capital and the internal market. A CLIN-based tax system would thus contribute to the efficientallocation of the production factors throughout the EC(see 3.). The author concludes, therefore, that eco-nomic policy and the fundamental freedoms securedby the EC Treaty strongly support, or at least do notprohibit, structuring tax treaties based on the principleof origin and the territoriality principle.126

Case law shows that these principles can actually beapplied under the fundamental freedoms of the ECTreaty. EU citizens and economic operators can choosewithin the European Community the most suitable taxsystem for themselves and their investments127 and candecide which of the Member States makes the mostappealing “offer” regarding the tax burden and publicservices.128 In this respect, it should be noted that, in

© 2006 IBFD

123. See Arts. 3(1)(b), (g) and (h) of the EC Treaty. 124. See e.g. ECJ, 9 February 1982, Case 270/80, Polydor; and ECJ, 5May 1982, Case 15/81, Gaston Schul I. 125. For criticism on the state of the internal market, see e.g. Mortelmans,supra note 119, at 101-136.126. See e.g. Vogel, supra note 71, at 31; Vogel, Klaus, “Should EuropeAdopt a Uniform Method for the Avoidance of Double Taxation”, IBFDInternational Tax Academy, Lecture No. 1, Amsterdam, 2000, at 11-15;Wattel, supra note 91, at 124-127; Terra and Wattel, supra note 120, at 259-260; Lehner, supra note 5, at 14; Pistone, Pasquale, The Influence ofCommunity Law on Tax Treaties, Issues and Solutions (London: KluwerLaw International, EUCOTAX Series on European Taxation, 2002),Sec. 3.6; and Wattel, Peter J., “Corporate tax jurisdiction in the EU withrespect to branches and subsidiaries; dislocation distinguished from dis-crimination and disparity; a plea for territoriality”, 12 EC Tax Review 194(2003). By contrast, according to Meyer (supra note 8, at 238-239), withinthe EC, the principle of residence can be the appropriate basis.127. See e.g. Terra and Wattel, supra note 120, at 240-243; Schön, Wolf-gang, “Tax Competition in Europe – General Report”, in Schön, Wolfgang(ed.), Tax Competition in Europe (Amsterdam: IBFD, European Associa-tion of Tax Law Professors, 2003), at 4-12; Pinto, Carlo, Tax Competitionand EU Law (The Hague: Kluwer Law International, EUCOTAX Series onEuropean Taxation, 2003), at 67-70; and Kiekebeld, Ben J., Harmful TaxCompetition in the European Union, Code of Conduct, Countermeasuresand EU Law (Deventer, the Netherlands: Kluwer, Europese Fiscale Stu -dies, 2004), at 55-78, 105-118 and 136.128. Tax competition is the norm within the European Union, but this normcannot be applied unrestrictedly. The Member States may not jeopardize theother fundamental objectives of the EC Treaty when entering into tax com-petition with the other Member States. They may not breach the loyaltyprinciple as laid down in Art. 10 of the EC Treaty. It is likely that this pro-vision has to be applied in conjunction with other specific provisions of theEC Treaty, such as Art. 87 (state aid), Art. 96 (distortion of competition)and/or Art. 99 (coordination of economic policies). If, however, the Mem-ber States’ regimes, even aggressive ones, are nevertheless compatible withthe EC Treaty’s objectives, there is no breach of loyalty since the general


Gilly, the ECJ ruled, inter alia, that “the differencesbetween the tax scales of the Member States con-cerned, and, in the absence of any Community legisla-tion in the field, the determination of those scales is amatter for the Member States” (emphasis added).129

The Eurowings case may also be considered very rele-vant in this respect. In that case, an Irish resident com-pany which benefited from a special low corporateincome tax rate of 10% (a special regime that wasapproved by the European Commission) leased an air-plane to a German resident company. For Germantrade tax purposes, the German company had to add toits profit half of the lease payments made to the Irishcompany. If the lease payments had been made to aGerman resident lessor, no amount would have had tobe added to the profit. The lower taxation of the Irishlessor was raised as a possible justification by the Ger-man tax administration, but it was firmly rejected bythe ECJ:

[t]hat difference of treatment can also not be justified bythe fact that the lessor established in another MemberState is there subject to lower taxation. ... Any taxadvantage resulting for providers of services from thelow taxation to which they are subject in the MemberState in which they are established cannot be used tojustify less favourable treatment in tax matters given torecipients of services established in the latter State. ...Such compensatory arrangements prejudice the veryfoundations of the single market (emphasis added).130

In Futura, the ECJ explicitly accepted the territorialityprinciple. The case dealt with the carry-forward oflosses derived from a Luxembourg permanent estab-lishment of a French resident company.131 The carry-forward was made subject to, inter alia, the conditionthat the loss be economically related to the incomeearned by the taxpayer in Luxembourg. Regarding thiscondition, the ECJ ruled that a system of calculatingthe basis of assessment for non-resident taxpayerswhich, when calculating the tax payable by them inLuxembourg, takes into account only the profits andlosses arising from their Luxembourg activities is inconformity with the tax principle of territoriality andcannot be regarded as entailing any discrimination,overt or covert, prohibited by the E(E)C Treaty.132

This case law points out that the fundamental freedomsallow the Member States to determine the structuralelements of their own tax system. A Member State mayfundamentally select its level of taxation and maygrant special tax incentives in accordance with the ECTreaty. In addition, the Gilly and Saint-Gobain casesshow that the Member States are also free to choosetheir own system for relieving double taxation, e.g. atax credit or an exemption system.133 Such choicesmust basically be respected by the other MemberStates. Therefore, although CLIN best satisfies the ECTreaty, its application is not mandatory under currentEC law.

4.3. Substantial income-producing activitymeans “economic activity” in the EC Treaty

As stated above (see 2.3.1.1.), only individuals can cre-ate income; things in themselves cannot. The intellec-tual element is the key component in the production ofincome. Through an individual’s action, value may be

added to things, whether or not a device is used. Theplace of origin of an individual’s income is the site ofhis income-producing activity (see 2.3.1.1.). In addi-tion, the author thinks that, to allocate tax jurisdictionwith respect to income from activities, a substantialrelationship between the activity and the state con-cerned is required. A sufficient relationship with a stateshould be considered present if a substantial income-producing activity is exercised in that state. Anincome-producing activity is considered to be substan-tial if it forms an essential and significant part of theactivity as a whole (see 2.3.1.4.).

This concept of a substantial income-producing activ-ity matches superbly the concept of “economic activ-ity” in the EC Treaty. This is evidenced by the ECJ’scase law on “fish quota hopping”. Since fish is scarce,the EC introduced national fishing quotas to limit thevolume of fish being caught. Spanish fishermen triedto obtain larger quotas in the United Kingdom by set-ting up a UK company. The UK tried to stop this“quota hopping” by introducing conditions for regis-tering a vessel and, consequently, for using the UK’squotas. A fishing vessel is eligible for registration inthe UK register only if: (1) the vessel is British-owned;(2) the vessel is managed, and its operations aredirected and controlled, from within the UK; and (3)any charterer, manager or operator of the vessel is aqualified person or company.

In the Jaderow and Factortame II cases,134 the ECJruled that the conditions concerning nationality,135 resi-dence and domicile violate the freedom of establish-ment.136 The activity test (condition 2), however, is inline with the concept of “establishment” in Art. 43.137

In Factortame II, the ECJ ruled (emphasis added):

© 2006 IBFD

rule of tax sovereignty applies. But it should also be taken into account thatpolitical instruments, like the Code of Conduct (soft law), limit the factualscope of those sovereign rights.129. ECJ, 12 May 1998, Case C-336/96, Gilly, Para. 47.130. ECJ, 26 October 1999, Case C-294/97, Eurowings, Paras. 43-45. Seealso e.g. ECJ, 3 October 2002, Case C-136/00, Danner, Paras. 53-56; andECJ, 11 December 2003, Case C-364/01, Barbier, Para. 71.131. ECJ, 15 May 1997, Case C-250/95, Futura. See also ECJ, 10March 2005, Case C-39/04, Laboratoires Fournier; and ECJ, 13 Decem-ber 2005, Case C-446/03, Marks & Spencer.132. Futura, supra note 131, Paras. 21 and 22. See also LaboratoiresFournier, supra note 131, Paras. 18-19; and Marks & Spencer, supranote 131, Paras. 39, 43 and 45-46. Disagreeing: e.g. Steyger, E., “De neven-effecten van het vrij verkeer op specifiek nationale beleidsterreinen”, SEW1999/6, at 226-233; and van der Woude, supra note 121, at 87-88 and 98(arguing that the territoriality principle is at right angles to the fundamentalfreedoms of the EC Treaty and that tax treaties might be within the scope ofthis principle).133. ECJ, 12 May 1998, Case C-336/96, Gilly; and ECJ, 21 Septem-ber 1999, Case C-307/97, Saint-Gobain.134. ECJ, 14 December 1989, Case C-216/87, Jaderow; and ECJ, 25July 1991, Case C-221/89, Factortame II, especially Paras. 20-22 and 34-36.135. See e.g. ECJ, 12 June 1997, Case C-151/96, Commission v. Ireland;and ECJ, 27 November 1997, Case C-62/96, Commission v. Greece.136. These conditions also infringe Art. 294 of the EC Treaty, whichinvolves national treatment as regards participation in the capital of com-panies or firms within the meaning of Art. 48. In ECJ, 14 December 1989,Case C-3/87, Agegate, also a “fish quota hopping” case, the ECJ ruled sim-ilarly with respect to the free movement of workers.137. See ECJ, 7 March 1996, Case C-334/94, Commission v. France,Paras. 14-24; and ECJ, 29 October 1998, Case C-114/97, Commission v.Spain, Paras. 31-48.


20. It must be observed in that regard that the conceptof establishment within the meaning of Article 52 et seq.of the Treaty involves the actual pursuit of an economicactivity through a fixed establishment in another Mem-ber State for an indefinite period.

21. Consequently, the registration of a vessel does notnecessarily involve establishment within the meaning ofthe Treaty, in particular where the vessel is not used topursue an economic activity or where the application forregistration is made by or on behalf of a person who isnot established, and has no intention of becoming estab-lished, in the State concerned.

22. However, where the vessel constitutes an instru-ment for pursuing an economic activity which involvesa fixed establishment in the Member State concerned,the registration of that vessel cannot be dissociated fromthe exercise of the freedom of establishment.

34. In this regard, it is sufficient to point out that arequirement for the registration of a vessel to the effectthat it must be managed and its operations directed andcontrolled from within the Member State in which it is tobe registered essentially coincides with the actual con-cept of establishment within the meaning of Article 52 etseq. of the Treaty, which implies a fixed establishment.It follows that those articles, which enshrine the veryconcept of freedom of establishment, cannot be inter-preted as precluding such a requirement. ...

36. Consequently, the reply to the national court mustbe that it is not contrary to Community law for a Mem-ber State to stipulate as a condition for the registrationof a fishing vessel in its national register that the vesselin question must be managed and its operations directedand controlled from within that Member State.

From Gebhard, it follows that the concept of establish-ment is very broad:

allowing a Community national to participate, on a sta-ble and continuous basis, in the economic life of a Mem-ber State other than his state of origin and to profit there-from, so contributing to economic and socialinterpenetration with the Community in the sphere ofactivities as self-employed persons (emphasis added).138

Factortame II and Gebhard, as quoted above, showthat there must be a sufficient economic nexus with theMember State concerned in order to rely on the free-dom of establishment. In any case, an establishment,and therefore an economic activity, is present if anasset is managed, and its operations are directed andcontrolled, from within the Member State concerned.Therefore, in the author’s view, the concept of substan-tial income-producing activity matches remarkablywell the concept of economic activity in the EC Treaty.Thus, in the discussion below, the word “economic” isincluded in the term “substantial income-producingactivity”, resulting in “substantial income-producingeconomic activity”.

4.4. Case law supports source-based taxation

From the case law discussed in 4.2. and 4.3., it can bededuced not only that CLIN best satisfies the ECTreaty and that the concept of substantial income-pro-ducing economic activity matches very well the con-cept of economic activity in the EC Treaty, but also thatCLIN supports an origin-based interpretation of“source”, or at least that it does not prevent such aninterpretation.

4.5. Directives support residence-based taxation

On the other hand, the Parent-Subsidiary Directive, theInterest and Royalties Directive, and the Savings TaxDirective support residence-based taxation more thansource-based taxation.139

The Parent-Subsidiary Directive shows clear traces ofthe principle of origin and CLIN. The aim of introdu-cing tax rules that are neutral from the point of view ofcompetition appeals to CLIN, as discussed above.140 Awithholding tax on qualifying dividend payments isnot allowed. The possible exemption at the level of theparent company for dividends received from a sub-sidiary is an example of applying both the principle oforigin and CLIN. However, the Directive does not pre-scribe a system based only on these principles. Theresidence principle and CLEN are obviously present.141

The Member States have the choice of applying anindirect credit instead of an exemption from the taxbase.

In the Interest and Royalties Directive, a choice wasmade to abolish the taxation of interest and royaltypayments in the Member State in which they arise,whether the tax is collected by deduction at source orby assessment. The choice regarding interest under-scores the broad impact of the residence principle andCLEN. On the other hand, the choice regarding royal-ties may generally be considered as being more in linewith the principle of origin and CLIN because the statein which the royalties arise must refrain from taxingthe royalty payments. In the draft Directive,142 the resi-dence system implemented better approximated theprinciple of origin since the draft required that a com-pany “qualify”, e.g. that its activities constitute aneffective and continuous link with the economy of thatMember State (draft Directive, Art. 3(1)(a)(i)). Thedraft would have coincided with the principle of originif it had been supplemented with the following addi-tional condition: the asset from which the royalty ori-ginates is used for pursuing the company’s economicactivity, i.e. that the intangible property is managed,and its operations are directed and controlled, fromwithin the Member State concerned. However, the finalDirective does not include these conditions; conse-quently, it is further away from the principle of originand CLIN than the 1998 draft.

The Savings Tax Directive also reflects to a largeextent the dominance of the residence principle and

© 2006 IBFD

138. ECJ, 30 November 1995, Case C-55/95, Gebhard, Para. 25. Under EClaw, the term “state of origin” means “home state” in this respect.139. Council Directive 90/435/EEC of 23 July 1990 on the common systemof taxation applicable in the case of parent companies and subsidiaries ofdifferent Member States; Council Directive 2003/49/EC of 3 June 2003 ona common system of taxation applicable to interest and royalty paymentsmade between associated companies of different Member States; and Coun-cil Directive 2003/48/EC of 3 June 2003 on taxation of savings income inthe form of interest payments, respectively.140. See e.g. de Hosson, Fred C., “The Parent-Subsidiary Directive”, Inter-tax 414 (No. 10, 1990), at 418-419.141. See e.g. van den Hurk, H.T.P.M., “Onderworpenheid en comparti-mentering; Europees geïnterpreteerd”, Weekblad voor Fiscaal Recht1994/6121, at 1435-1440.142. Proposal for a Council Directive on a common system of taxationapplicable to interest and royalty payments made between associated com-panies of different Member States, COM(1998) 67 final, 98/0087(CNS)of 4 March 1998.


CLEN.143 The state of “residence for tax purposes” ofthe beneficial owner of the interest is in principleassigned tax jurisdiction with respect to the interestincome. However, in contrast to the Interest and Royal-ties Directive, the Savings Tax Directive allows source-state taxation through a withholding tax. Austria, Bel-gium and Luxembourg apply the withholding taxsystem, whereas the other Member States apply theinformation system. The withholding tax is reallybased on the source principle as defined in this article,in particular, more on the paying-state principle, i.e.the state in which the economic operator, who isresponsible for paying the interest for the immediatebenefit of the beneficial owner, is established is enti-tled to levy a withholding tax. The principle of origin isexplicitly overruled by the source principle, even morethan once, see e.g. Arts. 1(2) and 4(1) of the Directive.The debtor of the capital producing the interest isexplicitly subordinated to the paying agent who paysthe interest.144 It should be noted, however, that theresidence state’s exclusive tax jurisdiction will berestored, i.e. no source-state taxation of the interestwill be allowed, if the beneficial owner authorizes thepaying agent to report information to his residencestate or if he proves that he has properly informed thetax authorities in his home state. The residence prin-ciple has been further emphasized by the source state’sobligation to transfer 75% of its revenue to the resi-dence state of the beneficial owner of the interest.Therefore, the source-state system is even applied topursue predominantly the residence principle insteadof the source principle.145

4.6. EC Treaty does not determine “source”

As argued above, the ECJ’s case law supports an ori-gin-based interpretation of “source”, or at least it doesnot prevent such an interpretation. It must also beemphasized, however, that the EC Treaty does notdetermine the concept of “source”. As the ECJ stated ine.g. Saint-Gobain, the Member States are competent todetermine the criteria for taxing income and wealth:

In this regard, it must be observed first of all that, in theabsence of unifying or harmonising measures adoptedin the Community, in particular under the second indentof Article 220 of the EC Treaty (now the second indentof Article 293 EC), the Member States remain compe-tent to determine the criteria for taxation of income andwealth with a view to eliminating double taxation bymeans, inter alia, of international agreements. In thiscontext, the Member States are at liberty, in the frame-work of bilateral agreements concluded in order to pre-vent double taxation, to determine the connecting fac-tors for the purposes of allocating powers of taxation asbetween themselves (see, to this effect, Case C-336/96Gilly, [1998] ECR I-2793, paragraphs 24 and 30)(emphasis added).146

Therefore, the EC Treaty does not force the MemberStates to accept a source-based income tax system oran origin-based interpretation of source. They may doso, but they are also free to use a residence-basedincome tax system. Their powers are not unrestricted,however. Whatever system the Member States choose,it must meet the standard that they must exercise theirtaxing powers consistently with Community law.147

In conclusion, we see conflicting trends in EC lawregarding source-based taxation. If an actual commonmarket does not exist and 25 different income tax sys-tems must be accepted, CLIN, source-based incometaxation and an origin-based interpretation of sourcebest satisfy the objectives and goals of the EC Treaty.The ECJ’s case law supports such an interpretation, orat least does not preclude it. On the other hand, theincome tax directives are generally more in favour ofresidence-based taxation. In any case, the EC Treatyand the ECJ’s case law do not determine the concept ofsource.

5. THE OECD MODEL: RESIDENCE-BASEDFLAWS TRIGGER SOURCE-BASEDCORRECTIVE ACTIONS

Most of the current tax treaties reflect a mix of CLENand CLIN, although CLEN seems to predominate. Forexample, the OECD and the UN have not chosen CLIN(tax exemption) or CLEN (tax credit), but have left itup to the contracting states. The US is clearly an adher-ent of CLEN, whereas the Netherlands inclines moreto CLIN with regard to active income, but withoutdoubt favours CLEN with regard to passive income.For persons who can invoke tax treaty benefits, theresults under the current model tax conventions are notsatisfactory. The residence principle, on the basis ofwhich the subjects eligible for treaty benefits wereestablished, may be identified as the (main) cause ofthe deficiencies. In principle, only a resident has accessto a tax treaty and its benefits. Therefore, under the cur-rent system, it is of principal interest for a person wish-ing to benefit from a state’s treaty (network) to be aresident. Consequently, residence plays a key role ininternational tax avoidance, including treaty abuse,since a place of residence can be chosen or transferredin order to claim the desired treaty benefits withoutnecessarily affecting the income-producing economicactivity. None of the models mentioned in this article –the OECD, UN, US and Netherlands Models – coversthe consequences of the change of residence of a per-son who ceases to be a resident of one contracting stateand becomes a resident of the other. The legal form inwhich an income-producing economic activity is car-ried on may also have a large impact on eligibility fortreaty benefits, again without necessarily affecting theincome-producing economic activity. This also trig-gers tax arbitrage. Transparent and hybrid entities cre-ate complex problems and opportunities. The qualifi-cation depends on the circumstances and the intereststo be served. In substance, the weakness of this resi-dence-based concept has been acknowledged by thereactions of some states, e.g. the United States,148 as

© 2006 IBFD

143. See e.g. Dourado, Ana Paula, “The EC Draft Directive on Interestfrom Savings from a Perspective of International Tax Law”, 9 EC TaxReview 144 (2000), at 149-151.144. See e.g. Cardani, Angelo M., “European Taxation Policy, A Change ofTack”, in Breuninger, Gottfried E., Welf Müller and Elisabeth Strobl-Haar-mann, Steuerrecht und europäishe Integration, Festschrift für Albert J.Rädler, zum 65. Geburtstag (Munich: Verlag C.H. Beck, 1999), at 130-133;and Dourado, supra note 143, at 151. 145. See Kemmeren, supra note 13, at 214-219 and 222-236.146. ECJ, 21 September 1999, Case C-307/97, Saint-Gobain, Para. 56.147. See e.g. id., Para. 57.148. See Art. 22 of the US Model.


well as the OECD.149 The author refers, for example, tothe introduction of limitation on benefits provisions,which generally limit the access to treaty benefits toresidents who have a sufficient economic nexus withthe state concerned. Such provisions, if fact, moveaway from the residence principle and come closer tothe principle or origin.150

As a result of the influence of the residence principle,the income allocation rules in treaties were and are pre-dominantly residence-based as well. The author refers,for example, to business income, dividends, interest,employment income, other income and capital gains aswell as to personal allowances, reliefs and reductions.Regarding the income allocation rules, however, wemay discover a move towards more source-based taxa-tion because the residence-based allocation rules haveled to unsatisfactory results.151 There are examples insome model conventions, e.g. the OECD, UN, US andNetherlands Models. Without providing an exhaustivelist, the following examples may be considered asemphasizing source-based instead of residence-basedtaxation: international shipping and air transport(OECD, UN, US and Netherlands Models); branchprofits tax (US Model); capital gains on shares in realestate companies (OECD, UN and US Models);artistes and sportsmen, which allocation rule comesclosest to the principle of origin (OECD, UN, US andNetherlands Models); private pensions (UN andNetherlands Models); social security payments (UN,US and Netherlands Models); other income (UNModel); non-discrimination of permanent establish-ments and foreign-held subsidiaries (OECD, UN, USand Netherlands Models) and the exemption method(OECD, UN and Netherlands Models).

Although these developments may be consideredpromising, it will probably be a long time before thereis a fundamental change in states’ policies regardingincome tax treaties, i.e. moving away radically or atleast substantially from a residence-based to an origin-based income tax system. However, sound economicpolicy for globalizing economies, improvement in theEC’s internal market, and the ECJ’s case law providestrong arguments in support of an origin-based system.Political timidity seems to be most obvious reason fornot acting quickly in this direction. But the pace ofglobalization of states’ economies may force politi-cians to give up tax policies that may be considered outof date more quickly than they think politically appro-priate at this time. Economics may be the inevitabledriving force for accelerating to more origin-basedincome taxation.

6. ALTERNATIVE ORIGIN-BASED TAXSYSTEM: TAX TREATIES, EC DIRECTIVESAND DOMESTIC LAW

The discussion below outlines some key elements of anorigin-based tax system which may be helpful indeveloping source rules for the 21st century. In thisregard, not only will the rules of tax treaties need to beadjusted, but the provisions of the EC income taxdirectives will also have to be amended. It must beemphasized, however, that domestic tax systems willnot necessarily need to be changed, but that could be

contemplated as well if it is considered desirable toturn the domestic tax system unilaterally into an ori-gin-based system. The origin-based system presentedbelow is based on the concept of a tax treaty, whichmay be bilateral or multilateral. Even if CLEN isembraced as the leading economic policy and a taxcredit system is applied, it is still possible to give theprinciple of origin a greater role than is done in the cur-rent treaties and model tax conventions.

In an origin-based treaty, the justification for allocatingtax jurisdiction with respect to income and capital willbe better. Origin-based rules identifying the eligibletreaty subject, allocating income and capital, and elim-inating double taxation will reduce significantly (atleast) the deficiencies of the current models becausethe location of substantial income-producing economicactivities is decisive for entitlement to treaty benefitsand the allocation of tax jurisdiction with respect toincome and capital. An appropriate allocation of taxjurisdiction with respect to e-commerce will also bebetter guaranteed. Tax arbitrage, including the (per-ceived) abuse of tax treaties, will be significantlyreduced. It will not be easy to manipulate the allocationof tax jurisdiction without affecting the economic loca-tion of a substantial income-producing economicactivity. The level playing field for enterprises,employees, artistes and sportsmen, debtors, lessors andlessees, and others will be improved because an origin-based system promotes CLIN. The efficient allocationof the production factors of labour and capital will alsobe improved. Consequently, the functioning of theEC’s internal market will be facilitated better than iscurrently the case. Developing states will be able toreduce the gap in economic development with devel-oped states.

The following key elements are addressed: eligibletreaty subject (this is not a source rule in a narrowsense, but it is included because it is essential to thesystem); business income (profits, dividends and cap-ital gains on shares); interest and capital gains on debtclaims; royalties and capital gains on the underlyingintangible property; pensions; and personal circum-stances.152

6.1. Eligible treaty subject

The underlying concept is that a person who pursues orhas pursued a substantial income-producing economicactivity within a state is entitled to invoke that state’stax treaties if the income or capital concerned must beattributed to that activity based on a functional analy-sis, i.e. the income or capital is or was functionallyconnected with the substantial income-producing eco-nomic activity.

With respect to capital taxes, a similar approach isadvocated based on the principle of economic location.In an origin-based system, treaty benefits are con-nected to objects rather than to subjects. The distinc-tion between residents and non-residents and differen-

© 2006 IBFD

149. See Paras. 7 to 26 of the Commentary on Art. 1.150. See Kemmeren, supra note 13, at 282-290.151. See id. at 321-504.152. For more details, see id. at 257-515.


tiation based on the legal form are eliminated, or atleast substantially reduced. The same is true withrespect to (abusive) treaty shopping through (hybrid)(legal) entities. As a consequence, a level playing fieldwill be created which benefits CLIN and the develop-ment of the EC’s internal market. An economic liable-to-tax condition will be partly superfluous in this sys-tem.

In an origin-based system, an individual is entitled toinvoke a tax treaty concluded by a state if he is:(1) a citizen of that state who is subject to tax because

of his citizenship there;(2) a resident of that state who is subject to tax because

of his domicile, residence or any other criterion ofa similar nature in that state; or

(3) (a) an individual who is neither a citizen nor a resi-dent of that state but pursues or has pursued a sub-stantial income-producing economic activitywithin that state and (b) the income or capital con-cerned must be attributed to that activity based on afunctional analysis.

A resident cannot invoke the tax treaty between theresidence state and the other contracting state if he caninvoke the tax treaty between the other contractingstate and a third state in which he pursues or has pur-sued a substantial income-producing economic activityto which the income concerned must to be attributedand if the residence state has also concluded a taxtreaty with the third state. The same applies mutatismutandis to a citizen in (1).

A person other than an individual is entitled to invokea state’s tax treaty only if:(1) the person pursues or has pursued a substantial

income-producing economic activity within thatstate; and

(2) the income or capital concerned must be attributedto that activity based on a functional analysis.

From the perspective of the principle of origin, theactivities of agents, whether or not dependent, shouldbe attributed to the income recipient if the incomereceived is in substance produced through the activitiesof the agents (i.e. they added the intellectual element)to the extent the benefits from their activities did notaccrue to the agents, but were passed on to the incomerecipient. Not attaching much weight to whether a per-son or company operates through a dependent or inde-pendent agent will also contribute to more CLIN and tothe EC’s internal market because the impact of thelegal form of the operation on the allocation of taxjurisdiction will be reduced. The question of who is theincome-producing agent should be considered on case-by-case basis.

If the income from a contracting state cannot be attrib-uted to a single substantial income-producing eco-nomic activity in one state, the income should beattributed pro rata parte to all the relevant substantialincome-producing economic activities in the contract-ing states with which the income is functionally con-nected. A functional connection exists if the propertyconcerned is used for pursuing that economic activity,i.e. the property is managed, and its operations aredirected and controlled, from within the state con-cerned.

To (better) ensure that the income so attributed is taxedin the contracting state of the substantial income-pro-ducing economic activity, the suggested rule should besupplemented as follows. The contracting state inwhich the substantial income-producing economicactivity occurs is entitled to and will tax the incomeflowing from the other contracting state attributable tothat activity the same way the state taxes such incomein the hands of its residents (and citizens, if applica-ble).

With respect to capital taxes, a similar system shouldapply based on the economic location of the capital.

6.2. Business income: profits, dividends andcapital gains on shares

In an origin-based system, tax jurisdiction with respectto business profits is allocated to the contracting statein which a person’s enterprise carries on its substantialentrepreneurial activities. As a consequence, allincome, whether it arose in the contracting state inwhich the entrepreneurial activity is carried on, in theother contracting state or in a third state, is taxable onlyin the state of the substantial entrepreneurial activity,unless another income allocation rule of the relevanttax treaty derogates from this rule. A substantial entre-preneurial activity is present if the relevant entrepre-neurial activity in a state forms an essential and signif-icant part of the entrepreneurial activity of theenterprise as a whole.

For treaty purposes, the term “enterprise” is defined asan independent and durable organization which aims toparticipate in economic life by means of labour or acombination of labour and capital with the purpose ofmaking a profit, which profit must reasonably beexpected. This definition satisfies the freedom ofestablishment (Art. 43 of the EC Treaty). The distinc-tion between entrepreneurial activities and independ-ent personal services has been disregarded. As a rule,services or activities cannot be performed at any placeother than where the individual performing them isphysically present. The decisive point is where thatperson works, not where the results of his work areexploited.

The enterprise, as defined, must then be attributed to aperson who can invoke the tax treaty. This attributionshould be guided by the question: For whose account isthe enterprise carried on? This person is relevant onlyin the third phase. First, it must be determined whetherthere is an enterprise, and second, if so, where thatenterprise carries on its substantial entrepreneurialactivities; third, it must be determined to whom thesubstantial entrepreneurial activities should be attrib-uted. This makes a tax treaty less vulnerable to abusesince real economic activities with a sufficient nexus toa state determine the allocation of tax jurisdiction withrespect to business income; this rule applies whether ornot tangible property with a(ny) degree of permanenceis used, or whether or not a person can be considered toconclude contracts in the name of a principal, in orderto create or avoid a permanent establishment, as underthe current systems.

© 2006 IBFD


Under the principle of origin, the concepts of perma-nent establishment, fixed base and agency permanentestablishment are considered to constitute unnecessaryconditions. It is sufficient that an individual pursuessubstantial activities for an enterprise in the state con-cerned: an enterprise carries on or has carried on a sub-stantial entrepreneurial activity in the other contractingstate if that activity, carried on by individuals attributa-ble to the enterprise, in itself forms or has formed anessential and significant part of the activity of theenterprise as a whole (“a branch”). If income is attrib-utable to a branch, but is deferred and received after thebranch ceases to exist, tax jurisdiction with respect tothe deferred income is assigned to the state in whichthe branch was situated.

The activities of individuals are attributed to the enter-prise if the activities are for its account. It does notmatter whether the individuals carry on the activitiesconcerned as dependent agents or as independentagents.

If it is considered desirable to define the term “substan-tial” more precisely, this could be done by reference tothe proportionate share of the entrepreneurial activitiesin the other state, the nature of the activities performed,and the relative contributions made in each contractingstate to the entrepreneurial activities. For practical rea-sons, safe harbours could be introduced. If a minimumperiod of human activity is considered to be a desirablethreshold for practical reasons, the minimum periodsfor any item of income should be harmonized as muchas possible, unless the nature of the activity indicatesotherwise. Since a state is assigned tax jurisdictiononly if the entrepreneurial activities in that state aresubstantial, auxiliary and preparatory activities areexcluded; so far, the alternative system will, to a cer-tain extent, operate comparably to the current system.

If an enterprise of a person carries on substantial entre-preneurial activities in both contracting states, theprofits must be allocated to both states based on theamount of income produced in each state. The attribu-tion of profits to each part of the enterprise must beneutral. The legal form of that part of the enterprise, abranch or a subsidiary, should be irrelevant since thelegal form may not affect the tax consequences, or doso as little as possible. In determining whether incomeis produced in one state or the other, the arm’s lengthprinciple is decisive.

The expenses incurred for the purposes of each branchshould be attributed to the part concerned and shouldbe deductible regardless of where they were incurred.If the expenses cannot be attributed to a single part,they should be attributed pro rata parte. If, for exam-ple, a head office in one state supplies funds from theequity of the enterprise to finance substantial entrepre-neurial activities in another contracting state, eco-nomic reality implies that the activities are financedwith equity, not with debt. Labelling such funds asinternal debt does not change this economic reality.Economic reality prevents an internal flow of interestfrom a substantial entrepreneurial activity to a headoffice. Assuming that tax neutrality requires that theprofits derived in the state of investment be taxed, itwould be equally non-neutral to deduct the interestpaid or deemed paid to the parent company from the

subsidiary’s gross income and to add it to the parent’sincome if the parent supplies funds from its equity tofinance the substantial entrepreneurial activities of itssubsidiary in another contracting state. Funds bor-rowed from third parties which are channelled throughthe head office or parent should be taken into accountat the level of the branch or subsidiary. However, taxjurisdiction with respect to the interest should beassigned to the same state because the interest paid wascreated through substantial entrepreneurial activitieswithin that state. This way, it is also possible to achieveneutrality between equity and debt financing. Espe-cially where it concerns the relationship between thehead office and another substantial entrepreneurialactivity of an enterprise of the same taxpayer, the issueof internal interest will not have any, or hardly any,practical relevance. For both theoretical and practicalreasons, the author suggests that internal interest calcu-lations not be made under the alternative system iffunds are transferred only within an enterprise. If,however, goods or services are internally transferred, itmight be appropriate to take the internal interest intoaccount as part of the arm’s length conditions. Goodsand services supplied by the head office or parent com-pany to a branch or subsidiary should be treated thesame as supplies to third parties. When (in)tangiblesare transferred internally, the economic activity willchange as a rule. Therefore, an internal rent or royaltycan be justified based on economic reality, the prin-ciple of origin and the arm’s length principle.

If an enterprise carries on (substantial) entrepreneurialactivities in states with which the enterprise’s orbranch’s state does not have a bilateral tax treaty or if itcarries on non-substantial activities in third states withwhich there are origin-based treaties, the income pro-duced by such activities should be attributed to thebranches with which the non-substantial activities arefunctionally most closely connected, and consequentlyto the contracting state in which the branches operate.This alternative system is a closed system regardingbusiness profits. In this respect, it should be noted that,in an origin-based system determining the eligibletreaty subject, it is stipulated that the income attributedto substantial income-producing economic activities ina contracting state with which it is functionally con-nected could be taxed in that contracting state. Thecontracting state in which the substantial income-pro-ducing economic activity takes place may tax theincome from the other contracting state attributable tothat activity the same way as the state taxes suchincome derived by its residents (or citizens).

Based on the principle of origin, tax jurisdiction withrespect to dividends and capital gains on shares mustbe assigned to the state in which the profits were pro-duced, which is not necessarily the state in which thepaying company is resident. The allocation of tax juris-diction with respect to a company’s profits, the divi-dends paid on its shares, and the capital gains on itsshares is harmonized in order to avoid both interna-tional juridical and economic double taxation. Theshareholder’s state should refrain from taxing the com-pany’s profits, the capital gains on its shares and thedividends received by the shareholder. It should benoted, however, that the suggested allocation rules donot compel this state to apply an income exemption

© 2006 IBFD


system as a method to eliminate double taxation. Thesuggested allocation rules can also be applied under asystem based on capital-export neutrality.

If the company carries on its enterprise in its residencestate, the state of origin and the residence state coin-cide. If the enterprise also carries on substantial busi-ness activities in the other contracting state (a branch),the residence state and the state of origin do not coin-cide. In this case, a branch profits tax must play a roleto ensure that the assignment of tax jurisdiction withrespect to profits is neutral regarding the legal form inwhich the business activities are carried on, i.e. it doesnot matter whether a subsidiary pays out its profits toits shareholder or a branch transfers its profits to itshead office. The same goes for capital gains. The sys-tems are harmonized in order to avoid both interna-tional juridical and economic double taxation irrespec-tive of whether the substantial entrepreneurialactivities are carried on directly by a sole proprietor,through a branch, or through a company.

A capital tax should tax the possession, not the produc-tion, of wealth. If a state provides the legal frameworkand/or physical infrastructure to establish and preservebusiness property, the state is justified in taxing its pos-session. The economic location of immovable propertyis the situs state. With respect to movable businessproperty situated in a state, allocating to this state theright to tax the mere possession of that property is alsojustified. Tax jurisdiction with respect to the posses-sion of intangibles is allocated to the state under whoselegal system the intangible was established and will bepreserved. No special rule regarding debt is required.

6.3. Interest and capital gains on debt claims

Among other things, an origin-based system withrespect to interest and capital gains on debt claims sig-nificantly reduces the current tension between equityand debt financing and mitigates (abusive) rule shop-ping.

The debtor is considered the originator of interestincome. The state in which the debtor produces theinterest income, which is not necessarily the residencestate of the debtor, is awarded unlimited tax jurisdic-tion with respect to interest. Capital gains on debtclaims are allocated to the same state. The expensesincurred for purposes of the interest income or capitalgains are deductible.

A feasible system can be created by means of the infor-mation available in the state of origin, which will facil-itate combating tax fraud. Tax neutrality will beimproved, and this will also enhance the EC’s internalmarket.

With respect to interest received through an intermedi-ary, e.g. a bank, a further refined origin-based systemmay be developed. Unrestricted tax jurisdiction withrespect to the interest will be allocated to the state ofthe debtor of the bank. This state must take intoaccount the bank’s spread as a deductible expense. Thespread is attributed to the state in which the bankingactivities are carried on.

If neither of the two contracting states can be consid-ered the true state of origin, we rely on the presumptionthat the debtor’s contracting state from which the inter-est payment is made is the state of origin for purposesof attributing tax jurisdiction with respect to the inter-est under the tax treaty, unless it is proved otherwise.The debtor’s contracting state is the state in which thedebtor carries on his relevant income-producing eco-nomic activities or, if this state cannot be identified, thestate in which the debtor, being an eligible treaty sub-ject in an origin-based system as described in 6.1., issituated. In substance, the principle of source is thenapplied.

Regarding triangular situations, the tax treaty betweenthe bank’s state (State B) and the residence state of theinterest recipient (State R) must stipulate that State Rwill not waive its tax jurisdiction if the interest paid byan intermediary, e.g. a bank, in State B did not origi-nate in State B or in a state with which State R has a taxtreaty. Earmarking at the level of the bank of its interestearned abroad makes such a system feasible. If there isa direct connection between the funds deposited by asaver at a bank and the loans issued by that bank, theearmarking is easy to apply. If such a connection can-not be found, a pro rata parte approach may provide afeasible result. State R will waive tax jurisdiction withrespect to the interest received by a saver based on cer-tain formulas. To reduce the administrative burden onthe saver, the ratio mentioned above could beexchanged between the tax administrations of the con-tracting states in a digitized format and, if consideredappropriate, only upon the request of the saver in histax return.

Example 1 provides a simple example illustrating howan origin-based system will operate.

Example 1

loan 100 deposit 100

State O State B State R

interest 6.5 interest 6.0

State O:– allows the entrepreneur a deduction of 6.5– may tax the bank on 6.5 less 0.5 6.0

State B:– may tax the bank on 6.5 less 6.0 0.5

State R:– (CLIN) may tax the saver on 6.0 less 6.0 0.0– (CLEN) may tax the saver on 6.0

State R tax minus State O tax = final State R tax.

State R does not waive tax jurisdiction if the interest paid bythe bank did not originate in State B or in a treaty partner ofState R.

6.4. Royalties and capital gains on underlyingintangible property

In an origin-based system, the state in which the intan-gible property was produced, not the state in which it isused, is entitled to tax the income from it (lump-sum or

© 2006 IBFD


periodical payment). Royalties are subdivided intofour parts:(1) compensation for write-offs on the original market

value of the intangible property concerned;(2) compensation for maintaining the intangible prop-

erty;(3) compensation for bearing the risks; and(4) an interest component.

The first three components are attributed to the state inwhich the lessor performs his activities, which is prob-ably the place of his entrepreneurial activities. Consis-tent with an origin-based system with respect to interest as discussed above (see 6.3.), the interest component is attributed to the state in which the lesseeperforms his activities, i.e. the state in which the intan-gible property is used.

To the extent that separating the interest component ina particular case is considered burdensome, a fixed part(percentage) of the royalty could be classified as inter-est.

The expenses incurred for purposes of each of the roy-alty components are attributed to the component con-cerned and should be deductible. If the expenses can-not be attributed to a single component, they areattributed pro rate parte.

By changing tax treaties and the model conventions asproposed, the author thinks that a conflict of incomeclassification (royalty or business/personal servicesincome) which may arise under the UN Model will beresolved.

Regarding capital gains on copyrights, patents, trade-marks, etc., the same rules apply in an origin-basedsystem as apply to royalties, although the interest com-ponent may be considered not to constitute part of thegain concerned.

Due to the nature of intangible property, e.g. debtclaims and patents, the possession of intangible prop-erty is related to the legal system under which the prop-erty was established and will be preserved rather thanto the place where e.g. the loan agreement or the patentis physically present. Tax jurisdiction with respect tothe possession of intangible property (capital tax) isallocated to the state under whose legal system theproperty was established and will be preserved.

6.5. Pensions

In substance, a pension payment consists of two com-ponents: (a) the contribution to the pension plan and(b) the growth of the contribution due to the pensionfund’s investment of the money in e.g. real estate,shares and loans (the “accretions”).

The origin of the first component is the employmentactivity. The state in and from which the employmentactivity was usually or substantially exercised is enti-tled to tax this part of the pension payment. This com-ponent is simply deferred salary. One of the advantagesis that the risk of double taxation or non-taxation asunder the current treaty system due to the disparity inthe tax systems regarding the deduction of pensioncontributions and the taxation of pension paymentswill be eliminated or at least reduced. Such a system is

considered feasible because the pension fund shouldbe able to trace the states in and from which the retiredperson concerned usually or substantially exercised hisemployment activity to which his pension contribu-tions relate. If, however, the number of states involvedis considered an impediment for the operation of sucha system, the number can be reduced by attributing taxjurisdiction only to the states in and from which theretired person usually exercised his employment activ-ity. If the number of states involved is still consideredtoo many, the number could be further reduced byattributing tax jurisdiction only to the most substantialstates in and from which the retired person usuallyexercised his employment activity, not exceeding a cer-tain number states (e.g. five). This number will alwaysbe arbitrary.

The tax jurisdiction with respect to the second compo-nent of the pension payment (the accretions) shouldnot be allocated either to the state where the employ-ment was exercised or to the residence state of the pen-sion fund. The tax jurisdiction with respect to theincome from e.g. real estate, shares, loans, etc., derivedby the pension fund was already attributed to therespective states of origin under the tax treaties con-cerned. These states should take into account part ofthe pension fund’s fee as a deductible expense sincethe pension fund in substance connects the markets ofcapital suppliers and capital demanders.

The origin-based system developed for pensions notonly guarantees better tax neutrality, especially CLIN,but also improves the functioning of the EC’s internalmarket regarding the different national tax systems. Itis also consistent with the subsidiarity principle.

Example 2 is a simple example illustrating how the ori-gin-based system will operate.

6.6. Personal circumstances

Personal allowances, reliefs and reductions must betaken into account in the state of origin of the active orpassive income, if necessary, pro rata parte if morethan one state of origin is involved in order to preventtheir utilization twice (or more). This way, the facultyprinciple will be satisfied on a structural basis as wellas the principles of sovereignty and subsidiarity, CLINand the fundamental freedoms of the EC Treaty. Anorigin-based allocation of personal allowances, reliefsand deductions is essential under both the exemptionmethod and a tax credit system.

An origin-based system is not only justified or equi-table, neutral and consistent with the EC’s internalmarket, but it can also be implemented feasibly. A per-son who wants to use his personal circumstances fortax purposes may be asked to provide the necessaryinformation and to cooperate in this respect. In order toconsider those circumstances, a state may require thatthe necessary information be provided with the taxreturn. New technologies, such as the Internet andintranets, make it possible for tax administrations toexchange the necessary information more easily thanpreviously. The exchange of information could bemade dependent on the person’s consent, e.g. bychecking a box on the tax return. If such consent is notgiven, no personal allowances, reliefs or reductions

© 2006 IBFD


need to be granted. This way, the loss of tax revenuecan be prevented. With respect to taking into accounte.g. personal circumstances regarding interest receivedthrough an intermediary, information could beobtained consistently with the system developed inorder to determine the relief for double taxation in theresidence state (see 6.3.).

If the origin-based system is considered too compli-cated with respect to income received via intermedi-aries, e.g. dividends via investment companies andinterest via banks, alternative approaches can be con-templated. A possible solution is for the investor’s resi-dence state to take into account his personal circum-stances, even if the dividends and interest are exemptfrom tax in that state, and for the state of origin to com-pensate the residence state for the loss of tax revenueconcerning the personal allowances, reliefs and reduc-tions attributable to the income received via intermedi-aries which originated in the state of origin. This way,the administrative burden on the investor may bereduced significantly, and the principle of origin maybe satisfied at the highest possible level. If this systemis also considered too complicated or undesirable, theauthor’s suggestion is to apply a system in which theresidence state takes into account the personal circum-stances attributable to income received via intermedi-aries without restriction and without a clearing mecha-nism.

7. SUMMARY AND CONCLUSIONS

The principle of source is commonly used by tax legis-latures, judges and scholars. The term “source”, how-ever, is not always clearly defined and is used in vari-ous meanings.

In globalizing economies, the concept of “source”should be interpreted based on the principle of origin.Taxation based on this principle justifies a state taxingthe income created within that state, i.e. the cause ofthe income is within the territory of that state. Thatstate makes it possible to derive income or acquire

wealth. Only individuals, not things, can createincome. The intellectual element is the key componentin producing income. Value may be added to things bythe actions of an individual, whether or not he uses adevice. The place of origin of an individual’s income iswhere his income-producing economic activity takesplace. If the income is produced to a substantial extentthrough the activities of an independent person (i.e. heis the person who adds the intellectual element) and thebenefits from the activities are passed on to anotherperson (i.e. the income recipient), the income origi-nates with the independent person (i.e. the originator),not with the recipient. Only substantial income-pro-ducing economic activities should be taken intoaccount. An income-producing economic activity issubstantial if it forms an essential and significant partof the economic activity as a whole.

In the context of a capital tax, “origin” might not be themost appropriate term because a capital tax is justifiedby the possession, not production, of wealth. In thisrespect, the term “economic location” is preferred. If astate provides the legal framework and/or physicalinfrastructure for establishing and preserving property,the state is justified in taxing the possession of thatproperty.

From the perspective of an optimal allocation of theproduction factors, investments should be made whereproduction is the cheapest, and the production shouldbe done by the person who can do so most cheaply. Inglobalizing economies, CLIN fosters efficiency; aCLEN-based system does not. Business competes withbusiness, not owners with owners. The real trade-off iswhether the activity will be carried on by a foreign-based firm or a domestic-based firm. CLIN supports anorigin-based interpretation of the term “source”.

EC law contains conflicting trends regarding source-based taxation. If an actual common market has notbeen established and 25 different income tax systemsapply, CLIN, source-based income taxation and an ori-gin-based interpretation of source best satisfy theobjectives and goals of the EC Treaty. The ECJ’s caselaw supports such an interpretation, or at least it does

© 2006 IBFD


Example 2

Residence state Employment state Pension fund state State of originRetired employeeInterest

contribution 1,000 loan 1,000

Retired Pension fund Debtoremployee

pension benefit 1,090 fee 10 interest 100contribution component 1,000 repayment 1,000accretions 90

Allocations to:Residence state: object exemption and pension benefitEmployment state: contribution component (1,000) and object exemption accretionsPension fund state: fee (10), object exemption and net interestState of origin: 90, i.e. interest (100) less fee (10)

not preclude it. On the other hand, the income taxdirectives generally favour residence-based taxation.In any case, the EC Treaty and the ECJ’s case law donot determine the concept of source.

The current residence-based system of tax treaties hasnecessitated source-based corrective actions, such asintroducing limitation on benefits provisions, allocat-ing capital gains on shares in real estate companies tothe situs state, and allowing the state in which a perma-nent establishment is situated to levy a branch profitstax. The treaty system is moving slowly towardssource-based taxation. The most obvious reason fornot acting quickly in this direction appears to be thelack of political will, but the pace of globalizationworldwide may force politicians to give up (possibly)out-of-date tax policies more quickly than they other-wise would. Economics may be the inevitable drivingforce for more origin-based income taxation.

This article has presented some key elements of analternative origin-based tax system which may be help-ful in developing source rules for the 21st century. Therules of the current tax treaties need to be adjusted; inaddition, the EC income tax directives should beamended. Domestic tax systems, however, need notnecessarily to be changed.

In conclusion, an origin-based interpretation of“source” should prevail in tax treaties and the ECincome tax directives because it is justified and feasi-ble, it improves the efficiency of globalizingeconomies and the EC’s internal market, it enablesdeveloping states to reduce the gap in economic devel-opment with developed states, and it improves world-wide prosperity.

© 2006 IBFD


BOOK

Latin American Tax HandbookPart of the Global Tax Series this annual publication provides detailedsummaries of the tax systems of 17 Latin American countries

Contents per country:

Taxation of companies• Corporate income tax• Groups of companies• Other taxes on income• Taxes on payroll• Taxes on capital• International aspects• Anti-avoidance• VAT• Miscellaneous indirect taxes

Taxation of individuals• Income tax• Other taxes on income• Social security contributions• Taxes on capital• Inheritance and gift taxes• International aspects

Countries covered:Argentina; Bolivia; Brazil; Chile; Colombia; CostaRica; Dominican Republic; Ecuador; Guatemala;Honduras; Mexico; Nicaragua; Panama;Paraguay; Peru; Uruguay; Venezuela.

Format: A4 Book; 270 pagesISBN: 978-90-8722-000-6Single Copy Price: EUR 145 / USD 180Annual Subscription: EUR 115 / USD 145Published: October 2006

To view detailed contents, read a chapter or ordervisit www.ibfd.org. Alternatively contact ourCustomer Service department via [email protected] or+31-20-554 0176.

IBFD, Your Portal to Cross-Border Tax Expertise030LATH/A01/H

Documents

Source of Income in Globalizing Economies: Overview of the ... · Moris, “Limitation of the national power of taxation by the fundamental freedoms and non-discrimination clauses