Global Taxation: Key Systems and Modern Tax Rules

Global taxation is a network of domestic laws and international agreements governing how income is taxed when it crosses borders. Because each country sets its own tax laws, rules can overlap when a transaction involves multiple nations, creating the potential for double taxation. The international tax system aims to provide a framework to resolve these issues, ensuring income is not taxed multiple times or escaping taxation altogether.

The structure of these rules directly impacts where companies choose to invest and report profits. This framework is evolving to address the digital economy, where companies can earn revenue in a country without a significant physical presence, challenging traditional tax rules. As a result, international standards are continuously adapting to new business models and preventing corporations from exploiting gaps between different countries’ tax systems.

Fundamental Systems of International Taxation

A country’s authority to tax income is based on two principles: residence and source. The residence principle allows a country to tax its residents on their worldwide income, while the source principle gives a country the right to tax income generated within its borders. Based on these principles, countries adopt one of two primary taxation systems.

The first is residence-based taxation, or a “worldwide” system, where a country taxes the entire global income of its residents. For instance, a corporation in such a country is taxed on profits earned at home and from its foreign operations.

The alternative is a source-based taxation system, known as a “territorial” system. This model is geographically confined, as a country using this system only taxes income generated from sources within its own territory. For example, if a French company owned a subsidiary in Brazil, the profits from the Brazilian operation would not be taxed by France.

A worldwide system ensures all residents contribute based on their total income, while a territorial system can make a country’s corporations more competitive abroad. This is because their foreign profits are not subject to an additional layer of home-country tax. The choice between these systems shapes a nation’s economic relationship with the world.

Mechanisms for Preventing Double Taxation

The overlap of worldwide and territorial tax systems creates double taxation, where the same income is taxed by two different countries. To prevent this, countries use bilateral tax treaties, which are agreements that coordinate tax rules and allocate taxing rights. Treaties establish rules for different types of income, designating which country has the primary right to tax. For example, a treaty might state that business profits are only taxable in the source country if the company has a “permanent establishment,” like an office or factory, there.

The primary method for relief is the foreign tax credit, used by countries with a worldwide tax system. It allows a taxpayer to reduce their domestic tax liability by the amount of income taxes already paid to a foreign government. For instance, if a U.S. company earns $1,000 abroad, pays $200 in foreign tax, and its U.S. tax on that income is $210, it can claim a $200 credit, owing only a $10 residual tax to the U.S.

Another approach is the exemption method, favored by countries with territorial systems. Under this method, the residence country excludes foreign-source income from its domestic tax base. This method is simpler to administer than the foreign tax credit but can incentivize investment in low-tax jurisdictions.

Key Issues in Corporate International Taxation

The taxation of multinational enterprises (MNEs) presents challenges centered on how profits are allocated among the countries where they operate. A central issue is transfer pricing, which refers to the prices charged for goods and services transferred between related entities within the same MNE. The price of these internal transactions directly affects how much profit is reported, and thus taxed, in each location.

This creates a potential for profit shifting, where MNEs manipulate internal prices to minimize their global tax burden. By setting an artificially high price for a component sold from a low-tax jurisdiction, an MNE can shift profits out of a high-tax country. Regulations require these prices to be at “arm’s length”—meaning what unrelated parties would charge.

To combat such strategies, many countries have implemented Controlled Foreign Corporation (CFC) rules. These domestic laws prevent MNEs from deferring home-country tax on profits held in foreign subsidiaries in low-tax jurisdictions. CFC rules allow the home country to tax the profits of these foreign subsidiaries as if they had been paid to the parent company, even if the cash remains offshore.

The effectiveness of profit shifting is linked to tax havens: jurisdictions with very low or zero corporate tax rates and a lack of transparency. MNEs can establish subsidiaries in these locations to hold assets or receive shifted profits. The use of tax havens has been a primary driver for recent global tax reform efforts.

The OECD/G20 Global Tax Framework

In response to corporate tax avoidance, the Organisation for Economic Co-operation and Development (OECD) and G20 nations initiated the Base Erosion and Profit Shifting (BEPS) project. This effort addressed strategies that exploit gaps in tax rules to artificially shift profits to low or no-tax locations, resulting in recommended actions for governments.

Building on BEPS, the international community developed a two-pillar solution for the digital economy. Pillar One focuses on re-allocating a portion of the profits of the largest MNEs to the market jurisdictions where their customers are located. This addresses situations where digital companies earn revenue from a country without a physical presence, but its implementation requires a multilateral treaty that is not yet finalized.

In contrast, Pillar Two is being implemented by many countries and introduces a global minimum corporate tax of 15% for MNEs with annual revenue exceeding €750 million. The goal is to put a floor on tax competition and ensure large MNEs pay a minimum level of tax. If an MNE’s profits in a jurisdiction are taxed below the 15% rate, other countries can apply a “top-up tax” to collect the difference.

This is achieved through the Income Inclusion Rule (IIR), applied by the MNE’s home country, and the Undertaxed Profits Rule (UTPR) which serves as a backstop. This framework targets the incentives for MNEs to shift profits to tax havens and is intended to end the “race to the bottom” on corporate tax rates.