Newsletter
SEPARATE TAXATION AT SOURCE: AN APPROPRIATE WAY TO TAX NEW FINANCIAL PRODUCTS?
In recent years, many commentators have sug-gested that in order to provide tax incentives to promote the development of the overall economy, or of specific industries, the government should tax certain forms of income separately from other income, with income tax being withheld at source at reduced tax rates, in place of the usual post-hoc system of consolidated tax assessment based on a final tax return.
Accordingly, some statutes have provided for such separate withholding tax for various new financial products at rates well below the maxi-mum tax rates of 40% for consolidated individ-ual income and 25% for business income. Ex-amples include: income tax on share dividends payable to beneficiaries of a shares trust, where the beneficiaries are unspecified or do not yet exist; income from the assets of a spe-cial-purpose trust, which is separately taxed at source at the time of actual distribution; and in-dividuals' interest income from the conditional sale of beneficiary certificates from real estate securitization or financial asset securitization, or from the amount by which the value of bonds at maturity exceeds their original purchase price.
However, while it is true that taxing income at source has the advantages of lower tax collection costs and of providing a more stable fiscal revenue stream, there is also a general concern that the considerations of fairness should not be ignored.
Under the Income Tax Act, the categories of income subject to withholding tax at source are all ones on which tax cannot be reliably collected on the basis of post-hoc filing of a tax return. Accordingly, the exceptions to post-hoc filing are mostly justified by specific reasons, which can be broadly categorized as follows:
‧Income that would be beyond the reach of the tax authorities if tax were not withheld at source, such as income of an enterprise with no fixed place of business or business agent in Taiwan.
‧Income for which the attribution of costs is difficult to calculate, such as income from the provision of technical services to a Taiwanese firm by an overseas entity.
‧Income for which post-hoc filing is inappro-priate or administratively impractical, such as interest income from short-term notes and bills.
‧Other considerations, such as keeping confi-dential the identity of recipients of awards for reporting criminal activities, or preventing sales of government-sponsored lottery tickets being impacted by the application of progres-sive tax rates.
These exceptions indicate the principle that separate taxation at source should not be widely applied to all types of income. The rationale is that taxation on income should be based on abil-ity to pay, i.e., that tax should be levied only if there is income, and that the higher the income, the more tax should be payable. Thus under the post-hoc filing system, an income recipient de-clares its total income over a specific period, and after deduction of necessary expenditures, the net income (if positive) is subject to taxation at progressive tax rates; but if there is no positive income, or the income recipient has incurred a net loss, no tax liability arises. By contrast, un-der a system of separate taxation at source, tax is withheld from gross income, and expenditures cannot be deducted. Thus even if an enterprise has net losses in a particular year, tax will still be withheld from its revenues, with the result that it is burdened with income tax despite having no income.
Moreover, in the case of individual taxpayers, fixed withholding rates mean that a single tax rate is applied to individuals who on the basis of their total income would fall into different tax brackets, thus creating a so-called "vertical in-equity" in taxation. This not only vitiates the effect of income redistribution, but also causes capital to be excessively directed toward sepa-rately taxed products, thus distorting the alloca-tion of resources. Conversely, individuals falling within the same tax bracket may be subject to different actual tax burdens depending on whether or not they have invested in products that are separately taxed; this is termed a "hori-zontal inequity" in taxation. Even if the tax withholding rate is as low as 10%, investors who fall within the 6% tax bracket on their consoli-dated income will have to pay an extra 4% of income tax.
Furthermore, if separate taxation at source were to be applied to all of an income recipient's in-come, this would negate the effect of the post-hoc filing system, whereby an income re-cipient's losses on individual transactions can be used to reduce overall tax liability. Therefore, a more reasonable system is one whereby an in-come recipient files a final tax return for all of its ROC-source income for an entire tax year, and is allowed to deduct costs in order to reflect its true profit and loss status, and tax amounts already withheld at source can be offset against its tax liability for the year.
For example, if a foreign enterprise that has no fixed place of business and no business agent in Taiwan has income from an ROC source, tax on such income should normally be withheld at source. However, if the country under whose tax jurisdiction the enterprise falls has signed a double taxation agreement (DTA) with Taiwan, then the Taiwanese tax authorities can obtain information on the enterprise's income for the year in question from the taxation agencies of the other party to the DTA, and there is no longer any reason for tax to be withheld at source on each individual transaction.
In an interpretation dated 11 January 2007, the Ministry of Finance stated that if ROC-source income received by an enterprise of a country that has a DTA with Taiwan are subject to tax withholding at the time of payment under Article 73 Paragraph 1 of the Act, and the enterprise has no fixed place of business or a business agent in Taiwan, it can apply to the MOF to switch to paying income tax by post-hoc filing, thus ena-bling it to reduce its tax liability by deducting business expenditures. To be eligible to do so, it must appoint a tax agent in Taiwan to handle the filing and payment of taxes on its behalf. The appointed tax agent must establish separate ac-counting records, and must obtain lawful receipts and related evidentiary documents and data, and must also retain documentary evidence of its transfer pricing, for inspection by the tax collec-tion authorities.
This MOF interpretation is consistent with the principle of taxation mentioned above. It thus promotes equity in taxation, and is highly bene-ficial to enterprises of countries with which Taiwan has signed a DTA. As for the many new financial products for which the mode of taxation has still not been finally decided, it is to be hoped that the MOF will carefully define the scope of application of separate taxation, to ensure that it is only applied in cases where it is not feasible to reliably collect tax on the categories of income concerned through the post-hoc filing system. This approach will ensure that separate taxation at source is applied only where there is a legiti-mate need for it, and will avoid the risk of un-dermining the fairness and internal consistency of Taiwan's income tax system.
For income tax payers, the mode of taxation ap-plied to each type of new financial product does not represent an absolute advantage or disad-vantage: although separate taxation at source can prevent the application of high progressive tax rates, the amount of tax withheld is based on gross income, so that if trading in financial products results in losses, or if necessary expen-ditures are incurred, it is not possible to offset these against the tax withheld, and the overall tax burden will not necessarily be lower.
Conversely, under the post-hoc filing system tax is assessed on net income, so that the tax base is smaller; there is also the opportunity to take ad-vantage of other concessions and incentives un-der Taiwan's tax system, such as offsetting losses carried over from previous years, or offsetting investments, and the situation does not arise of a taxpayer that has incurred a net loss still being liable for income tax.
Therefore, when constructing the taxation sys-tem for financial products the MOF and legisla-tors should make a comprehensive and careful consideration, and should not base their conclu-sions merely on data from specific tax years. Otherwise, although low tax rates on particular products may create commercial opportunities for their issuers, they may also give rise to an excessive income tax burden.