Determining which tax would have been payable

Generally, the objective is to determine source county tax payable in the hypothetical ab-sence of the qualifying tax incentive measures.²²⁹ First it has to be established which me-thod is to be deployed for computing the hypothetical tax payable. Second, it has to be de-termined which specific factors are to be included in the computation.

9.2.2.1 Hypothetical tax liability in the State of source

Generally, the ordinary tax is constituted by the specific tax that would be paid in the State of source in the absence of the relevant tax concessions, by the specific taxpayer, in the specific tax period. Seemingly, this is the general method of computing the credit based on the tax foregone. For example, it is adopted in the UK and Ghana provision cited above

228 Vogel (1997) p. 1256-1257.

229 Vogel (1997) p. 1256 and Viherkenttä (1991) p. 148.

and, for the sake of a different example, article 24(2)(d) of the Denmark and Thailand trea-ty of 1998, which prescribes that a

“(…) deduction from Danish tax for Thai tax shall be allowed as if no such exemp-tion or reducexemp-tion had been granted, (…)”

Although the wording is different from the wording in the UK and Ghana provision, the substance is generally the same in respect to the computation. As it is the hypothetical tax payable under domestic law of the State of source, in the specific case, that has to be com-puted, it is difficult to generalize how the computation is carried out. This fully relies on the tax system and the applicable provisions of the State of source.

Modifications from this general approach could occur. For example, specific provisions of domestic law could be specifically excluded when computing the ordinary host country tax or it could be stipulated that time limited tax measures are not included when computing the hypothetical tax payable. The latter case will be discussed in the following section.

9.2.2.2 Treatment of ineligible tax incentive measures

It is clear that a credit for notional is not provided for tax incentive measures not covered by the tax sparing provision. A different question relating to ineligible tax incentives is whether they are included when computing the tax that would have been payable, i.e. the ordinary tax. In the affirmative case, such tax incentive measures would effectively reduce the credit for notional tax compared to what the case would be in their absence. Thus, the host State would basically reduce the effect of its qualifying tax concessions. If ineligible tax incentives are not included, the credit for notional tax is based on the “actual” ordinary level of tax and the eligible measures are consequently unaffected.

Generally, tax sparing provisions seemingly do not directly deal with this issue. For in-stance, article 23(4) of the Australia and Vietnam treaty of 1992, taking into account the amendment of 1996, prescribes that the basis for computing the ordinary tax includes

“(…), the total amount which under the law of Vietnam relating to Vietnamese tax and in accordance with this Agreement, would have been payable as Vietnamese tax on income (…)”

As tax incentive measures are clearly of a legal nature and relate to tax, the concessions that do not qualify for tax sparing are included in the computation of the total amount that would have been payable, thus reducing the credit for notional tax.

On the other hand, the UK and Ghana provision cited above computes the notional tax on basis of “any amount which would have been payable as Ghana tax for any year”. The phrase “for any year”, implies that time limited tax measures are not included. Many tax incentive measures are time limited and will thus not be included. However, generally, oth-er tax incentive measures are not excluded. For example, investment tax credits and in-vestment allowances may be of a permanent character and could thus reduce the credit for notional tax.

To prevent this effect, the developing country could repeal tax incentive measures that do not qualify and thereby increase the credit. However, this may be an inexpedient solution, especially if the developing country has several tax treaties that provide tax sparing and the provisions cover different tax incentive measures or stipulate different general conditions for tax sparing.

The basic objective of tax sparing is to ensure that tax concessions granted by developing countries accrue to the investor and not the revenue of the State of residence. It could be argued that including ineligible tax incentive measures when computing the hypothetical tax is contrary to this objective, as it effectively entails that the investor accrue a reduced benefit because of the ineligible tax concession, consequently benefiting the State of resi-dence.

A major practical issue of excluding ineligible tax incentive measures when computing the ordinary tax is that a distinction has to be made between “tax incentives” and other tax measures. First a criterion has to be established, and then it has to be assessed continuously each tax period whether the applicable domestic tax laws, which constitute the tax liability of the investor, are tax incentives or not.

Whether it is appropriate to draft the provision so that ineligible tax incentive measures are excluded from the computation of ordinary tax very much depends on the specific condi-tions of the developing country, such as the overall tax incentive regime and which of the incentives are available to the investors. Moreover, it is also relevant whether the investor may waive tax incentive benefits that the home State does not want the tax sparing provi-sion to cover, so that the ineligible incentives do not constitute a part of the ordinary tax liability.