What is the difference between Residence Based Taxation and Source Based Taxation?

Globalization has increased interaction among nations through trade, investment and movement of people. Companies and individuals move to other countries and create income. Here, there is a vital question, in which country he/it has to give taxes?

When a company or individual from country A gets income in country B, which country has the right to tax such income is an area of controversy. Economic borders may have eroded due to globalization, but tax power of countries remains the same. Similarly, every country would like to tax an income if it is related with that country.

Here, there are two principles to guide taxation. The first is called residence based taxation and the second one-source based taxation.

What is residence based taxation?

Resident based taxation instructs that, the country can tax persons if they are residents or domiciled in the country, regardless of the source of income. In the case companies, the place of incorporation or registration of the entity or the place where its place of effective management is located is its place of residence.

In the case of income tax, individuals/companies have to pay taxes for their global income. Therefore, the principle of residence-based taxation of income envisages the taxation of global income.

It is not citizenship; rather it is residential stay that determines the tax jurisdiction of an individual. In India, residence of an individual depends upon his number of days of physical stay. The simple rule is that if a person has resided in India for 182 days or more during the last year, he was a resident of India during the last year. Hence, he has to pay taxes in India. There is one more criteria for determining the residence of an individual which you can refer from other sources.

For company, it is a resident of India, if:

  1. It is an Indian company (registered in India) or
  2. Its Place of Effective Management (POEM) is in India

Such companies have to pay tax in India for the income they have obtained in India and the income they have got from other countries as well.

What is Source Based Taxation

In the case of source based taxation principle, importance is to the source (country) where income is generated. There are individuals/entities whose “residence” is in one country but their business is actually carried on in another country and their income is earned in the latter country. In such cases, the principle of residence-based taxation would be inappropriate. Therefore, there is a view that the country which provides the opportunity and facilities to generate income or profits (COS) should also have the right to tax the same.

India is following basically residence based taxation. Still foreign companies are taxed in accordance with source taxation and domestic companies are taxed on residence principle. Double taxation avoidance agreements signed with other countries decisively ensures that an income is not taxed twice.

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