Get to Know to Connecting Factors on International Tax

Oleh: Erikson Wijaya, Directorate General of Taxes officer

We are about to discuss the connecting factor. It is what causes tax to take place among international businesses and transactions. Tax on international business emerges due to the interests of each nation to secure its revenue. The problem is the fact that sometimes, either countries or jurisdictions have their tax policy. It leads to disputes since different countries could tax one income from the same transaction twice. To respond to this, countries and jurisdictions conducted international tax regulation. Countries usually design their tax rules so that profits are taxed once, rather than multiple times by multiple jurisdictions  since it is expected to mitigate double taxation on income from international business. One principle upheld in international tax is that the right to tax will be given to a country as long as connecting factors exist. This results in a clause that the right is irrelevant if they are not present within the transactions.

In their article, Darussalam and Danny (2017) declared two common connecting factors implanted in countries' tax policies when ruling international aspects within their tax regulation. The first is the Personal Connecting Factor, and the other is the Objective Connecting Factor. By deploying one or two factors, international tax regulation could accommodate fair treatment for domestic taxpayers who earned income abroad and foreign taxpayers gaining income from one's territory. The connecting factors identification is not a risk-free option. If it is not well managed, it can also trigger disputes among transacting countries. They considered themselves eligible to tax the income raised from the business. In this situation, international tax policy will create guidelines referring to some existing models, including either the OECD Model or the UN Model.

Connecting factor number one is the Personal Connecting Factor (PCF). It retaliates one country’s right to tax based on the relationship between the taxpayers and the country. This is valid for both personal taxpayers and corporate taxpayers. This factor makes residential issues important for personal taxpayers and personal attachments for corporate taxpayers. PCF promotes substantial tests, including duration of stay (Substantial Presence Test), in a country to see taxpayers’ citizenship. Indonesia defines a personal taxpayer as a nonresident if the stay is less than 183 days within 12 months. Meanwhile, generally, a corporation is treated as domestic if it is created or organized under the laws of Indonesia, any Region, or the Ministry. No other criteria related to the place of management will cause a corporation to be domestic.

Once a taxpayer does not satisfy those criteria, the tax system will treat them as a foreign taxpayer. It brings consequences from the tax tariff to the reporting procedures. International tax procedures will work, and it is where technical guidance is needed. It means any income earned by the foreign taxpayer will be subject to tax by the country where it is made and maintained and by the one on which the taxpayers come from. The first approach is the Objective Connecting Factor (OCF), which connects the right to tax to income as the object of economic activity within the country or jurisdiction. Specifically, economic activity includes a place of asset where service is provided and given, the contract is signed, the payor or project giver resides, or where all the cost is burdened. This concept is considered as a source or objective attachment.

Countries adopting worldwide income believe they are eligible to tax any income earned from any source; it aligns with what the PCF instructs. However, under OCF, tax can only be applied to any income gained in one country (territoriality principle). Regardless of any connecting factors to be involved, disputes are unavoidable. Taxpayers may file objections or protests for any possibility of double taxation on the same income. It triggers the OECD and the UN to establish a treaty between the transacting countries. The Tax Treaty is an integral part of international tax. Under the treaty, a fair share, equal treatment, and efficiency are expected to be present. Further discussion about substantial aspects of the tax treaty will be provided in another article.

*) This article represents the author's personal views and does not represent the stance of the institution. 

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