Source-Based and Residence-Based Taxation

Source-based taxation gives the country where income arises the right to tax it, while residence-based taxation gives that right to the country where the taxpayer is resident. For capital gains, these principles connect the gain either to the location or economic connection of the asset sold, or to the seller's tax residence. Both connections can exist simultaneously, so taxing rights need not belong exclusively to one country.

How the two principles apply to capital gains

A capital gain arises when an asset is transferred for more than its relevant tax cost, subject to applicable tax rules. The two principles identify different connections between that gain and a taxing jurisdiction.

• Under the source principle, a country may tax a non-resident's gain because the asset or underlying economic interest is located within its jurisdiction. Gains from selling immovable property are a clear example.
• Under the residence principle, a country generally taxes its residents on worldwide income, including gains from assets abroad, subject to its domestic rules and treaty obligations.
• Tax residence is determined under applicable tax rules; it is not necessarily the same as citizenship or nationality.

How tax treaties allocate the rights

Domestic law establishes a country's tax claim, while a Double Taxation Avoidance Agreement (DTAA) can restrict that claim. Treaty allocation varies by asset category and by the wording of the particular agreement.

• Gains from immovable property may generally be taxed in the country where the property is situated.
• Gains on assets belonging to a permanent establishment may generally be taxed in the country where that establishment is situated.
• For shares and other assets, allocation varies across treaties. Some preserve source-country taxation for specified share gains, while others reserve particular gains to the seller's residence country.
• A treaty saying that a gain 'may be taxed' in the source country does not necessarily exclude residence-country taxation; wording such as 'taxable only' grants an exclusive treaty taxing right.

Overlapping claims and double-taxation relief

Suppose a resident of Country A sells land in Country B. Country B may tax the gain as the source country, while Country A may include it under residence-based taxation.

• Under the exemption method, the residence country exempts the foreign gain in accordance with the applicable relief provisions.
• Under the foreign tax credit method, the residence country allows credit for source-country tax, generally limited to its own tax attributable to that income.