International double taxation issues arise because of overlaps in taxation concepts of the different taxing jurisdictions concerned. Some jurisdictions will tax income or gains because the source of the income or gain e.g. land, is located in that jurisdiction, while another jurisdiction may seek to tax the same income or gain because the owner of the income or gain is tax resident in that jurisdiction. Double taxation occurs where the same income or gain becomes taxable in more than one jurisdiction.
The two main forms in which double taxation arises are as follows:
· Juridical Double Taxation – this occurs where jurisdictions levy taxes not only on domestic assets and domestic economic transaction, but also on capital situated and transactions carried out in other countries. The foreign income or foreign capital of a resident is commonly taxed on a residence basis.
· Economic Double Taxation – this arises where an item of income or capital is taxed in two or more states in the same tax period, but that income or capital is in the hands of different taxpayers.
Double taxation relief is concerned with the processes by which countries recognise these multiples tax claims. Double taxation agreements (DTA) operate to relieve double taxation.
The OECD Model Tax Treaty
The Organisation for Economic Co-Operation and Development (“OECD”) provides a setting in which governments can co-ordinate domestic and international policies. For example, collaborations at the OECD regarding taxation has led to the growth of a global web of tax treaties.
In 1963 the OECD introduced the text of a draft Double Taxation Convention on Income and Capital, with the intention of giving a general example of a bilateral treaty from which two countries can base their agreement. Each article of the OECD Model Convention contains a commentary to expand upon and explain its intention. OECD member states can enter reservations (i.e. what they will not follow) and observations (i.e. interpretations that they do not agree with) on the provisions of the Model Tax Convention and these are recorded in the commentary.
Variations of this Model Convention have subsequently been adopted and it is under constant review to ensure that it is in line with member country views on the principles for the relief of double taxation.
These principles have reasonably wide international acceptance, however it is important to note that not every country is a member of the OECD and some countries may seek to adopt the model convention for the United Nations.
The format of the Model Convention is as follows. This may serve as a useful reference when examining DTA’s based on the Model Convention:
CHAPTER I Scope of the Convention Art. 1 Persons Covered Art. 2 Taxes covered CHAPTER II Definitions Art. 3 General definitions Art. 4 Resident Art. 5 Permanent establishment CHAPTER III Taxation of income Art. 6 Income from immovable property Art. 7 Business profits Art. 8 Shipping, inland waterways transport and air transport Art. 9 Associated enterprises Art. 10 Dividends Art. 11 Interest Art. 12 Royalties Art. 13 Capital gains Art. 14 [Deleted] Art. 15 Income from employment Art. 16 Directors' fees Art. 17 Artistes and sportsmen Art. 18 Pensions Art. 19 Government Service Art. 20 Students Art. 21 Other income CHAPTER IV Taxation of capital Art. 22 Capital CHAPTER V Methods for elimination of double taxation Art. 23 A Exemption method Art. 23 B Credit method CHAPTER VI Special provisions Art. 24 Non-discrimination Art. 25 Mutual agreement procedure Art. 26 Exchange of information Art. 27 Assistance in the collection of taxes Art. 28 Members of diplomatic missions and consular posts Art. 29 Territorial extension CHAPTER VII Final provisions Art. 30 Entry into force Art. 31 Termination
Double Taxation Relief
Double taxation relief can take a number of different forms. Double taxation relief can be provided for under the terms of a Double Tax Agreement (DTA), which can:
· Allocate taxing rights between the countries. For example, a treaty may stipulate that interest income arising in one country is taxable only in the country of the recipient.
· Limit taxation rights in the source country, for example to 10%.
· Allow a credit incurred in the source country against the tax liability in the country of residence. In this way, the taxpayer pays only a net taxation liability which limits any double taxation.
· Provide that income that has been taxed in the source country is exempt from taxation in the residence country. Countries using the exemption method for some income sources include France, Germany, Italy and the Netherlands.
Double taxation relief can additionally be provided for in domestic law of the country of residence or source. This is known as unilateral relief and can take the form of:
· An allocation of taxing rights to the other country;
· Permitting credit relief for foreign tax; or
· Exempting income that has already been taxed in the other country.
Double taxation relief is also provided for in EU Directives, such as the Parent-Subsidiary Directive and the Savings Directive, which allocate taxing rights between EU Member States and provide rules for eliminating or mitigating double taxation.
The foreign taxes for which foreign tax relief can be claimed are limited to taxes charged on income or capital gains that correspond to domestic corporation tax or capital taxes, but include withholding payable on dividends and underlying taxes paid on profits by the paying company (this can include federal or national taxes and other state, city canton or provincial taxes).
Double Taxation Relief Methods
There are three methods of relief to ensure an individual or company does not suffer double tax:
1. by deduction
2. by exemption
3. as a credit
It is important to always refer to the relevant DTA to assess what method applies to a source of income or gain.
This method provides for the deduction of foreign tax against the income taxable in the country of residence. It could be considered as much less benefit to the taxpayer when compared to the other two methods and does not fully relieve the foreign tax. The overall tax rate will generally be higher where the deduction method is used.
This method exempts income that has borne tax in the other country in accordance with the terms of a DTA. The total tax payable is the tax paid in the country of residence.
To give a real-world example of this method, under article 12 of the Ireland/UK treaty interest derived and beneficially owned by a resident of a contracting state is taxable only in that state.
Provided the income does not arise from property or rights used by a branch or agency carrying on a trade in the other contracting sate, then the income is simply ignores in the computation of assessable profits in the country from which the income is derived.
The credit method is used to calculate double taxation relief in the following circumstances:
1. When a double tax treaty is in place between two countries and one country applies foreign tax on income also taxable in the other country.
2. When foreign tax applies on dividends received by a resident company and no tax treaty is in place between the resident and foreign country which applies the foreign tax. This is what is known as a unilateral relief under domestic law but follows the credit method in calculating the tax relief due in the case of dividend income.
3. When foreign tax is paid by an Irish branch of a company resident in the EU, Norway or Iceland.
4. When foreign tax arises on the income of subsidiaries of domestic companies that qualify for tax relief under the EU Parent-Subsidiary Directive.
It is worth noting that a taxpayer can opt not to claim a tax credit for foreign tax but this is unlikely to be beneficial for the taxpayer.
Basic Credit Method Computation for Corporation Tax Purposes
The computation method for calculating a credit for foreign tax is complex and depends on the type of income on which the foreign tax is applied e.g. branch profits, dividends or interest etc.
Broadly speaking, to calculate a credit for foreign tax the following steps apply:
Step 1. Establish the amount of foreign income. Follow the rules applicable under domestic tax law to establish the assessable amount of foreign income.
Step 2. Establish the amount of foreign tax paid on the foreign income.
Step 3. Compute the foreign effective rate of tax.
Step 4. Determine the Domestic effective rate.
Step 5. Gross up net foreign income at the lower of the foreign or domestic effective rate of tax.
Step 6. The amount of the credit is:
· The re-grossed amount minus the net foreign income, or
· The amount by which the next foreign income has been grossed.
Scenarios to Watch Out For
Double tax can arise on a number of income sources such as trading royalties, trading interest payments, lease payments etc., each with its own associated complexities. The relevant DTA should always be referred to when determining whether and what relief may be applicable and whether the receiving company will be entitled to claim a credit, with the Model Convention and associated commentary providing useful further guidance.
Below are some common examples based on the OECD Model Convention.
Article 10 and Dividends
Under Article 10(1) dividends may be taxed in the State where they arise.
Dividend income is considered a ‘passive’ income. When dealing with passive income, the general rule is that such income should also be taxable in the State of source as well as the State of residence. Credit relief is often available for any foreign withholding tax applied on a foreign dividend, but also for tax paid on the profits out of which the dividend has been paid.
Article 11 and interest
Under Article 11(1) interest may be taxed in the State where it arise. Interest income (that arising from financial institutions excluded) is considered a ‘passive’ income. When dealing with passive income, the general rule is that such income should also be taxable in the state of source as well as the state of residence.
Article 12 and Royalties
Under Article 12(1) royalties may be taxed in the Contracting State where “beneficially owned”.
Royalty income is considered an ‘active’ income. When dealing with “active” income, the general rule is that unless there is a PE and the income attaches to that PE, the active income should be taxable in the State of residence.
The concept of ‘beneficial ownership’ was introduced into the OECD Model Tax Convention to try to eliminate the avoidance of withholding taxes by the appointment of nominees. However, the term ‘beneficial ownership’ is not defined in the domestic laws of many jurisdictions (it is generally a common law term). Therefore, care should be taken as to what the paying jurisdiction believes ‘beneficial ownership’ to mean when dealing with intermediate holding companies.
Foreign Branch Profits
A company which operates a cross-border business through a branch or PE will generally be subject to tax domestically on the profits of the foreign branch (as resident companies are generally subject to tax on worldwide profits in the country in which they are resident). However, it is also likely that foreign tax will be applied by the jurisdiction in which the branch is trading and so double tax will arise on the same income.
DTA’s based on the Model Convention may provide that tax payable under the domestic laws of the foreign territory on profits is allowed as a credit against domestic tax, computed by reference to the same profits. Where there is no DTA in place, unilateral relief may be provided for under domestic law. Broadly, the approach for computing relief for branches in treaty and non-treaty States is the same.
It is worth noting that domestic legislation may allow additional foreign tax pooling provisions for scenarios where there a company has branches in a number of countries and, in some countries, the foreign tax exceeds the domestic tax on the branch in question. It may be the case that the amount of foreign tax on each branch that has not qualified for credit relief can be pooled as a credit against the aggregate domestic tax payable on foreign branches.
If you have any questions on double tax, feel free to reach out or start a discussion on it in our tax forum.