How Tax Treaties Allow Benefits from Double Taxation
Double tax treaties provide for relieving double taxation; sometimes double taxation relief is extend to tax paid by foreign subsidiaries and other foreign affiliates in terms of economic definition.
In many cases such controls are exercised by legal definition, the reason being, the sphere of influence of economic definition is wide and broad and difficult to specify the precision needed for tax laws. For example, an economic double taxation may occur when tax is levied as earned and again taxed as consumed. And such double taxation relief on VAT or excises taxes are not permitted by states. The question of double taxation thus gains importance both for states and tax-payers. In this background, this article examines how tax treaties allow relief to tax payers from double taxation.
States, levy taxes not only on domestic assets and domestic economic transactions, but also levy taxes on global capital and transactions carried out in other countries. The foreign income or foreign capital of a resident (natural or juridical) is commonly taxed on residence basis.
An item of income or capital may be taxed in two or more states in the same tax period whether or not in the hands of different taxpayers: It occurs when assets are linked to different persons by the domestic law of the states involved, say for example, where the tax law of one state creates a nexus in respect of an item of capital to its legal owners and the tax law of the other state links that item of capital to the person who controls possession or controls economics.1
Where a state taxes a legal entity at its place of residence and another state disregards the legal entity and taxes its income or capital by attributing it to a resident shareholder, the action forms a double taxation.
Forms of Double Taxation: Double taxation is either juridical or economic.
Juridical double taxation
It occurs where states levy taxes not only on domestic assets and domestic economic transaction, but also levy taxes on capital situated and transactions carried out in other countries in relation to a resident taxpayer’s benefit. The foreign income or foreign capital of a resident (natural or juridical) is commonly taxed on residence basis.
Economic double taxation
It is a situation 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: It occurs where assets are linked to different persons by the domestic law of the states involved, say for example, where the tax law of one state creates a nexus in respect of an item of capital to its legal owners and the tax law of the other state links that item of capital to the person who controls possession or has an economic benefit.2 Economic double taxation can arise,
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1. Azeem, Zafar: Concept of Nexus in International Taxation: Development of New Horizons in Vodafone’s Case: Pakistan Tax and Corporate Laws Journal: 2011(Journal, 291)
2. See n.1.
for example if alimony received by a wife from his husband is considered income and is taxed and her hand is not allowed deduction in respect of same payment as an expense in his state of residence or if one state taxes a legal entity at its place of residence whereas another state disregards the legal entity and taxes its income or capital by attributing it to a resident shareholder.
Economic double taxation, like juridical double taxation, can be prevented by domestic laws. Economic double taxation arises due to variance in the rules regarding the inclusion or deduction of positive and negative elements of income and capital, say for example, in cases of transfer pricing. The term ‘economic double taxation’ sometimes is also used to describe the taxation of a corporation's income which is taxed initially at the corporate level and subsequently at the shareholder level.
Significance of the distinction between the two
In case of juridical double taxation it is an individual whose capital situated and transactions carried out in another country are subjected to the tax. Whereas in case of economic double taxation, the items of income or capital are taxed. The distinction provides assistance to draft rules for avoidance of double taxation and the distinction makes it easy for the development of rules and procedure for avoidance of double taxation for the framers of domestic law.
In the juridical double taxation individuals matter whereas in the economic double taxation it is the company or corporation which is attracted. The distinction makes it easy for the tax policy framers to draft the law providing benefits and attractions to individual or corporations. This distinction avoids a system of loopholes and can decrease the incidence of double taxation. It also limits the extention of sovereign’s command over a foreign territory by limiting the liabilities.
Typical Relief Provided by Tax Treaties
Tax treaties provides relief in many forms like deductions, exemptions, credits, allocation of expenses, and tax sparing. Each of these forms of relief is discussed below:
(a) Deductions
The country of resident allows its taxpayer to ask for deduction of taxes, which have been paid to a foreign government in respect of foreign source income.
(b) Exemptions
Usually country of residence taxes its residents on their domestic-source income and provides an exemption to them from domestic taxes on their foreign-source income. Jurisdiction to tax rests exclusively with the country of source.
Hong Kong is a prominent example which has adopted tax exemption method with respect to all foreign source income earned by their residents. Such countries tax only income form domestic sources. They tax on a territorial basis rather than on worldwide basis. The exemption of foreign source income granted is limited to certain types of income, say like business income and dividends of foreign affiliates.
(c) Credits
Generally reduced domestic taxes are payable by the amount of the foreign tax as a credit of tax already paid and the same is allowed. For example, if A pays a foreign tax of 10 per cent on some foreign source income which suffers a domestic tax of 40 per cent on that income, the foreign tax credit reduces liability of tax from 40 to 30. This method eliminates international double taxation of the residence-source type.
Such countries invariably do not allow tax refunds when their taxpayers pays a foreign income tax at a rate that is higher than the domestic tax rate.3 They also do not allow the excess paid foreign tax to offset imposed taxes on domestic income. The credit for foreign taxes paid is usually limited to the amount of the domestic tax payable on the foreign-source income. There are limitations too, (sometimes quite complex in application) and these limitations are used to prevent inappropriate uses of foreign tax credits. Foreign income is typically taxed at the foreign effective tax rate wherever their rates are higher than the domestic rates. In this system, foreign-source income earned by a resident is generally taxed at a higher rate than the domestic and foreign tax rates.
(d) Allocation of Expenses
Whether a country uses an exemption method or a credit method for providing relief from international double taxation, it allows expenses incurred by its taxpayers between their foreign-source gross income and their domestic-source gross income. Most countries recognize the need for such rules when they are taxing non-residents on their domestic-source income. They routinely deny non-residents a deduction for expenses unless those expenses are properly related to the earning of the domestic income subject to tax. Few countries seem to be as aware of the comparable need to apportion properly the expenses of their domestic
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3. Article 23B of the OECD Model Treaty.
taxpayers between domestic-source and foreign-source income.
(e) Tax Sparing
Tax treaties, provide for “tax sparing,” typically through a tax sparing credit. It is a credit granted by the residence country, to foreign taxes which for some reason were not actually paid to the source country but were payable under the country’s normal tax rules. Non payment of tax or a tax holiday occurs due to tax incentive provided by the source country to foreign investors to encourage to investment and business in the country. In the absence of tax sparing, the actual beneficiary of a tax incentive provided by a source country to attract foreign investment may be the residence country. This happens when the residence country’s (source-country) tax is replaced by an increase in residence-country tax.
Methods Used to Relieve International Double Taxation
Following are the methods used to relieve the burden of double taxation:
· Deduction method. The residence country permits its taxpayer to ask for a deduction of taxes, including income taxes, which have been paid to a foreign government in respect of foreign-source income.
· Exemption method. The residence country allows the taxpayers with an exemption in respect of foreign-source income.
· Credit method. The residence country permits its taxpayers credit against taxes payable for income taxes to a foreign country. In certain cases, the credit is extended to income tax paid to a foreign sub-national government.4
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4. Only the exemption method and credit method are accepted norms by OECD Model Treaty and UN Model Treaty.
(a) Deduction Method
For example, consider a 100 deduction for cost of goods sold, which is what was originally paid for the goods. First, we must match this deduction to the income it produces, which is the income from the sales of the goods. The second step is apportionment, where we must identify the percentage of the income that originated from the sale of the goods. Let us suppose that these particular goods are all sold outside the United States, so then the deduction must be apportioned to foreign-source income. However, if 50 percent of the goods were sold in foreign markets and 50 percent in the United States, the deduction is apportioned the same way: 50 percent to the United States and 50 percent overseas. That is apparently a sensible system and is relatively flexible.
As a consequence of deduction method, resident’s earning foreign-source income and payment of income taxes on that income are taxable at a higher combined tax rate compared to the rate applied to domestic-source income. Reluctantly, this method creates a bias in favor of domestic investment compared to foreign investment in the circumstances when the foreign investment is going to attract a foreign income tax.5 And in this way domestic investment is encouraged, and the residents with equal net worldwide income are treated equally as they pay the same domestic tax. From the perspective of the total income (combined domestic and foreign), it is a tax burden on a taxpayer's worldwide income, since the deduction method does not achieve equal treatment of residents. Although residents with equal net worldwide income may pay the same domestic tax, as they pay widely differing amounts of foreign tax. The deduction method is not neutral in terms of the allocation of resources between countries.
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5. National self-interest may justify this treatment.
Debit method usually attracts lower rate of tax, in case of income from royalty interest, dividend, personal services, etc. and also in case of no permanent establishment. Business profit having permanent establishment are required to pay tax in other country and no deductions is made at the source.
(b) Credit Method
Income of foreign branch is to be inducted into total income of resident person, and tax is to be worked out at the rate applicable in the country of residence, and tax paid by branch to the other country is to be given credit, and balance if any is payable as part of tax deposited in the other country, and the exceeding tax is payable in the country of person residence and no refund is allowable. Its working is illustration in the following example:
Illustration: US$
A’s income in its country 500
Branch income in another country 500
Total 1000
Tax applicable @ 20% 200
Tax deposited by branch 150
Payable 50
If
A’s income in its country 500
Branch income in another country 500
Total 1000
Tax applicable @ 20% 200
Tax deposited by branch 150
Payable NIL No refund
(c) Exemption Method
Overall effect of the exemption method is that such countries tax only income from domestic sources. Accordingly, tax is levied on territorial basis rather than worldwide basis. Exemption is limited to certain type of income such as business income and dividends from foreign affiliates. It may also be restricted to a minimum rate of tax by foreign country. It is a simple method for administering the tax and eliminates international double taxation. Its working is explained through the following illustration:
Under this method foreign source income is exempted. Jurisdiction to tax rests exclusively with the country of source. This method completely eliminates residence – source international double taxation because of one jurisdiction, the source country imposing tax. The level of foreign tax in the foreign country is not relevant.
Resident person shall be taxed in his country maximum at the rate applicable as per agreement for avoidance of double taxation.
Illustration: US$
A’s income in its country 100
Income tax rate as per resident
Country @ 30% 30
Treaty @ 20% 20
Maximum payment 20
This is how the mechanism of double tax treaties provide relief to tax payers from harmful effects of double taxation.
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