All our previous posts were about tax jurisdiction and “whom” to pay tax. But today’s post is about how “not pay tax” in two countries. Yes. Today’s post is about the mitigation of double taxation. Let’s dig deep.
Of all the available methodologies of elimination of double taxation, the OECD Model tax convention has provided the option of two methods to choose:
- The exemption method with progression
- The ordinary credit method
The Contracting States are free to adopt the combination of these two methods or anyone or both methods for elimination of double taxation.
The underlying principle of Article 23 is the obligation of providing relief is always on the State of Residence!
Both Article 23A and 23B grants relief when an income “may be taxed in the other Contracting State in accordance with the provision of this Convention.” It holds even if the same income is taxable under different Articles by the Contracting States.
Types of issues while availing the tax relief
There can be multiple issues faced when two countries tax the same income. Let us look into the two common difference:
- Different provisions of domestic laws
- Different interpretations of the fact/provisions of the Convention.
- Double non-taxation of the income
Different provisions of domestic laws
Such an issue arises when the State of Source and State of Residence interpret income in different Articles due to separate tax policies under domestic laws. Even in such situations, the State of Residence will grant relief to the taxpayer.
State A and State B have adopted the OECD Model Tax Convention. Linka LLC is the partnership registered in State A by Mr. Louis and Mr. Zinka. Mr. Louis is the tax resident of State B, hence his global income is taxed in State B. State A treats partnership firm as a fiscally transparent entity. In contrast, it is a taxable entity according to State B tax laws.
Mr. Louis chose to sell his rights in the partnership firm to Mr. Alpha. Which country will have the rights to tax the income of Mr. Louis?
Justification of State A:
Income taxable under Article 13(1) /13(2) as alienation by a partner of underlying assets of the business
Justification of State B:
For State B, alienation of an interest in the firm is similar to the alienation company’s shares hence not taxable under Article 13(1)/13(2). Yet, State B will provide relief to Mr. Louis, as the income is taxed by the Other State (i.e., State A) as per the provisions of the Tax Convention.
Difference in the interpretation of facts/provisions
During the difference in interpretation of the facts/provisions of the tax convention, then the State of Residence is not under any obligation to provide the tax relief. Such issues will have to be resolved by the Mutual Agreement Procedure.
State A and State B have adopted the OECD Model Tax Convention. Miss Anna, a tax resident of State A, has created an automatic meat cutting machine which she has patented in State A. She sends the device to her aunt Mrs. Stella for use in her shop for a while. Mrs. Stella pays annually 1000$ to Miss Anna for the usage of the machine. State B tax authorities consider the device as “a fixed place of business” of Miss Anna in State B and taxes the income under Article 5. State A tax authorities believe the income as a royalty which is taxable only in the State of Residence as per Article 12. Will State A provide a tax credit to Miss Anna for the tax paid in State B?
Justification of State A: No tax relief to be provided as the income was taxable only in the State of Residence and “not taxable under any provision of the tax convention by the other State.”
Justification of State B: The machine a fixed place of the business hence taxable.
Remedy for the taxpayer: When a difference of opinion arises on the facts, State A will not provide relief. Hence taxpayer will resort to Article 25 – Mutual Agreement Procedure.
Double Non – taxation
This issue arises when the income though taxable under the treaty is not taxable under the Domestic laws of the State of Source. In such cases, will the State of Residence tax the income? Or provide the relief?
State A and State B have adopted the OECD Model Tax Convention. Miss Anna, a tax resident of State A, has immovable property in State B and receives the rental income on it. As per the Tax convention between State A and State B, the rental income is taxable under the State of Source,.ie. State B. But the domestic tax laws of State B has exempted the taxation of the revenue. Should State A exempt the taxation of the income?
State A, in the given case, will not give up its right to taxation, as the income is not taxed by State B even if it has the right to do so under the Tax Convention but has chosen otherwise. If State A exempts this income, it will be the non-taxation of income in both countries, which was never the intention of the tax convention. Hence in such cases, State A can choose to tax the rental income as Miss Anna’s global income is taxable in the State of Residence.