Some of us have been there, right? Tax notice from one country after paying tax in another country! How outrageous are the demands! A prestigious college in the USA invited my friend as guest speaker, the fees received was after considering the USA tax. Also, in the UK, she was expected to pay tax!
These are the real-life case of double taxation of income where a common man faces hardships. So how do we ‘avoid’ the double taxation? Here the OECD Model tax convention comes in to picture! Throughout the article 6 to 22, we have been through the allocation of the taxation rights of income among the countries. The model convention provides relief of double taxation in Article 23A and 23B, by providing the mechanism of eliminating double taxation.
To understand the relief part, we first need to understand the types of double taxation.
There exist two categories of Double Taxation :
- Juridical Double Taxation: As the name suggests, this is the taxation of income of the same person in two different jurisdictions.
- Economic Double Taxation: This is a bit complicated. It is the taxation of the same income between two people. It is not easy to imagine but happens in a few cases. For example, Dividends are taxable in the hands of the company and the investor.
Article 23A and 23B resolve juridical double taxation. For resolution from economic double taxation, the countries involved will have to pen down in bilateral negotiations.
International juridical double taxation arises in the following scenarios:
- Both countries tax the same person on their worldwide income or capital.
Illustration: Avon, is a citizen of the USA and tax resident of Germany for the year. Germany will tax his worldwide income as a residence-based tax, and the USA will tax his global income as he is the resident.
- Tax resident of one country owns capital or earns income in another State. Both State of residence and State of source tax the income and capital
Illustration: Jane Doe is a resident and citizen of Ireland. She owns a yacht in Vancouver, which she often rents for celebrity parties. Income from renting the yacht is taxable in Canada, and her global income is taxable in Ireland.
- Triangular Case – A person is non-resident in the States involved in revenue-generating transactions and both the States tax the income.
Illustration: Gavin International, the owner of chain restaurants, is a resident of Taiwan. It has established the restaurant ‘Gavins Food’ in Germany, which is qualified as a permanent establishment in German law. Gavin International has acquired a commercial building in Austria to continue the expansion of ‘Gavins Food’ in Europe. German’s exchequer will tax income derived by leasing the unused portion of the commercial building in Austria.
We will take case studies in future posts to better understanding the scenarios.
What are the principal methods of eliminating double taxation?
The OECD Model Tax Convention follows two leading principles for the elimination of the double tax.
- The Principle of Exemption = Look at income
Here the State of residence does not tax the income which, according to the convention, will be taxable in the State of Source or the State where the permanent establishment is situated. Its implementation has two ways
- The income which is taxed in other States (State of Source or State of Permanent Establishment) is not taken into consideration when determining the tax to be imposed on the rest of the income = Full exemption method
- The income, which is taxed in other States (State of Source or State of Permanent Establishment), is taken into consideration when determining the tax rate to be imposed on the rest of the income = Exemption with the progression method.
- The Principle of Credit = Look at credit
Here the State of Residence will compute its tax based on taxpayer’s total income, including the income from the State of Source and State, where Permanent establishment exists. It then allows a deduction from its tax for the tax paid in the other State. It is imperative to note that the income does not include the income which is exclusively taxed in the State of Source.
Two methods of application of the principle of credit:
- The State of Residence allows the deduction of the total amount of tax paid in the Other State on income which may be taxed in that State= Full Credit
- The deduction given by the State R for the tax paid in the Other State is restricted to that part of its tax, which is appropriate to the income which may be taxed in the other state= Ordinary Credit.