In the previous post, we dealt with Article 23A on the Exemption method. Article 23B covers the Credit method for avoidance of the brunt of double taxation.
Paragraph 1 of Article 23B of the OECD Model Tax Convention
Article 23B of the OECD Model Tax Convention covers the ordinary credit method. The State of Residence allows a deduction from its taxes for taxes paid in the other State. But the deduction is restricted/limited to the appropriate proportion of the tax levied in the State of Residence.
When will the State of Residence provide a tax credit for tax paid in the State of Source?
Article 23B imposes an obligation to provide the tax credit depending on the taxability of income items under the OECD Model Tax Convention.
Like any other Articles of the OECD Model Tax Convention, Article 23B sets out the credit method’s main rules. However, it does not provide detailed guidelines on the computation and operation of the Credit method.
How to identify the ‘maximum deduction’?
Paragraph 1 of Article 23B states that the deduction under the credit method the deduction which the State of Residence is to allow is restricted to that part of the income tax appropriate to the income derived from the State of Source State where PE exists.
Such maximum deduction can be computed either by:
- Apportioning the total tax on total income in the ratio of income for which credit Is to be given and the total income, or
- By applying the tax rate for total income to the income for which credit is to the given.
Do note that if the taxes paid in the State of Source are equal or exceeds the taxes levied in the State of Residence, the credit method will have the same effect as the exemption method with progression.
The maximum deduction is computed as the tax on net income, i.e., the State of Source’s income less allowable deductions (specified or proportional) connected with such income. For such reasons, the maximum deduction in many cases might be lower than the tax paid in the State of Source.
Meg, the tax resident of France, has borrowed funds in France to loan a friend in Seoul. She earns an interest of 1000$ yearly and has to pay an interest of 500$ on the borrowed fund. Assuming France and South Korea have adopted the OECD Model tax convention and the tax rate on the interest in both countries is 30%, how much is France allowed?
South Korea will deduct tax @ 30% on the interest paid to Meg: 300$
France will tax on the net income:
Interest income earned: 1000$
Interest expense paid: 500$
Net interest income earned by Meg: 500$
Tax on the net income @ 30%: 150$
The maximum deduction from the taxes available will be 150$, and the total tax paid by Meg in both the countries will be 300$.
As paragraph 1 states explicitly, credit is to be allowed for income tax only against income tax and for capital tax only against capital tax. Consequently, credit for or against capital tax will be given only if there is a capital tax in both Contracting States.
Paragraph 2 of Article 23B of the OECD Model Tax Convention
Paragraph 2 of Article 23B enables the State of residence to retain the right to take the amount of income or capital exempted in that State in to consideration when determining the tax to be imposed on the rest of the income or capital. The principle of progression is safeguarded the for the State of residence, not only in relation to income or capital which “may be taxed” in the other State but also for income or capital which “shall be taxable only” in that other Stated.
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