Double taxation arises when the resident country and source country exercise the right to tax the same income. Double tax relief is to be dealt with the resident state always. Double taxation is a central problem of international taxation.
Let us take an example to understand the impact of Double taxation. Henry, a resident of the USA, went to Australia and earned 10000$ in a horse race. Letus presume Australia has no Doule Tax Avoidance Treaty with the USA, and the tax rate in Australia is 30%, and in the USA, it is 35%. Henry will have to pay 3000$ in Australia and 3500$ in the USA.
Such an instance is not an uncommon situation and is prevalent in many countries.
Four Ways in which resident country deals with the Double Taxation:
No action is where the resident state takes no work on the tax relief, and the person will have to pay tax in both resident country and source country.
In our example: The USA will not consider Source country tax, and Henry will pay the tax in the USA for $3500 and Australia 3000$.
The resident country provides relief by allowing deduction on the taxes paid in the source country and taxes only the remittance received.
In our example: The USA will provide relief for taxes paid in Australia by allowing Henry to pay tax on the remittance he received in the USA. i.e., 35% of 7000$. Henry will pay 3000$ in Australia and 2450$ in the USA.
Here, the credit is allowed for taxes paid in the source country against the taxes paid in the resident state. Resident tax is based upon full income is considered for calculation of resident tax, and withholding taxes paid in the source country is utilized as a credit.
In our example: The USA will provide credit for the taxes paid in Australia. The USA will tax the total income at 35% (i.e., 10000$ X 35% = 3500$) and provide a credit of taxes paid in Australia. Henry will pay 3000$ in Australia and 500$ in the USA. The effective rate of 35%
The exemption method imposes no tax on foreign source income.
In our example: the USA will exempt all the foreign source income. Hence Henry will pay 3000$ in Australia only.