How Can International Tax Treaties Avoid Double Taxation?
What is an international tax treaty?
Treaty is an international agreement between two states, and international law governs the terms of the treaty. An international tax treaty is a bilateral agreement between countries for preventing double taxing their respective citizens' active or passive income. Lately, international tax treaties deal with many subjects apart from double taxation.
Income tax treaties lay down the tax amount that a county can levy on taxpayers' income, capital, estate, or wealth.
Tax havens
Tax havens are tax-free or low tax places or countries. The tax-free setup attracts foreign investors to establish a business there. Typically, these countries are not parties to international tax treaties.
Understanding tax treaty
When a foreign national or company invests, the issue is which country has the right to tax that individual or firm. Whether the receiving country (capital/investment) or the country where the investors have their residence? The receiving country is the country that receives capital or investment from the investor. It is precisely to avoid double taxing the same investor's same income that countries sign a tax treaty. These agreements are identified as double taxation avoidance agreements (DTTAAs).
Trade will flourish between two countries when these countries' governments will not burden the relevant service providers with double tax. Treaties keep the above objective at the centre and allocate the right to tax based on certain principles between parties to treaty.
The countries resort to tax credit or tax exemption to avoid double taxing the investor. A tax credit, for example, ensures that the residence country refunds tax paid by an investor in the source country or capital importing country, and the converse.
Under tax exemption, the investor is exempted from tax in the host country or place of the residence country.
Types of DTAA
DTAAs are of two types:
1) Comprehensive: These cover a wide range of incomes provided under different tax model conventions
2) Limited: These are restricted in scope and cover fewer types of income. For example, DTAA between India and Pakistan is limited to shipping and aircraft profits only.
Individuals or organizations who are taxed by authorities have the alternative to choose which tax laws that are, DTTA or national income tax law, must apply to them.
Indian Income-tax law
Further, sec. 90 (2) of the Indian Income Tax Act provides the assessee with the alternative to choose Tax law that the authorities must apply to them. The choice is between DTTA or the Income Tax Act.
DTAA implementing
1. The first step is to identify whether the convention applies to the issue at hand. Whether the taxpayer falls within the ambit of the convention, it is crucial to ascertain the applicability of the convention. It involves determining the residential status of the taxpayer.
Treaty must be in effect for the relevant period that the country seeks to tax the income.
2. The relevant definitions must be applied.
3. Identify the provisions that apply to various categories of income, capital gains or capital.
4. Apply the substantive provisions
a) The source state may tax without any restriction
b) The source state can tax up to a limit: upper ceiling
c) The source state may not tax, and the residence state has a right to tax the specific transaction
Illustration
The problem of double taxation can be better understood through this illustration of how countries may treat interest income received from a loan granted by a lender. The lender is a citizen of the U.S, resides in Canada, and has granted a loan to a Guatemalan citizen. Three countries, i.e., Canada, the U.S. and Guatemala, can tax the interest earned by the lender. The U.S can assert its right to tax based on the lender's citizenship, Canada can claim to tax the interest originating from the residence of the lender, and Guatemala can tax the interest received based on source jurisdiction.
DTAAs ensures that countries do not tax the same income earned by an individual or a firm.
Tax treaties, including DTAAs, are based on one of the two models: The Organization for Economic Co-operation and Development (OECD) Model and the United Nations (U.N.) Model Convention.
We will discuss the two models in this section.
OECD model
Partnership
We have uncertainty regarding countries applying the convention's provisions to partnerships. While some countries treat partnerships as taxable units, some countries treat individual partners' income from the partnership as taxable units and ignore the partnership's income as a whole for taxing. We call the latter approach as the fiscally transparent approach.
The countries understand the need for effectively administering tax rules that will prevent tax evasion through information sharing and aid in collecting taxes.
Incomes that country can tax under OECD
According to the OECD model, the incomes mentioned below can be taxed without restraint in the State of source:
· Income from immovable property situated in that State –
· permanent establishment's profit located in that State, gains from the alienation of such a permanent establishment, and capital representing movable property forming part of the business property of such a permanent establishment
· Artistes' and Sportsmen's income generated from activities in that State
· Private sector Employees' remuneration in that State unless the employee remains in that State for a period not exceeding 183 days in the 12 months commencing or ending in the fiscal year concerned
· Except in a few cases, remuneration and pensions received for government service rendered
Incomes that state tax limitedly:
Dividends: where the holding that pays the dividend is not related or connected to a permanent establishment in the source state, the respective State must limit its tax rate to 5% of gross dividend amount,
Where the beneficiary is a holding company that holds directly, in the previous year, at least 25% of companies' capital, the company that pays the dividend
The source state must not tax the interest more than 10% of the interest gross amount
Other income or capital may not be taxed in the State of source or situs; as a rule, they are taxable only in the State of residence of the taxpayer
The biggest challenge while negotiating a tax treaty is to what extent the source county must relinquish its taxing rights. A source country is that hosts the investment or capital importing country. In contrast, the residence country is where the investor resides or has resided for a certain period in the immediately preceding days.
If the host country relinquishes its right to tax, the residence country taxes the profits of the investor. However, where the host country taxes the investor, the residence country will credit tax amount that the investor has paid in the host country. And if the investor still needs to pay tax in the residence country, in cases, where the tax rate is higher than the host country, the investor must pay the differential tax amount.
U.N. Model
Art 1 states that the convention will apply to people who are residents of one or both contracting parties.
Art 2 mentions that convention will apply to taxes both on income and capital.
Art 4 defines resident, and Art5 explains permanent establishment. These two concepts are crucial for identifying which State has the authority to tax.
Difference between U.N. and OECD model
The two models are different because the developed countries drafted the OECD model; in contrast, the U.N. model espouses the developing countries' interests. OECD model favours a more lenient tax regime concerning source jurisdiction-yielding of developing countries' power to tax foreign investment flowing into their country. On the other hand, the developing country wants to retain authority to tax the foreign investments befitting their circumstances.
Conclusion
A uniform tax regime aids in the growth of global trade, and along with it, the countries that participate in the international trade benefit from trade between countries. Both developing and developed countries