What is a double tax treaty?
Many countries have agreed with other countries in treaties to mitigate the effects of double taxation (tax treaties). Tax treaties may cover income taxes, inheritance taxes, value added taxes, or other taxes
Besides bilateral treaties, also multilateral countries are in place: Countries of the European Union (EU) have also entered into a multilateral agreement with respect to value added taxes under auspices of the EU, while a joint treaty of the Council of Europe and the OECD exists open to all nations.
Tax treaties tend to reduce taxes of one treaty country for residents of the other treaty country in order to reduce double taxation of the same income.
The provisions and goals vary highly; very few tax treaties are alike. Most treaties: define which taxes are covered and who is a resident and eligible for benefits, reduce the amounts of tax withheld from interest, dividends, and royalties paid by a resident of one country to residents of the other country, limit tax of one country on business income of a resident of the other country to that income from a permanent establishment in the first country, define circumstances in which income of individuals resident in one country will be taxed in the other country, including salary, self employment, pension, and other income, provide for exemption of certain types of organizations or individuals, and provide procedural frameworks for enforcement and dispute resolution.
The stated goals for entering into a treaty often include reduction of double taxation, eliminating tax evasion, and encouraging cross-border trade efficiency.
It is generally accepted that tax treaties improve certainty for taxpayers and tax authorities in their international dealings.
Several governments and organizations have proposed model treaties to use as starting points in their own negotiations. The Organization for Economic Cooperation and Development (OECD, an inter-governmental organization) model treaty is often used as such a starting point.
The OECD members have from time to time agreed on various provisions of the model treaty, and the official commentary and member comments thereon serve as a guidance as to interpretation by each member country.
Definition: Tax Residency
The principles of Tax Residency:
In general, the benefits of tax treaties are available only to persons who are residents of one of the treaty countries.
In most cases, a resident of a country is any person that is subject to tax under the domestic laws of that country by reason of domicile, residence, place of incorporation, or similar criteria.
Generally, individuals are considered resident under a tax treaty and subject to taxation where they maintain their primary place of abode. However, residence for treaty purposes extends well beyond the narrow scope of primary place of above. For example, many countries also treat persons spending more than a fixed number of days in the country as residents.
The United States includes citizens and blue card holders, wherever living, as subject to taxation, and therefore as residents for tax treaty purposes.
Because residence is defined so broadly, most treaties recognize that a person could meet the definition of residence in more than one jurisdiction (i.e., “dual residence”) and provide a âtie breakerâ clause Such clauses typically have a hierarchy of three to five tests for resolving multiple residency, typically including permanent abode as a major factor.
Tax residency rarely impacts citizenship or permanent resident status, though certain residency statuses under a country’s immigration law may influence tax residency.
Entities may be considered resident based on their country of seat of management, their country of organization, or other factors.
The criteria are often specified in a treaty, which may enhance or override local law. It is possible under most treaties for an entity to be resident in both countries, particularly where a treaty is between two countries that use different standards for residence under their domestic law. Some treaties provide âtie breakerâ rules for entity residency, some do not.
Residency is irrelevant in the case of some entities and/or types of income, as members of the entity rather than the entity are subject to tax.
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Most treaties provide that business profits (sometimes defined in the treaty) of a resident of one country are subject to tax in the other country only if the profits arise through a permanent establishment in the other country. Many treaties, however, address certain types of business profits (such as directors’ fees or income from the activities of athletes and entertainers) separately.
Such treaties also define what constitutes a permanent establishment (PE).
Most but not all tax treaties follow the definition of PE in the OECD Model Treaty..
Under the OECD definition, a PE is a fixed place of business through which the business of an enterprise is carried on. Certain locations are specifically enumerated as examples of PEs, including branches, offices, workshops, and others. Specific exceptions from the definition of PE are also provided, such as a site where only preliminary or ancillary activities (such as warehousing of inventory, purchasing of goods, or collection of information) are conducted.
While in general tax treaties do not specify a period of time for which business activities must be conducted through a location before it gives rise to a PE, most OECD member countries do not find a PE in cases in which a place of business exists for less than six months, absent special circumstances.
Many treaties explicitly provide a longer threshold, commonly one year or more, for which a construction site must exist before it gives rise to a permanent establishment.
In addition, some treaties, most commonly those in which at least one party is a developing country, contain provisions which deem a PE to exist if certain activities (such as services) are conducted for certain periods of time, even where a PE would not otherwise exist.
Even where a resident of one country does not conduct its business activities in another country through a fixed place or business, a PE may still be found to exist in that other country where the business is carried out through a person in that other country that has the authority to conclude contracts on behalf of the resident of the first country.
Thus, a resident of one country cannot avoid being treated as having a PE by acting through a dependent agent rather than conducting its business directly.
However, carrying on business through an independent agent will generally not result in a PE.
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Many tax systems provide for collection of tax from nonresidents by requiring payers of certain types of income to withhold tax from the payment and remit it to the government.
Such income often includes interest, dividends, royalties, and payments for technical assistance.
Most tax treaties reduce or eliminate the amount of tax required to be withheld with respect to residents of a treaty country.
Harmonization of tax rates:
Tax treaties usually specify the same maximum rate of tax that may be imposed on some types of income. As an example, a treaty may provide that interest earned by a nonresident eligible for benefits under the treaty is taxed at no more than five percent (5%).
However, local law in some cases may provide a lower rate of tax irrespective of the treaty. In such cases, the lower local law rate prevails.
Provisions unique to inheritance taxes:
Generally, income taxes and inheritance taxes are addressed in separate treaties. Inheritance tax treaties often cover estate and gift taxes.
Generally fiscal domicile under such treaties is defined by reference to domicile as opposed to tax residence. Such treaties specify what persons and property are subject to tax by each country upon transfer of the property by inheritance or gift.
Some treaties specify which party bears the burden of such tax, but often such determination relies on local law (which may differ from country to country).
Most inheritance tax treaties permit each county to tax domiciliary of the other country on real property situated in the taxing country, property forming a part of a trade or business in the taxing country, tangible movable property situated in the taxing country at the time of transfer (often excluding ships and aircraft operated internationally), and certain other items.
Most treaties permit the estate or donor to claim certain deductions, exemptions, or credits in calculating the tax that might not otherwise be allowed to non-domiciliary.
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Double tax relief:
Nearly all tax treaties provide a specific mechanism for eliminating it, but the risk of double taxation is still potentially present.
This mechanism usually requires that each country grant a credit for the taxes of the other country to reduce the taxes of a resident of the country.
The treaty may or may not provide mechanisms for limiting this credit, and may or may not limit the application of local law mechanisms to do the same. Mutual Enforcement
Taxpayers may relocate themselves and their assets to avoid paying taxes. Some treaties thus require each treaty country to assist the other in collection of taxes and other enforcement of their tax rules.
Most tax treaties include, at a minimum, a requirement that the countries exchange of information needed to foster enforcement.
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