International Double Taxation
and methods of its elimination
in the view of the OECD Model Convention with respect to taxes on income and on capital
Cite as - J. Mathias, International Double Taxation and Methods of its Elimination, dirittotributario.eu Working Papers, 2010, n.1
Taxes have always been one of the attributes of the State power and as a result, fiscal jurisdiction is often the most aggressively guarded jurisdiction of a nation. Taxes are the main income for a State, they help to develop the economy, stabilise the intern market, they play a big role in state budget. Considering all these factors it is clear how important they are for every country.
The problem has started with the civilisation and economic development which initiated the formation of the global sales network and transborder exchange of goods, capitals, services and workers. The States are willing to tax every income of its nationals, also the ones made abroad. At the same time, they don't want to resign from taxing the gainings achieved on their territory by aliens. It is based on the theory that the State has every right to tax the incomes that are made on its territory, no matter if its subject is a State national or not.
That way of thinking causes the crossing and overlapping of intern ways of taxation and usually create so called international double taxation, which issue I will develop further on the next pages.
Nowadays, states usually decide to base their tax system on two conceptions:
- the theory of the residence or nationality, or
- the theory of the source
The theory of the residence
That conception is based on the subjective criterion. It stands, that every income of taxpayers persons that has the place of residence or seat in the territory of the state is taxed, no matter where the income was made. It is called as unlimited tax duty.
There are several criteria that decide if the “residence” occurred:
- place of living
- place of having business
2) juridical persons:
- place of registration
- place of residence
The theory of the source
The objective theory. In that case, state taxes every income that was made on its territory, no matter where is the residence of the taxpayer person. In the doctrine it is called as limited tax duty.
The phenomenon of international double taxation appears when two countries are using both ways of taxation. This practice causes the situation when the same person is obliged to pay taxes to two states for the same income.
Doctrine distinguish two kinds of double taxation: law double taxation and economic double taxation.
The law double taxation is usually defined by the international tax law specialists as imposing similar taxes in two or more States, on the same taxpayer, from the same title and for the same period. It means that the law double taxation could only appear when there occur jointly five factors:
- tax is imposed by two different (or more) countries
- identity of the subject of taxation
- identity of the object of taxation
- identity of the taxed period
- similarity of taxes
There are three situations in which that kind of double taxation may happen:
1. a taxpayer has seats in two States so in both appears the unlimited tax duty,
2. a taxpayer has a residence in one country and makes income in the other one, so in the first one he is paying because of the residence criterion and in the other on the base of the source rule, or
3. a taxpayer has an establishment in one country, which makes income in the other one, in the situation when a taxpayer is a resident of none of them (limited tax duty in two countries)
The economic double taxation, on the other hand, appears in the situation when there is the lack of identity of subjects but still the same income or capital is taxed. The difference between these two types of double taxation depends from which point of view we are contemplating this phenomenon. In the law double taxation the attention is focused on the subject of taxation which is the taxpayer obliged to pay taxes to two or more different States. In the economic double taxation the pressure is put on the object of taxation, which is one income which is taxed twice.
That kind of taxation could be well illustrated by the example of an enterprise which has the residence in one country and department in another one. The company makes an income in the state of residence and then send money to the department as a dividend. Gainings are taxed twice: first time by the state of residence, because that is the place where the income was made, second time in the state of department as dividends. It happens that way, because dividends are treated as a kind of income.
International law does not ban the double taxation, in spite of the fact that it aggravates the participation of foreign individuals and companies in international market. It is consider to have very negative and harmful influence on the world economy and because of that, is definitely undesirable.
There are several ways in limiting this phenomenon and they could be classified as unilateral, bilateral and multilateral.
Unilateral measures are the ones introduced by the state itself. They consist in changing the intern law due to facilitate the international trade by giving some special advantages to individuals or enterprises, who are taking part in interstate exchange of goods. There are three possible methods: exemption, deduction or tax credit.
The exemption is used when that was proved that the income made abroad is taxed in other country on the same basis and that country is acting on mutual terms, but only if a special contract between states does not state differently. That solution is in my opinion the most profitable and at the same time the easiest for taxpayer. He simply pays taxes in one country, without having any issues in the other one. This method could be used as full exemption or as progressive exemption.
The deduction method consist in considering duties taxed by foreign state as expenses which could be withhold from the general taxed income. Here, taxpayer has to pay twice but he shouldn't be loosing anything.
Last method, which is called as tax credit, also consist in dividing a paid duty among two states. In that situation, the tax paid abroad is being accepted as a part of intern taxes. It means that the taxpayer is exempted from the part of taxes which he had paid in another state.
It is obvious, that unilateral measures are not enough to eliminate the phenomenon of double taxation. They have usually facultative character, which means that they are only used when there are no international treaties between states, concerning that issue. The main problem with that intern solutions is based on a big liquidity of the state tax system and the lack of plain norms in it. What is more, there are also differences in defining legal expressions, which vary from state to state. In these conditions the need to regulate the taxes rules on international area became very burning.
Here, I'm moving to bilateral and multilateral ways to limit a double taxation. The best solution would be to create an international treaty concerning the problem and have it sign by all states. It would unify the structure of duty's systems all over the world and bring some plain and equal rules of taxation in every country.
Unfortunately the creation of multilateral convention in the subject of taxes was never carried out. It seems really impossible because of the specificity of the problem, which is indeed the division of tax influences. It is very doubtful if many states would agree to sign at one time the treaty that determines equally their relationships with various international partners. Also the practice of signing treaties by several countries is rather rare. Poland has never agreed to be a part of any.
All described factors effected in the development of bilateral contracts between states, which is definitely the most comfortable way to determine the tax rules which oblige citizens of both of them.
First bilateral treaties were signed in XIX century. Since twenties of XX century there have been several trials to create a model of convention. Its scope would be to construct a skeleton, an example how the tax treaty should be build, which provisions should be inserted to make a contact complete. Another, very important aim was to unify the terms, definitions and vocabulary concerning tax law.
The time showed how difficult task it is to write that kind of model convention. First one was created in 1928 based on the work of the League of Nations, second, called Mexican version, in 1943 in Mexico, third in London in 1946. In spite of being a model for several bilateral treaties, none of them was fully accepted and respected.
Then in 1963 was created a model convention which was a breakthrough. It was called Model Convention with respect to taxes on income and on capital and was accepted by The Council of Organisation for Economic Cooperation and Development (OECD). Since then the model has gained a wide influence on negotiating, constructing and interpreting bilateral contracts. It gained even the bigger impact when in created in 1980 model tax treaty for developing countries by the United Nations, there were put some of regulations from the Model Convention of OECD. It made it possible to harmonise contracts to avoid double taxation with benefits for both: taxpayers and state's administration.
To the convention from 1963 there was elaborate the Commentary, which as well as model itself, is being periodically amended.
First title of the Convention (first draft from 1963 and then update from 1977) included a reference to the elimination of double taxation. However, due to the fact that the model does not deal exclusively with the problem of international double taxation, but also addresses other issues, such as prevention of tax evasion and non-discrimination, it was decided to introduce shorter title, which didn't include that reference.
The Convention applies to all taxpayers who are residents of one or both of the Contracting States (Art. 1). According to Art. 4 from Chapter II, were all useful definitions are inserted, the resident is “(...)any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature”.
The model occupies with the taxes on income and capital, which are described briefly in Art. 2.
To reach the scope of eliminating double taxation, the Convention establish two categories of rules. First, Art. 6 to 21 determine, with regard to different classes of income, the relative rights to tax of the State of residence and of the State of source. Art. 22 does the same regards capital.
The Convention creates tree classes in which the income or capital in the State of source could be classified:
- income and capital may be taxed without any limitation in the State of source,
for example: profits of a permanent establishment situated in that state, income from immovable properties situated in that state or a capital representing it;
- income that may be subjected to limited taxation in the State of source,
for example: dividends or interests;
- income that may not be taxed in the State of source, instead is all taxed in the State of residence.
In this category there is the rest of incomes and capital, for example: royalties, business profits that do not derive from permanent establishment in the State of source, private sector pensions, etc.
As classification above shows, model generally allocates the primary right to tax to the country from which capital investment originates (resident country) rather than the country in which the investment is made (source country). As a result, it is most effective as between two countries with reciprocal investment flows (such as among the OECD member countries), but can be very unbalanced when one of the signatory countries is economically weaker than the other (such as between OECD and non-OECD pairings). In that kind of situation the model clearly favours countries that are stronger economically. Why? I will try to illustrate that reference on the example.
Usually abroad invest companies from states on higher level of development. They have a permanent establishment in their origin country and they are just making businesses, which obviously gives them gainings, in the other, usually economically weaker state. Clearly, both sides benefits: the company makes income with lower cost (as in less developed countries investing is less expensive: labour, means of production) and the country of investment develops. The problem begins when it comes to taxes. As Art 7 § 1 of the Model Convention states: “The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein”. The taxes from income made by that company will be paid on the whole in the stronger country. This practice will in fact lead to enforcement of the state which is already in a better situation.
In the Model Convention there were also inserted some special provisions which concern various issues connected to the problem of double taxation as the elimination of tax discrimination in various circumstances, the exchange of information between tax authorities of the Contracting States or the guidance how to resolve conflicts of interpretation of the Convention.
Being a model, the Convention is a kind of skeleton, which shows how to create a bilateral contract between two states in the subject of international taxes. According to the model the contact should consist on 7 chapters in determine order, which include regulations in the following issues:
I. Range of application,
II. General definitions,
III. Detailed regulations concerning the income taxations, and
IV. Capital, if the contract consists also regulations in capital,
V. Methods for elimination of double taxation,
VI. Particular regulations,
VII. Final regulations.
The Convention provides two types of regulations, which deals with the issue of double taxation in a different way. Some articles contain a direct indication which State is allowed to tax the income, which solves the problem immediately. The others, however, give the States free choice to decide which of two methods of limiting the double taxation described below to apply.
Every article where we can find the expression “shall be taxable only” gives the one of the Contracting States the exclusive right to tax income. This expression indeed, preclude the other Contracting State from taxing. The State that is usually given that kind of right is usually the State which a taxpayer is a resident in a meaning of Art. 4 of the Convention.
Other articles contain the expression “may be taxed”, which, as I wrote before, indicates the possibility of States to regulate that issue by themselves. Here, as the right to tax is not exclusive, the income could be also taxed in a State which is not a State of residence of the taxpayer, but in a State of source or a State where the permanent establishment is placed. In such a case, the State of residence must give relief so as to avoid the double taxation.
Now, I would like to describe the way in which the problem of international double taxation is solved in the Model. In the Convention this issue is developed in Articles 23 A and 23 B.
These articles deals with so-called juridical double taxation, as contrasted with economic double taxation, where the same income or capital is taxable in the hands of one person by more then one State.
Art. 23 A and 23 B apply to the situation in which a resident of the State of residence derive income from, or has capital in, the State of source or in the State where there is placed the permanent establishment. In accordance with the Convention such income or capital could be taxed only in such other State of source or State of permanent establishment. The thing is, that in these articles, the problem is solved only from the point of view of the State of residence, as there are no prescriptions for two other States.
The Art. 23 A introduces the principle of exemption. Under this rule the State of residence doesn't tax the income which according to the Convention should be taxed in State of source or State of permanent establishment.
The principle of exemption could be used in two different ways :
- First one is called as full exemption method. In that case the income which is taxable in State of source or State of permanent establishment is not taken into account at all by the State of residence. The State cannot also take into consideration that kind of income, while determining the tax to be imposted on the rest of the income.
- Second one is exemption with progression method. Here, as well as in the method of full exemption, the State of residence is not entitled to tax income which under regulations of the Model Convention may be taxed in the State of source or the State of permanent establishment. The only difference is that in the case of exemption with progression the State of residence retains the possibility to take that income into account during determining the tax to be imposted on the rest of the income.
In the Art. 23 B there is drafted another of two possible on the ground of the Convention methods in limiting the effect of double taxation, which is the principle of credit.
Accordingly to that rule, the State of residence include in its inter calculations regarding taxes, the income from the State of source or State of permanent establishment, which under the Convention may be taxed in this other State. Then, it is permitted to deduct from its own tax the tax paid in the other State.
The principle of the tax credit could be used in two manners, as a full credit method and ordinary credit method. In that first one the State of residence allows its taxpayers for deduction of the total amount of tax paid in the other State on income that might be taxed in that other State. In the second method, which is ordinary credit, the State of residence also permits deduction of the tax paid in the other State (State of source or State of permanent establishment) but this time the deduction is restricted to the part of its own tax which is appropriate to the income which may be taxed in the other State.
In the treaties concluded between the Member countries of OECD both methods in limiting double taxation appears. Some States have a preference to the first one, the others to the second. Theoretically it would be much easier is only one principal was chosen, but is was decided to leave the States free to make their own choice.
However, no matter how important the free choice is, it was found desirable to limit the possibilities left to States to avoid chaos in conventions. That way, according to the Convention two methods are permitted: the exemption method with progression (Art. 23 A) and the ordinary credit method (Art. 23 B).
The States may decide also how to use these principals. There are three possibilities. They could both decide to choose one method, then each of them may choose different one or they could decide to combine these two principals.
If both of Contracting States choose the same method it will be sufficient to insert the relevant Article (correspondently Art. 23 A or 23 B) in the convention. That is definitely the easiest way to set tax rules between counties.
On the other hand, if they decide to base their tax system on different principals, both Articles from the Model Convention could be inserted in one Article. Then it will be just necessary to state in adequate places in the Article which State has chosen with method.
When it comes to the combination of two principals, the Convention doesn't give the exact answer how to compute them together. That issue was left to the domestic law and practice applicable. Of course, it could be also negotiate by the Contracting States themselves before signing the convention.
Double taxation causes diminution in the taxpayer income, and what is more, it creates in the society the impression of injustice. Then it brings a reluctance in paying taxes and mistrastfulness to the Government. All these factors together are definitely harmful to the intern economy.
It is understood that this third phenomenon is the one most dangerous for the State, as taxes are one of the most important incomes to state budget.
That is why the compromise between States concerning taxes is so important. The bilateral conventions to eliminate the occurrence of international double taxation are the only measure to make every party of that conflict satisfied. They are the instrument to avoid conflicts and misunderstandings on the base of overlapping tax systems.
The aim of that instrument is the contractual division of the rights to tax incomes of one taxpayer between the State of residence of the taxpayer, the State of source and the State of permanent establishment.
The division in tax domination to be accepted and truly followed has to be introduced on common and widely respected rules. These rules are all gained in one not banding convention: the Model Convention with respect to taxes on income and on capital elaborated by OECD.
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