How to Eliminate Double Taxation?

Ankita Tiwari

13 Jun, 2024

A country has the exclusive right to tax anyone and anything within its fiscal borders but in this age of globalization, cross-border transactions involve two separate jurisdictions. Both jurisdictions are sovereign, and neither of them can impose its tax laws on the other. There is no single international tax law that governs the taxation of cross-border/international transactions. The overlapping of laws of different jurisdictions gives rise to international double taxation which is an unintended result of a disparity in tax legislation. To eliminate double taxation, jurisdictions enter into Double Taxation Avoidance Agreements (DTAAs). The OECD Model and UN Model provisions describe methods to eliminate double taxation. These provisions on elimination of double taxation have been discussed below in detail.

OECD Model

Articles 23A and 23B of the OECD Model prescribe the methods to eliminate double taxation particularly juridical double taxation which arises when two or more countries tax the same item of income or capital in the hands of the same recipient. Three instances give rise to juridical double taxation:

• Residence – Residence conflict

This instance of conflict arises when both the contracting states, tax the worldwide income of a taxpayer they consider as their resident. This conflict is resolved by the tie-breaker rules provided under Article 4 of the OECD Model. However, the tie-breaker rules do not apply when the contracting states levy tax at different times.

• Source – residence conflict

This instance of this conflict is resolved in two ways either:

1. By granting exclusive taxing rights to one of the contracting states. The state that has the exclusive taxing right will be the state where the person deriving the income will be a resident. In such cases, the distributive rules provide the wording ‘shall be taxable only’ which ensures that double taxation is avoided by providing an exclusive taxing right to one of the contracting states and precluding the other contracting state from the taxing right; or
2. Both states sharing taxing rights. In such cases, the distributive rule states that an item of income may be taxed in the source country or the country of permanent establishment. Under this, the relevant rule generally provides for a limitation on the level of tax that the source state may levy. On the other side, no limitation is placed on the level of taxation that may be imposed by the residence state therefore, the residence state may apply the domestic laws for taxing the income derived by its residents from the other country. Generally in this type of conflict, relief is granted by the residence state to eliminate double taxation. The relief is granted either by exempting the income already subjected to tax in the source state or by granting credit for the tax already paid in the other state.

Articles 23A and 23B of the OECD Model apply exclusively to the residence state.

• Source-source conflict

This conflict and the double taxation arising from such conflict are not resolved by the OECD Model.

Choice of Double Tax Relief Method

It is onto the states to choose whether to employ the exemption method under Article 23A of the OECD Model or the credit method under Article 23B of the OECD Model or a mixture of methods in their tax treaties. In certain situations, a mixture of both methods is desirable for the states which mostly follow the exemption method. A state which generally applies the exemption may apply the credit method for specific incomes that benefit from a preferential tax treatment in the other state. Other exceptions from the exemption method may include a tax treaty to avoid double non-taxation. Exceptions to the exemption method are generally done to achieve reciprocity i.e. one of the concerned states adopts the exemption method whereas the other state adopts the credit method to eliminate double taxation.

• Exemption method: Article 23A
  Under the method of exemption, the residence state does not tax income for which the tax treaty allows the source state to tax. The two ways in which this principle is applied are:
  1. Full exemption method
     Under this method, the income derived from the source state is completely disregarded for calculating the taxable income of the taxpayer in the residence country. So the tax base of the taxpayer in the source country remains unaffected by any income derived from an outside source.
  2. Progressive exemption method
     Under this method, the residence state will not tax the income derived from the source state and will consider such income into consideration to determine the tax to be imposed on the remainder of the income.
     From the above discussion, it is clear that under both exemption methods, no tax is to be levied on the income derived from the source state. Both methods essentially describe how the income from the source state affects the taxation of the remaining income in the residence state.
     It might be onto the state to choose whether they wish to rely on the principle of exemption method or credit method to eliminate double taxation but Article 23A and 23B of the OECD Model also prescribes limits to the methods used to apply these principles.

• Credit Method: Article 23B
  Under the credit method, the resident state calculates its tax based on the global income derived by the taxpayer. The global income might include foreign income which has already been taxed in the source state. So a deduction of the amount of tax already paid in the other state is allowed from the tax due in the resident state. The two ways in which the credit method may be applied are as follows:
  1. Full credit method
     Under this method of credit, the resident state grants a deduction on the full amount of tax paid in the other state.
  2. Ordinary credit method
     Under this method of credit, the resident state limits the deduction only to the amount of tax on foreign income as determined under the domestic law of the resident state.

However, Article 23B of the OECD Model provides only for the ordinary credit method. For Article 23B to apply the income should be taxed in the source state. The credit granted is equal to the amount of tax effectively paid in the source state. Further, under Article 23B(2), the credit is further limited to the amount of tax on the foreign income calculated using the domestic provisions of the resident state. The credit amount calculated is generally the maximum deduction calculated as a tax on the net income so it may be lower than the actual amount paid in the source state. In addition to this, the tax treaty provisions may contain tax-sparing provisions which allow a notional tax credit to be granted for the tax not paid due to the application of a special incentive scheme or similar allowances in the source state. If however, such credit is not granted but still the residence state applied the credit method to eliminate double taxation then any incentive granted by the source state to the foreign investors would be nullified in the resident state of the investor. Some countries consider the credit method as an ineffective method to promote foreign investment as they have the potential for abuse. Another reason for this method to be considered inefficient is that reducing the tax cost of repatriating profits to the resident state also discourages the reinvestment of the profits in the source state. On the contrary, some states also consider that the credit method protects the tax incentives given to foreign investors in developing states. The OECD Model recommends that tax-sparing provisions be used only by those states whose economic level is considerably below the OECD Member States as the objective of the credit method is to apply to exclusively genuine investments aimed at developing the infrastructure of the source state.

UN Model – Eliminate Double Taxation

Articles 23A and 23B of the UN Model are similar to that of the OECD Model. The only notable difference is that Article 23A of the UN Model extends the method to royalties and fees for technical services. These incomes are taxed as per the source rule under the UN Model like that of dividend and interest income under the OECD Model. In addition to this, Article 23B of the UN Model follows a different approach regarding tax-sparing credits.

Conclusion

The tax treaty to eliminate double taxation is generally based on either the OECD Model or the UN Model. The majority of states follow the OECD Model. As per these Models, the contracting states mutually decide on the taxing rights of each state on different types of income and capital to eliminate double taxation. If one state as the taxing right then the other state will either exempt the income from being taxed or provide relief by crediting the tax already paid. In this way, it is ensured that the tax conflicts between states is minimized.

Also Read:
A Complete Analysis on International Double Taxation
DTAA – What is the Double Taxation Avoidance Agreement?