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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.
Table of Contents
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:
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.
This instance of this conflict is resolved in two ways either:
Articles 23A and 23B of the OECD Model apply exclusively to the residence state.
This conflict and the double taxation arising from such conflict are not resolved by the OECD Model.
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.
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.
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.
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 TaxationDTAA – What is the Double Taxation Avoidance Agreement?
Ankita is an Advocate and has joined Enterslice as a Legal Researcher. Her work focuses on General Civil and Commercial laws, Corporate Taxation Laws, Labour and Employment Laws and Dispute Resolution. She is a law graduate from School of Law, University of Petroleum and Energy Studies. Prior to joining Enterslice, Ankita has the experience of practicing law in Delhi and Odisha.
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