Tax Treaties and their role in International Taxation
A treaty in general terms means an agreement concluded between two or more countries in a written form. It is governed by international law. This agreement can be in the form of a single instrument or two or more related instruments. Tax Treaties are one of the many categories of treaties and they deal with matters specifically related to taxation.
There are two main types of tax treaties i.e. Bilateral Tax Treaties and Multilateral Tax Treaties. A Bilateral Tax Treaty is a treaty concluded on a bilateral basis i.e. treaties between two parties. Whereas Multilateral Tax Treaty is concluded between more than two parties. Different treaties are entered into covering different taxes like taxes on income and taxes on capital. Capital and income tax treaties are referred to as “comprehensive tax treaties” as they include almost all types of income like business income, passive income, and employment income. There are treaties on inheritance and gifts which cover taxes on estates, inheritance, and gifts. Some treaties regulate cross-border transactions relating to social security levies and administrative assistance agreements. Every treaty is either based on the OECD Model or the UN Model.
How do tax treaties affect the domestic legal framework?
At present, tax treaties plus domestic tax legislation create a legal framework for the tax system in a country. A tax treaty is binding on the taxpayers and tax authorities of the countries that are party to the treaty. From the moment, a treaty is signed it becomes enforceable in the countries that are party to the agreement. Generally, confusion arises as to the difference between tax treaties and domestic legislation of a country. The difference between the applications of the two is that such treaties do not create a tax liability for taxpayers and only determine the right of a country to levy tax and to what extent the right can be exercised. This makes such treaties relieving in nature by limiting the right to tax only to the parties to the treaty. On the other hand, domestic legislation levies the tax and provides the mechanism for its collection.
What is the purpose?
The OECD in ‘OECD Model Tax Convention on Income and Capital’ states the two main purposes for entering into tax treaties are: i) to avoid double taxation, and ii) to prevent tax evasion. These two main purposes have also been affirmed by the titles/preamble of various tax treaties. Apart from the two main purposes, other purposes of tax treaties include providing clarity and confirming the fiscal situation of the taxpayers by applying common solutions to identical cases. The purpose of tax treaties have been further discusses in detail below:
- Avoidance of double taxation
One of the most important purposes of tax treaties is to avoid double taxation. It is done by limiting the taxing rights of one or both parties to the treaty and by providing double taxation relief. When the tax treaties were at a developing stage, domestic laws were not that advanced to cater to the issues of double taxation. The bilateral treaties introduced comprehensive solutions. In addition to this, the importance of tax treaties increase as they cannot be modified unilaterally, therefore, ensuring a stable legal framework.
Distribution rules or allocation rules are applied to limit taxing rights. Distribution rules or allocation rules are those rules that indicate which of the country that is a party to the treaty has the right to tax and to what extent. If both countries are allowed to tax the same income, then one country has to provide relief from taxation. In such cases, the country providing relief from taxation, is generally, the country of residence. The distributive rules apply to particular types of income and capital given under the substantive provisions while the relief is provided in separate provisions. The substantive provisions are similar to that of the OECD model. There are different types of distributive rules which are discussed below:
- Under the first type of distributive rule, the source state is not permitted to tax and the residence state has exclusive taxing rights. By restricting the taxing rights to the residence country, double taxation is avoided.
- Under the second type of distributive rule, the source country has the right to tax but only to a specified maximum extent. The resident country provides tax relief to avoid double taxation.
- Under the third type of distributive rule, the source country has an unlimited taxing right. Like the second distributive rule, the resident country provides relief to eliminate double taxation.
- Prevention of tax evasion and avoidance
The second most important purpose of a tax treaty is to prevent tax evasion and tax avoidance. It is done through the exchange of information between countries and by assisting in the collection of taxes. The significance of tax treaties in preventing tax avoidance is discussed in the framework of the OECD/G20 project to deal with the issue of base erosion and profit shifting (BEPS). Tax treaty provisions do not intend to create opportunities for non-taxation or reduced taxation rather they prevent such arrangements. The BEPS Project was also launched expressing the intention to eliminate double taxation and reduce the opportunity for non-taxation or reduced taxation or tax evasion and avoidance.
- Other objectives of tax treaties
Apart from the two main purposes of relieving from double taxation and preventing tax evasion and tax avoidance, such treaties have other purposes as well. One such purpose is to prohibit discriminatory tax treatment on different issues including the issue of nationality. As a consequence of non-discriminating clauses, domestic law may be impacted. The non-discrimination provision may lead to the grant of some reliefs to a non-resident taxpayer which is otherwise not available under domestic law. Another important purpose served by a tax treaty is to encourage and foster economic ties between the parties to the treaty. Treaties protect foreign investors from discriminatory tax treatment and offer support in resolving cross-border tax disputes through mutual agreement procedures. Further, tax treaties also create a legal framework that cannot be altered easily without negotiation between the parties to the treaty thereby ensuring a greater level of certainty for foreign investors.
Tax treaties are not just agreements to prevent double taxation and prevent tax evasion, but they also minimize conflicts as countries mutually agree on the terms of the treaty. Tax treaty acts as a connecting factor in determining the taxing rights between source-based income and residence-based income. Tax Treaty also promotes international trade by removing the tax disputes arising due to differences in tax systems. It deals with various problems that arise due to the diversity in domestic tax systems and provides clarity on the taxing rights of a country. Thus, it can be said that tax treaties play a significant role in promoting cross-border transactions.
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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.