Double Taxation Relief
Most countries tax their residents on their worldwide income and non-residents on their domestic source income. Due to this, foreign source income earned by a resident of a country may be taxed by both the country in which the income is earned (i.e. source country) and the country in which the taxpayer is resident (i.e. residence country). This situation causes international double taxation.
International double taxation can also occur due to differences in the way countries define income and, in the timing, and tax accounting rules (i.e. IFRS or GAAP) they adopt for computing income. International double taxation may also occur due to disputes between countries about the proper arm’s-length prices for cross-border transfers of goods and services between related parties. Sometimes other rules adopted to curtail tax avoidance can also produce double taxation. The variation in tax rates across countries and increase in trade and commerce make it very important to understand the available relief from double taxation.
The relief for the tax charged in the source country may take various forms under the domestic law of the residence country:
·The foreign income is exempt from the tax (the exemption method);
·The foreign income is taxable, but the tax paid in the source country is credited against the tax due in the residence country (the credit method), with the possibility for a credit to be given for certain notional taxes that are not actually payable in the source country (tax sparing credit);
·The foreign income is taxable, but the tax paid in the source country is allowed as an expense deduction in the residence country (the deduction method); and
·The foreign income is taxable, but at a reduced tax rate (the reduced rate method).
The first two methods provide full relief from juridical double taxation and the same is covered in OECD and UN model tax conventions. While the third method does not completely eliminate the source-residence conflict. Most counties use a mixture of these methods, while the reduced rate method is not so popular.
Exemption method
This principle of exemption may be applied in two ways. Firstly, under the full exemption method, the residents are taxed only on income earned from domestic sources, while foreign-source income is not subject to tax. Secondly, under exemption with progression method, foreign income is not taxed but is taken into account to determine the tax rate applicable on the non-exempt income. The benefit of the exemption on the foreign income is not impacted; it is only the remaining income that is charged at a higher rate.
For the application of the exemption method, many counties include a condition that the foreign income must be subject to tax (or taxable at a comparable rate) in the source country. In addition, no deduction is generally available in the residence country for costs incurred in relation to earning the tax-exempt foreign income.
Although the exemption method is widely used and is sanctioned by both the OECD and UN model conventions (i.e. Article 23A), it is inconsistent with the tax policy objectives of fairness and economic efficiency. To the extent that foreign taxes are lower than domestic taxes, resident taxpayers with exempt foreign source income are treated more favourably than other residents. Moreover, an exemption system encourages resident taxpayers to invest abroad in countries with lower tax rates, especially in tax heavens, and encourages them to divert domestic source income to such countries.
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Credit method
Under this method, the residence country taxes its residents on their worldwide income but provides credit for tax paid in the source country, which may be withholding taxes or tax paid on assessment. The credit is used to offset the foreign tax actually paid against the tax payable in the residence country. The foreign tax credit may be either full credit or ordinary credit.
As per full credit, the taxpayer receives full credit for the foreign tax paid and is liable to pay only the difference between the tax payable in the residence country and the foreign tax paid on the same income or, if the foreign tax exceeds the tax payable in the residence country, the excess tax refunded. The full credit method is rarely used; most countries using the credit method provide relief for juridical double taxation and grant ordinary credit relief for foreign taxes.
Under the ordinary credit relief method, the credit is limited to the tax on the foreign income as computed under the provisions of domestic tax law, as if the income were earned in the residence country in the same accounting period/year. The taxpayer pays any deficit as tax if the equivalent tax computed under the provisions of the residence country exceeds the foreign tax paid on the same income, but the excess is not refunded if the foreign tax is higher. Thus the taxpayer will suffer tax at the higher of the source and the residence country tax rates.
Tax-sparing credit
In many countries, incentives are given to the companies by way of a tax holiday, by virtue of which no tax would have been paid in the source country. As the credit method provides credit only for taxes paid in the source country, no credit would be available since no taxes were paid in the source country, and thus the benefit of tax incentive in the source country would be lost. Consequently, the concept of tax sparing was introduced. Tax sparing consists of granting a tax credit in the resident country for the amount of tax that would have been payable in the source country had there been no reduction or exemption under the tax regulation of the source country. Under this concept, the tax incentives offered by the source country are deemed to have been paid as a foreign tax for the purpose of computing the foreign tax credit granted by the resident country.
Tax-sparing or deemed credits are seldom found under domestic law. However, provisions for tax-sparing credits are included in the tax treaties of several countries, which grant a notional tax credit for the tax not paid, under special incentive schemes or similar allowances in the source country. These credits are usually attached to dividends, interest, and royalty payments but may also apply to income from foreign branches. They may relate to all or only certain specified incentives and may be granted for either an unlimited or, more commonly, for a specified period of time. Tax treaties may also provide that future tax incentives of a similar nature also qualify under certain conditions.
Deduction method
Countries using the deduction method tax their residents on their worldwide income and allow those taxpayers to take a deduction for foreign tax paid in the computation of their taxable income. In effect, foreign taxes/income taxes and other types of taxes are treated as costs or current expenses of doing business or earning income in a foreign jurisdiction. The tax treatment may vary, for example, some countries allow a deduction for the foreign tax paid, only provided that the related foreign income is taxable in the residence country, while other countries allow that taxpayer to elect for either the deduction method or the credit method.
In Conclusion
As we observed that there are various methods for claiming double taxation relief which can substantially reduce tax obligations in the residence country. For any cross-border transaction involved, it is important to understand the tax implication prior to the implementation of those transactions. These prior planning and study help to mitigate uncertainty for tax obligations. Like any other transaction, it is of utmost importance for taxpayers to maintain a complete documents trail for claiming double taxation relief. Documents such as payment of tax in a foreign country, and tax withholding certificates in name of taxpayers are mandatory documents for the claim of credit/exemption.
This article is contributed by Ram Kumar Chhetri - Executive - TransPrice Tax Advisors LLP and Mayur Khanna - Associate Director - TransPrice Tax Advisors LLP.
