Understanding Tax Treaties
When dealing with multi jurisdiction issues, it is very important to understand the tax treaties between countries.
What Is a Tax Treaty?
A tax treaty is a bilateral (two-party) agreement made by two countries to resolve issues involving double taxation of passive and active income of each of their respective citizens. Income tax treaties generally determine the amount of tax that a country can apply to a taxpayer’s income, capital, estate, or wealth.
An income tax treaty is also called a Double Tax Agreement (DTA)
Some countries are seen as being tax shelters. Generally, a tax shelter is a country or a place with low or no corporate taxes that allow foreign investors to set up businesses there.
Tax shelters typically do not enter in to tax treaties.
How does a Tax Treaty Work?
When a person moves to a new country and has income or assets in his original place of abode or an individual or business invests in a foreign country, the issue of which country should tax the investor’s earnings will arise. Both countries–the source country and the residence country–may enter into a tax treaty to agree on which country should tax the investment income to prevent the same income from getting taxed twice.
The source country is the country that hosts the investment or the asset. The residence country is the investor’s country of residence. The residence country is the country that hosts the owner of the asset or investment.
To avoid double taxation, tax treaties may follow one of two models:
The Organization for Economic Co-operation and Development (OECD) Model or the United Nations (UN) Model Convention.
OECD Tax Treaty Model
The Organization for Economic Co-operation and Development (OECD) is a group of 37 countries who have come together to promote world trade and economic progress.
The OECD Tax Convention on Income and on Capital is more favorable to capital-exporting countries than capital-importing countries. It requires the source country to give up some or all of its tax on certain categories of income earned by residents of the other treaty country.
The two involved countries will benefit from such an agreement if the flow of trade and investment between the two countries is reasonably equal, and the residence country taxes any income exempted by the source country.
UN Tax Treaty Model
The second tax treaty model is formally referred to as the United Nations Model Double Taxation Convention between Developed and Developing Countries.
A treaty that follows the UN’s model gives favorable taxing rights to foreign countries of investment. Typically, this taxing system benefits developing countries who receive inward investment. It gives the source country increased taxing rights over the business income of non-residents compared to the OECD Model.
One of the most important aspects of a tax treaty is the treaty’s policy on withholding taxes because it determines how much tax is to be paid on any income earned (interest and dividends) from securities owned by a non-resident.
For example, if a tax treaty between country A and country B determines that their withholding tax on dividends is 10%, then country A will tax dividend payments that are going to country B at a rate of 10%, and vice versa.
For example, The U.S. has more than 200 tax treaties with other tax jurisdictions, that help to reduce—or eliminate—the tax paid by residents of foreign countries. These reduced rates and exemptions vary among countries and specific items of income.
Under these same treaties, residents or citizens of the U.S. are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries. Tax treaties are said to be reciprocal because they apply in both treaty countries.
Income tax treaties typically include a clause, referred to as a “saving clause,” that is intended to prevent residents of a jurisdiction from taking advantage of certain parts of the tax treaty to avoid taxation of a domestic source of income.
For individuals that are residents of countries that do not have tax treaties between the source and resident jurisdiction, any source of income that is earned within the source. is taxed in the same way and at the regular rates in each jurisdiction.
What is a Tax Ruling?
When there is uncertainty regarding the tax treaty or the question of withholding taxes the Tax Commissioner of one of the jurisdictions can issue a ruling. Taxpayers who rely on tax rulings receive specific rights. They receive protection, so even when the Commissioner alters a ruling, it can’t increase the taxpayer’s obligation.
However, tax rulings are difficult to attain. They can take months to complete because the tax commissioners try to avoid legal bindings. There are some cases where the commissioner may not issue a ruling at all.
The alternative is a Tax opinion
On the other hand, an opinion is not a legally binding statement. An opinion is just a way for your accounting firm or tax expert to guide you and to avoid litigation if you are audited, and the commissioner does not agree with the opinion.
Unlike rulings, opinions only take a few days or several weeks to receive.