International tax law and nature of a Double Taxation Agreement (DTA)
As a rule, cross-border activities give rise to questions of delimitation regarding a state’s tax access to the income earned. The taxpayer comes under the sovereignty of different sovereign states with their own right of taxation for their territory.
The state in which the taxpayer is resident demands taxes on the taxpayer’s world income (residence taxation, unlimited tax liability; see below).
In addition, however, the states in which the taxpayer is active also want to levy taxes on the facts realised in their territory (withholding tax, limited tax liability; see below).
This co-existence leads to double taxation. The tax law of the country of residence usually contains provisions to avoid or mitigate double taxation (e.g. tax exemption, credit for foreign taxes).
The scope of a withholding tax is not only important for the distribution of tax revenue between domestic and foreign sources, but also for the taxpayer himself:
If the foreign tax rate is higher than the domestic tax rate, tax collection abroad means an additional burden for the taxpayer. If, on the other hand, the foreign tax rate were lower, the taxpayer would have an interest in his income being subject to withholding tax there in conjunction with a tax exemption in Germany.
Since national regulations do not necessarily and in all cases avoid double taxation, many states conclude so-called double taxation agreements among themselves.
International tax law is therefore complex and requires the consideration of three aspects:
- The corporate tax law of the country of origin, with rules that are generally not applicable to companies that do not have cross-border activities
- The tax law of the foreign state in whose jurisdiction these activities are carried out and which may therefore apply to the company; and
- The interaction between the home and foreign country and the application of double taxation agreements.
In the following, we provide a little more detail on the above-mentioned methods of taxation under international tax law.
Within the framework of a national tax law, the State may, in principle, link taxation to two binding elements: there must be a personal link or a material link between the taxpayer and the State.
A personal link is established through territoriality, such as nationality, domicile, residence, place of management, etc. These forms are referred to as taxation according to the nationality principle and according to the principle of residence or domicile. If taxation is based on personal characteristics, this usually results in unlimited tax liability (taxation of world income).
A material link is established through the generation of income or the location of assets in Switzerland. This form is called taxation at source or origin. The material affiliation usually triggers limited tax liability, limited to income from that state (hence also: territoriality principle).
Due to the application of these different principles in the states, double taxation of a cross-border situation can occur, see two examples:
- O is resident and ordinarily resident in Great Britain. He receives income from Austria. The United Kingdom taxes the income according to the principle of residence in Austria, and withholding tax is levied at the same time. The combination of unlimited tax liability in Great Britain and limited tax liability in Austria results in double taxation.
- S has a permanent establishment in Ireland. Via this permanent establishment he receives income from Great Britain or holds his assets there. Ireland and Great Britain tax both accordingly according to the source principle. Limited tax liability in both Ireland and Great Britain results in double taxation.
National options for avoiding double taxation
The State of residence alone can generally avoid double taxation by either fully exempting the tax incurred in the other State (exemption method) or crediting it against domestic tax (credit method), both of which are internationally predominant. In addition, there are also the methods of tax deduction, lump-sum taxation and tax remission.
The avoidance of double taxation in treaty law
Double taxation agreements are international treaties and take precedence over national tax laws as a special norm. Their origin and effects are determined by national constitutional law and the Vienna Convention on the Law of Treaties of 23 May 1969.
As a rule, the treaty is concluded between two states that adapt their own sovereign tax law with regard to the taxation of cross-border situations between the two contracting parties. The aim of the agreement is to avoid double taxation, but also to prevent tax evasion.
The agreements do not determine which national law is applicable, but rather to what extent in certain constellations of competition between the taxation norms of both contracting states these norms are withdrawn or modified in favour of the other. The whether and how of taxation is thus governed by national law, whereas the DTA sets limits against national tax collection. A DTA always only sets limits against the legal claims of a state under national law, but never establishes legal claims.
If two states conclude a treaty with each other to avoid double taxation, this treaty applies only between the two contracting states. DTAs are basically individual. However, the OECD has drafted a model agreement with commentary, to which almost all newer DTAs between industrialised countries are based. As a result, there is a substantial degree of agreement on basic structures in the DTAs.
Scope of an Agreement
The following points need to be clarified if a company wishes to rely on the agreement to ensure that the scope of the agreement covers the transaction or income in question:
- Scope: a DTA applies only to the territories which have concluded it
- Effective date: a DTA only becomes valid on a fixed date
- Included taxes: a DTA determines the tax types to which it is to apply.
- Residence: in principle, the benefits of a DTA can only be claimed by a resident of one of the contracting states.
- Identification of the relevant income item: Some types of income may be covered by more than one article of the DTA. The hierarchy of these articles in their application must be identified.
- General anti-abuse provisions: a DTA may contain general provisions which limit its application (“Limiation on Benefits”)
- Some countries, such as Germany, also limit the application of a DTA under national law.
- Special anti-abuse provisions: special provisions may exclude the application of a particular article to a business transaction or income start, without generally excluding the application of the DTA.
Interpretation of an Agreement
The first model convention was created in the so-called League of Nations (1920 – 1946). Since then, the OECD has been working to create a model convention to standardize and harmonize the individual agreements between the members of the OECD, which is revised from time to time. Most recent agreements of Western countries follow the OECD standard, even with territories that are not themselves members of the OECD.
There are other model agreements in addition to the OECD, essentially the UN and US model agreements.
The UN Model Convention is designed for use with developing countries. Its main feature is that it leaves more taxing rights in the country where the type of income originates.
The OECD has prepared a commentary on its Model Convention, which explains the scope, terms and provisions in the Convention and is also revised from time to time. The tax administrations of the various countries and their jurisdictions essentially follow the Commentary or at least use it as an essential tool; however, there are occasional differences in interpretation and published “reservations” that set out a divergent understanding.
Establishment of an Agreement (OECD Model Convention)
The OECD Model Convention is structured in seven sections:
Sections I and II: Conditions of application, scope
Section III: Distribution standards for the taxation of income, broken down by type of income
Section IV: Distribution standards for the taxation of assets, broken down by type of asset
Section V: Elimination of double taxation in the State of residence if the rules of apportionment do not provide for a final legal consequence
Section VI: Non-discrimination, mutual agreement procedures between the two countries, exchange of information
Section VII: Final provisions (entry into force, termination)
The avoidance of double taxation in treaty law
The OECD Model Convention and DTAs based on it aim to limit withholding tax. The agreement contains the following measures to this end:
- Maintenance of withholding tax
This is done essentially by applying the principle of location. Under the Convention, income from immovable property is taxed by the state in which the property is located.
- Limitation of the tax base
– The permanent establishment principle is applied to company profits. According to this principle, the source state may only tax commercial income of non-resident companies if they have a permanent establishment in its territory.
– Income from employment is only taxed in the source State under the place of work principle if the work is carried out in its territory.
- Limitation of the tax rate
The tax rate is limited for income that is only loosely connected with the source state, such as dividends and interest, and in some DTAs also for royalties.
- Abolition of withholding tax
This should be done when only a very loose connection to the source state remains. According to the OECD agreement, this should be done in the case of royalties and pensions.
In the state of residence, the treatment of foreign income depends on how the taxation in the source state was determined:
- If the restricted conditions for taxation in the source state are not met or are eliminated, the income is subject to taxation in the state of residence.
- If the amount of taxation in the source state is limited, taxation will nevertheless take place in both the source state and the state of residence. The foreign tax is credited against the domestic tax under national law.
- If the source state is granted the exclusive right of taxation, double taxation is avoided under the treaty by means of the exemption method or alternatively the credit method.
DBA clauses to combat abuse
Double taxation conventions may contain various rules to ensure that the application of the convention does not result in the non-taxation of income or the unjustified use of tax benefits. The rules are set out in the following clauses, for example:
- Subject-to-tax clause
Some DTAs contain explicit tax reservations which make the exemption of income dependent on taxation in the other Contracting State. The clause may apply to all income or be limited to certain income. As a rule, this clause refers to the State of residence. The exemption of income in that State is dependent on the taxation of that income in the source State or the State of activity.
Occasionally, this clause is also applied to the source or activity State if the latter grants the reduction or exemption only subject to taxation in the State of residence.
- Remittance-base clause
Under the national law of some Contracting States, certain income is subject to taxation only if it has been transferred to or received in the Contracting State (see remittance basis taxation in the UK, Guernsey and Ireland). In such cases, some DTAs provide that the source State grants tax exemption or tax relief only to the extent that the income was actually transferred to or received in the other Contracting State and is therefore subject to taxation there.
- Switch-over clause
These clauses are agreed in order to avoid double taxation, double exemptions or low taxation which are caused by conflicts of qualification. According to these clauses, under certain conditions the state of residence may apply the imputation method instead of the exemption method. In cases of double taxation, however, the prerequisite is that no agreement could be reached in the mutual agreement procedure.
A company engaged in cross-border activities is confronted with a variety of legal systems with significant differences in the rules governing withholding tax. Each state decides independently and differently on which facts it wishes to subject to a tax liability that a non-resident taxpayer has realised on its territory. The existence of a DTA with the corresponding State of activity offers a certain degree of legal certainty with regard to the overall tax consequences.
For each individual case, careful planning of foreign withholding tax and its influence on the respective domestic taxation is essential within the framework of sound international tax planning.