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The home country often taxes the income using the residence principle, and the foreign country taxes the income using the source principle... Domestic double taxation may arise • with re

CHAP 3

DOUBLE TAXATION DOUBLE TAXATION RELIEF

LECTURER: Dang Thi Bach Van(MA)

Approach 1: Two kinds of double taxation:

• Economic

• Juridical

INTRODUCTION

• Economic double taxation is a broad term that covers any situation where an amount of income

is taxed twice

EX1: the case of the taxation of corporate profits These are subject to corporation tax and when the post-tax profits are distributed to shareholders in the form of dividends, the shareholders are subject to income tax in part or in full on the dividend they recieve

INTRODUCTION

• Economic double taxation is a broad term that

covers any situation where an amount of income is taxed twice

EX 2: when a worker spends the (post-income tax) wages, he may be subject to a consumption tax

 Note in international double taxation

INTRODUCTION

• Juridical double taxation occurs where more than one

country attempts to tax the same income It arises specifically because of a “jurisdictional” conflict in the rules that are used to determine residence and/or source

• Most commonly, juridical double taxation occurs because a

company or a individual has a source of income in a country other than the country of residence The home country often taxes the income using the residence principle, and the foreign country taxes the income using the source principle

• EX 5.1/p.98

INTRODUCTION

Types of double taxation:

• Source-source conflicts

• Residence-residence conflicts

• Residence-source conflicts

INTRODUCTION

• Two or more countries assert the right to tax

the same income of a taxpayer because they all claim the income is sourced in their country

Source-source conflicts

• Two or more countries assert the right to tax

the same income of a taxpayer because they claim the taxpayer is a resident of their country A taxpayer that is a resident of two countries is commonly referred to as a “dual- resident taxpayer”

Residence-residence conflicts

• One country asserts the right to tax

foreign-source income of a taxpayer because the taxpayer is a resident of that country, and another country asserts the right to tax the same income because the source of the income is in that country.

Residence-source conflicts

• Relief from double taxation resulting from the

imposition of tax by a residence country and a source country on the same income is ordinarily granted by the residence country.

•  the source country’s right to tax has priority

over the residence country’s right

• International double taxation (IDT) has been defined as the imposition of comparable income taxes by two or more sovereign

countries on the same item of income of the

same taxable person for the same taxable period.

•  Legal definition of IDT >< broader economic

concept of double taxation

International double taxation defined

• Under the broader approach, double taxation occurs whenever there is multiple taxation of the same items

of economic income.

• Under the legal definition, taxation of a subsidiary company by one country and the taxation of the parent company on a dividend from that subsidiary

by another country is not international double

taxation because the two companies are separate legal entities.

International double taxation defined

• IDT should be distinguished from internal of domestic double taxation Domestic double taxation may arise

• with respect to income earned by a corporation and distributed to its domestic shareholders under the so- called classical method of corporate taxation

• when tax is imposed on the income of a person by both the central government of a country and one or more of its political subdivisions.

International double taxation defined

• The country of residence adopt double taxation relief

to prevent or reduce the extent to which its residents are taxed more than once on the same income.

• Often set out in double tax treaties DTTs;

• In addition to the use of DTTs, most countries normally set out provisions for unilaterally relieving double taxation on their residents in their domestic law

Relief mechanisms

• The residence country allows its taxpayers to claim a deduction for taxes, including income taxes, paid to a foreign government in respect of foreign-source income.

Deduction method

• Countries using the deduction method tax their

residents on their worldwide income and allow those taxpayers to take a deduction for foreign taxes paid in the computation of their taxable income

• In effect, foreign taxes-income taxes and other types of

businesses or earning income in the foreign jurisdiction.

•  This is the least generous method of granting relief from international double taxation.

Deduction method

• Effect of the deduction method:

• Residents earning foreign-source income and paying foreign income taxes on that income are taxable at a higher combined tax rate than the rate applied to domestic-soure income

•  from the perspective of the total (combined domestic and foreign) tax burden on a taxpayer’s worldwide income, the deduction method does not achieve equal treatment of residents; is not neutral in terms of the allocation of resources between countries

Deduction method

• EX: assume that Fco, a foreign corporation, earns 100 and pays a foreign income tax of 20 Out of the remaining 80, Fco pays a dividend of 20 to

R, a resident of country A who owns 25 % of the shares of Fco Under these facts, R has itilized Fco to earn 25 of foreign source income on which a foreign income tax of 5 (1/4*20) was paid.

• If country A taxes R on income of 20, it is in effect allowing R a deduction for the 5 of income tax that was paid by Fco.

• Notes: a country that requires the associated tax to be added to net dividends is said to “ Gross up” the dividends The purpose of a gross-up rule is to provide equivalent treatment to taxpayers earning foreign income directly and taxpayers earning such income indirectly through a foreign corporation.

Deduction method

• Under the exemption method, the country of residence taxes its residents on their domestic-source income and exempts them from domestic tax on their foreign-source income.

• In effect, jurisdiction to tax rests exclusively with the country of source

•  The exemption method completely eliminates residence-source international double taxation because only one jurisdiction, the source country, is imposing tax.

Exemption method

• Foreign-source income, although exempt, may be taken into account in determining the rate of tax appliable to the taxpayer’s other taxable income

• In such systems, the foreign-source income is initially included in income for the limited purpose of determining the average tax rate at which the taxpayer would pay if the foreign income were taxable (the case of Netherlands)

Exemption with progression

• EX 1: assume that country A levies tax at 20% on the first 10,000

of income and at 40% on income in excess of 10,000 T, a taxpayer resident in country A, has 10,000 of domestic-source income and 10,000 of exempt foreign-source income T would pay tax of 2,000 (20% of 10,000) under a regular exemption system.

• Under an exemption with progression system, T must determine the average tax rate that would apply if his entire income of 20,000 were domestic-source income In this case, the average

rate would be 30% ((10,000* 20% + 10,000*40%) divided by

20,000)

Exemption with progression

• Several countries use the exemption method for active business income earned through a foreign branch or permanent establishment Several countries also exempt certain dividends received from foreign corporations in which resident corporations have a minimum ownership interest, usually 5% or 10% This exemption for dividends is often referred to as a participation exemption

Participation Exemption

• Under the credit method, foreign taxes paid by a resident taxpayers on foreign-source income generally reduce domestic taxes payable by the amount of the foreign tax.

• Credit countries do not pay tax refunds when their taxpayers pay a foreign income tax at an effective rate that is higher than the domestic effective tax rate Nor do they allow the excess foreign tax to offset taxes imposed on domestic income

 The credit for foreign taxes paid is usually limited to the amount of the domestic tax payable on the foreign-source income

CREDIT method

• GENERAL RULES:

• The credit method avoids the shortcomings of the deduction method Resident taxpayers are treated equally from the perspective of the total domestic and foreign tax burden, exept

if foreign taxes exceed domestic taxes

• Moreover, subject to the same exception, the credit method is neutral with respect to a resident taxpayer’s decision to invest domestically or abroad

• See ex/p.37

credit method

• On tax policy grounds, the credit method is generally recognized to be the best method for eliminating international double taxation

• Problems of the credit method:

(i) What foreign taxes are creditable?

(ii) How should the limitations on the credit be

calculated? On a source-by-source or item-by-item basis? On a country-by-country basis? Or on an overall basis, with various special rules applicable

to certain types of income? Or some combination of these methods?

Credit method

• Problems of the credit method:

• (iii) What rules should be adopted for determining the source of income and deductions?

• (iv) Should a credit be allowed for the underlying foreign taxes paid by a foreign affiliate on its income out of which it pays dividends?

Credit method

• Types of limitations:

(i) Under an overall or worldwide limitation, all foreign taxes

are agggregate  the credit is limited to the lesser of the aggregate of foreign taxes paid and the domestic tax payable

on the total amount of the taxpayer’s foreign source income;(ii) Under a country-by-country limitation, the credit is limited

to the lesser of the taxes paid to each foreign country;

(iii) Under an item-by-item limitation, the credit is limited to the

lesser of the foreign tax paid on each particular item of income and the domestic tax payable on that item of income (category of income)

Credit method

• INDIRECT CREDIT

• The indirect credit is a credit granted to a domestic corporation for the foreign income taxes paid by a

foreign affiliated company It is granted at the time

distribution from its foreign affiliate

• See ex/p42

Credit method

• A company resident in country A, where the rate of corporation tax

is 30%, has a branch in country B The country B branch pays country B profits tax on its profits at the rate of 35% Complete the following table:

LMS exercise: Compare the three methods

No relief Deduction Exemption Credit

Country B brandch profits 1000 1000 1000 1000

Country B tax @35%

Net after tax profits

Country A tax on 1000 @30%

Country A tax on 650 @ 30%

Credit for country B tax

Total tax paid

Effective tax rate (total tax/profits before

tax)

• When choosing which method, or combination of methods to employ, a country will need to consider the following factors:

• Capital export neutrality;

• Protection of it tax base; and

• The costs to state and to taxpayers of the method adopted.

p.101-105

Choosing between methods of double tax

relief

Two types of taxes that may be credited in connection with foreign dividends:

• Direct taxes on the foreign shareholder: withholding taxes

• Indirect taxes on income suffered by the foreign shareholder/head office – usually the foreign corporation tax

TYPES OF FOREIGN TAX WHICH MAY QUALIFY

FOR DOUBLE TAX RELIEF