In part 1 of this series of articles, we looked at how a typical Double Tax Agreement (‘DTA’) is used to determine the taxing rights of the two relevant countries, namely the country of residence of the individual or company, and the country where the income or capital gain arises.
In this article, we will consider how the relevant income or capital gain is taxed, the concept of a permanent establishment and why it matters, and general relief from double taxation. As in the previous article, we will use the UK/USA DTA as an example. Income from the US can be taxed in a few ways when the recipient is resident in the UK:
Rental profits on US property will be taxed in the US as well as in the UK, but with a credit for the US tax suffered.
Dividends paid by a US corporation to a UK resident will be taxed in the UK. They may also be taxed in the US, but limited to 5% where the beneficial owner is a company that owns at least 10% of the shares of the paying company, or otherwise 15%.
Interest arising in the US and owned by a UK resident is taxable only in the UK.
Pensions earned by a UK resident from a US source are taxable only in the UK.
There are conditions set out in the articles of the DTA in regard to the income types and gains, so the above are general rules only.
‘Permanent establishment’ (’PE’) means, in respect of say a UK company, a fixed place of business in the US through which the business of the UK company is carried on. Examples of a PE include a place of management, a branch, an office, a factory. Examples of what is not a PE include storage facilities, i.e. the maintenance of a stock of goods for storage, display, delivery or onward processing. Also excluded as a PE are a place of business solely for any one of or a combination of purchasing goods, collecting information or any preparatory or auxiliary activity.
The UK/US DTA then says a UK company may be taxed in the US where it has a PE in the US, but only on those business profits attributable to the US PE. The attributable profits are broadly those that would have been made in the US had the PE been a separate and independent company. The UK company will then include the results of the US PE in its own annual accounts, but will be able to claim a credit against its UK tax bill on the US tax suffered on its US source profits, thus avoiding double tax.
Three interesting issues that arise are:
- It is a highly subjective judgment as to what the ’attributable profits’ really are. This could involve a difficult negotiation involving both the IRS and HMRC.
- The level of control and authorisation carried out from the place of business is also critical to determining whether a PE exists or not. For example, the ability to conclude agreements by the people manning the place of business would increase the likelihood that there is a PE.
- Many DTAs, and the UK/US DTA is a case in point being some 16 years old, do not take into account the significant effects of the digital age. For example, where a UK company has a server in the US, does this constitute a US PE? Countries such as Italy and India, to name just two, have sought to redefine PEs to include services carried out through electronic means. These are generally services supplied through the internet or an electronic network, the nature of which makes the performance completely automatic, with minimum human intervention and for which the information technology component is essential. We can expect to see the traditional concept of a PE changing worldwide to recognise the digital economy.
In regard to Relief from Double Taxation, the relevant article of the UK/US DTA stipulates that tax due in either country by virtue of the DTA must be allowed as a tax credit in the other country. The net effect of this is that, where tax is due in both countries and the appropriate credit is given for tax paid or accrued in one of them, the overall tax rate on the relevant income or gain will be the higher of the two countries’ rates. Nonetheless, it is enshrined in the DTA that credit must be given by the ‘second taxing country’ for tax paid or accrued in the ’first taxing country’.
We hope that this and the previous article provide an overview of some of the more relevant terms of DTAs in general, using the UK/US DTA as a typical example. All DTAs are not the same, although generally based on the OECD model treaty. It therefore goes without saying that the relevant DTA should be checked in regard to situations where an income item or a gain arises in a country to a resident of the other country.Back to top