Double tax agreements – How to avoid being taxed twice
Every country has its own tax laws, and if you are resident in one jurisdiction and have income from another, you may be obliged to pay tax on the same income in both locations.
What is double taxation?
The above is known as ‘double taxation’. In this article, we will explore this concept, what we mean by double taxation agreements and how these can be utilised to avoid being taxed twice.
What is a Double Taxation Agreement (DTA)?
A Double Taxation Agreement (DTA) is an agreement between two countries (known in DTA terminology as ‘contracting states’) drawn up in such a way as to avoid the same income, gain or asset being taxed twice. Most states’ DTAs are based on the Organisation for Economic Co-operation and Development (‘OECD’) model treaty. As a result, most DTAs have similar structures and there are generally many similarities between most DTAs.
The structure of a typical DTA includes the following ‘articles’:
- Taxes covered, e.g. income tax, capital gains tax, corporation tax, petroleum tax, etc.
- Residence – how the prime residence is determined when an individual or company appears to be resident in both states.
- Numerous articles dealing with how and where various types of income are taxed, e.g. rent, business profits, dividends, employment income, state and private pension receipts, etc.
- How and where capital gains are taxed.
- Relief from double taxation.
- Exchange of information.
…and many more.
Where should you be taxed?
Clients with international lifestyles frequently ask us questions on income tax laws. Examples include:
- If I live in Country A and have income from Country B, am I taxed twice on this income?
- If I live in Country A, but have a holiday home in Country B, a pension from Country C and a Buy to Let in Country D, where on earth am I taxed?
The starting point to answering these and similar questions is to check the DTAs between the country of residence and the country where the asset is situated or where the income arises. So, let’s take a whistle-stop tour of DTAs.
In numerous cases, both states may have taxing rights on certain income (rents are a typical example). Where the DTA permits both states to tax, the DTA will give guidance as to which state gets the first taxing rights. The second state can then tax the same income but must give a credit for the tax suffered in the first state. This credit however is limited to the tax payable in the second state. So, a taxpayer cannot claim a tax refund in either state if the tax in the second state is less than the tax in the first state. If it is more, the taxpayer pays the difference in the second state. Therefore, where both states tax, the total tax suffered will be the higher of the two states’ rates.
The UK/USA DTA
Taking the UK/USA DTA as an example, the residence article firstly defines what and who is included as a ‘resident’. Aside from an individual and a company/corporation, a resident includes a pension scheme, employee benefit trust, charity and other less obvious entities and organisations. The DTA then goes on to cover situations where an individual is a resident of both states. This is effectively a tie-breaker clause which determines which state has the first taxing rights, or in which country an individual or company is ‘more resident’. The order of how this is determined is by reference to:
- Where the individual has their permanent home, or if in both states;
- Where his/her centre of vital interests is, this being where his personal or economic relations are closer, or if this is inconclusive;
- Where he/she has a habitual abode, or if this is inconclusive;
- Of which state he/she is a national, or if this is inconclusive;
- Then the ‘competent authorities’ of the two states (in the case of the UK/USA DTA, this would be HMRC and the IRS) “shall endeavour to settle the question by mutual consent”. Heaven help the individual if that arises, which, in reality, it seldom does!
How will your income be taxed?
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)
‘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 does not classify as 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 taxation.
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 consider 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.
Regarding 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’.
How can Gerald Edelman help?
We hope that this article provides an overview of some of the more relevant terms of DTAs in general, using the UK/US DTA as a typical example. Not all DTAs are the same, although most are generally based on the OECD model treaty. It, therefore, goes without saying that the relevant DTA should be checked regarding situations where an income item or a gain arises in a country to a resident of the other country. For further guidance on double taxation agreements or for cross-border tax advice, please get in touch today.