Tax treaty
A tax treaty, also called double tax agreement (DTA) or double tax avoidance agreement (DTAA), is an agreement between two countries to avoid or mitigate double taxation. Such treaties may cover a range of taxes including income taxes, inheritance taxes, value added taxes, or other taxes.[1] Besides bilateral treaties, multilateral treaties are also in place. For example, European Union (EU) countries are parties to a multilateral agreement with respect to value added taxes under auspices of the EU, while a joint treaty on mutual administrative assistance of the Council of Europe and the Organisation for Economic Co-operation and Development (OECD) is open to all countries. Tax treaties tend to reduce taxes of one treaty country for residents of the other treaty country to reduce double taxation of the same income.
The provisions and goals vary significantly, with very few tax treaties being alike. Most treaties:
The stated goals for entering into a treaty often include reduction of double taxation, eliminating tax evasion, and encouraging cross-border trade efficiency.[3] It is generally accepted that tax treaties improve certainty for taxpayers and tax authorities in their international dealings.[4]
Several governments and organizations use model treaties as starting points. Double taxation treaties generally follow the OECD Model Convention[5] and the official commentary[6] and member comments thereon serve as a guidance as to interpretation by each member country. Other relevant models are the UN Model Convention,[7] in the case of treaties with developing countries and the US Model Convention,[8] in the case of treaties negotiated by the United States.
Income from employment[edit]
Most treaties provide mechanisms eliminating taxation of residents of one country by the other country where the amount or duration of performance of services is minimal but also taxing the income in the country performed where it is not minimal. Most treaties also provide special provisions for entertainers and athletes of one country having income in the other country, though such provisions vary highly. Also most treaties provide for limits to taxation of pension or other retirement income.[29]
Tax exemptions[edit]
Most treaties eliminate from taxation income of certain diplomatic personnel. Most tax treaties also provide that certain entities exempt from tax in one country are also exempt from tax in the other. Entities typically exempt include charities, pension trusts, and government owned entities. Many treaties provide for other exemptions from taxation that one or both countries as considered relevant under their governmental or economic system.[30]
Harmonization of tax rates[edit]
Tax treaties usually specify the same maximum rate of tax that may be imposed on some types of income. As an example, a treaty may provide that interest earned by a nonresident eligible for benefits under the treaty is taxed at no more than five percent (5%). However, local law in some cases may provide a lower rate of tax irrespective of the treaty. In such cases, the lower local law rate prevails.[31]
Provisions unique to inheritance taxes[edit]
Generally, income taxes and inheritance taxes are addressed in separate treaties.[32] Inheritance tax treaties often cover estate and gift taxes. Generally fiscal domicile under such treaties is defined by reference to domicile as opposed to tax residence. Such treaties specify what persons and property are subject to tax by each country upon transfer of the property by inheritance or gift. Some treaties specify which party bears the burden of such tax, but often such determination relies on local law (which may differ from country to country).
Most inheritance tax treaties permit each country to tax domiciliaries of the other country on real property situated in the taxing country, property forming a part of a trade or business in the taxing country, tangible movable property situated in the taxing country at the time of transfer (often excluding ships and aircraft operated internationally), and certain other items. Most treaties permit the estate or donor to claim certain deductions, exemptions, or credits in calculating the tax that might not otherwise be allowed to non-domiciliaries.[33]
Double tax relief[edit]
Nearly all tax treaties provide a specific mechanism for eliminating it, but the risk of double taxation is still potentially present. This mechanism usually requires that each country grant a credit for the taxes of the other country to reduce the taxes of a resident of the country. Seen in the US-India treaty, as per the DTAA, if interest income arises in India and the amount belongs to a US Resident, then the said amount shall be taxable in the US. However, such interest may be liable to tax in India as per the Indian Income Tax Act.[34] The treaty may or may not provide mechanisms for limiting this credit, and may or may not limit the application of local law mechanisms to do the same.[35]
Mutual enforcement[edit]
Taxpayers may relocate themselves and their assets to avoid paying taxes. Some treaties thus require each treaty country to assist the other in collection of taxes, to counter the revenue rule, and other enforcement of their tax rules.[36] Most tax treaties include, at a minimum, a requirement that the countries exchange of information needed to foster enforcement.[14]
Dispute resolution[edit]
Nearly all tax treaties provide some mechanism under which taxpayers and the countries can resolve disputes arising under the treaty.[38] Generally, the government agency responsible for conducting dispute resolution procedures under the treaty is referred to as the “competent authority” of the country. Competent authorities generally have the power to bind their government in specific cases. The treaty mechanism often calls for the competent authorities to attempt to agree in resolving disputes.
Limitations on benefits[edit]
Recent treaties of certain countries have contained an article intended to prevent "treaty shopping," which is the inappropriate use of tax treaties by residents of third states. These limitation on benefits articles deny the benefits of the tax treaty to residents that do not meet additional tests. Limitation on Benefits articles vary widely from treaty to treaty, and are often quite complex.[39] The treaties of some countries, such as the United Kingdom and Italy, focus on subjective purpose for a particular transaction, denying benefits where the transaction was entered into in order to obtain benefits under the treaty. Other countries, such as the United States, focus on the objective characteristics of the party seeking benefits. Generally, individuals and publicly traded companies and their subsidiaries are not adversely impacted by the provisions of a typical limitation of benefits provision in a U.S. tax treaty. With respect to other entities, the provisions tend to deny benefits where an entity seeking benefits is not sufficiently owned by residents of one of the treaty countries (or, in the case of treaties with members of a unified economic bloc such as the European Union or NAFTA, by "equivalent beneficiaries" in the same group of countries).[40] Even where entities are not owned by qualified residents, however, benefits are often available for income earned from the active conduct of a trade or business.[41]
Priority of law[edit]
Treaties are considered the supreme law of many countries. In those countries, treaty provisions fully override conflicting domestic law provisions. For example, many EU countries could not enforce their group relief schemes under the EU directives. In some countries, treaties are considered of equal weight to domestic law.[42] In those countries, a conflict between domestic law and the treaty must be resolved under the dispute resolution mechanisms of either domestic law or the treaty.[43]