Tax treaty
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Tax treaties exist between many countries on a bilateral basis to prevent double taxation (taxes levied twice on the same income, profit, capital gain, inheritance or other item).
Tax treaties tend not to exist when either party regards the other as a tax haven, for obvious reasons. There are a number of model tax treaties published by various national and international bodies, such as the United Nations and the OECD.
The concept of international double taxation
International double taxation, narrowly defined, occurs when two different states impose a comparable tax on the same potential taxpayer on the same taxable item. The concept has been defined more broadly, but with less precision, as the result of overlapping tax claims of two or more states. For example, someone who is resident for tax purposes in France and who makes an interest-bearing deposit with a bank in the UK is potentially exposed to income tax on the interest in the UK and in France.
The concept of international double taxation that bilateral tax treaties seek to remove is broader than the narrow definition. It includes some types of economic double taxation—that is, taxation of something already taxed under another country's laws whether or not it is formally subject to multiple levels of taxation. For example, many tax treaties operate to provide tax relief to a corporate group when a state has imposed a corporate income tax on profits earned by a subsidiary corporation and another state otherwise would impose a corporate income tax on its parent corporation when those profits are distributed as a dividend.
In general, tax treaties attempt to eliminate most forms of international double taxation, narrowly defined, and various other forms of international double taxation when a failure to do so would have a demonstrably harmful impact on international trade and investment.
A major goal of bilateral tax treaties is to remove impediments to international trade and investment by abating the risk of double taxation that can occur when both contracting states impose tax on the same income. This goal is advanced in four distinct ways.
- First, a bilateral tax treaty generally increases the extent to which exporters residing in one contracting state can engage in trading activity in the other contracting state without attracting tax liability in that latter. The second state can usually only impose tax on the business profits of a person who is resident in the other state if they operate in the second state through a permanent establishment there.
- Second, when a resident of a contracting state does engage in a sufficient activity in the other contracting state for that state to have the right to tax, the treaty establishes certain guidelines on how that income is to be taxed; that is, in general, which profits are attributable to the permanent establishment in the second state. For example, those guidelines may assign to one contracting state or the other the primary right of taxation with respect to particular categories of income. They may, in certain cases, provide for the allowance of deductions in measuring the amount of income subject to tax. They may require a reduction in the withholding taxes otherwise imposed by a contracting state on payments made to a resident of the other contracting state.
- Third, a bilateral tax treaty provides a dispute resolution mechanism that the contracting states may invoke to relieve double taxation in particular circumstances not dealt with explicitly under the treaty.
- Fourth, where income or gains remain in principle taxable in both contracting states, the state of residence of the taxpayer will relieve the double taxation that results either by allowing a credit for the tax paid in the other state or by exempting the income or gain from its own tax in practice.
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