International tax treaties

What Are International Tax Treaties?

International tax treaties, also known as double taxation agreements (DTAs), are bilateral agreements between two countries designed to prevent individuals and businesses from being taxed twice on the same income or assets across different jurisdictions. These treaties are a fundamental component of international taxation, aiming to promote cross-border trade and cross-border investment by providing clarity and certainty regarding taxing rights. By establishing rules for the allocation of taxing authority, international tax treaties help mitigate double taxation and reduce barriers to global economic activity.

Such treaties often cover various types of income, including business profits, dividends, interest, royalties, and capital gains, and address issues like tax residency and the concept of a permanent establishment.

History and Origin

The origins of international tax treaties can be traced back to the early 20th century, spurred by the rise of international commerce and the associated complexities of taxing income earned across national borders. Before formalized agreements, businesses and individuals often faced situations where their income was subject to taxation in both the country where the income originated (source country) and their country of residence (residence country).

Early efforts to address double taxation began after World War I, with the League of Nations playing a pivotal role in developing initial model conventions in the 1920s and 1930s. This foundational work laid the groundwork for modern treaty frameworks. The Organization for European Economic Co-operation (OEEC), the precursor to the Organisation for Economic Co-operation and Development (OECD), took over this work, leading to the publication of the first draft of the OECD Model Tax Convention on Income and on Capital in 1963. This model has since become a global benchmark, forming the basis for over 3,000 tax treaties worldwide.¹⁰,⁹ Simultaneously, the United Nations (UN) also developed its own model, the UN Model Double Taxation Convention between Developed and Developing Countries, first published in 1980, which emphasizes source country taxation rights more than the OECD model, to better suit the needs of developing economies.⁸

Key Takeaways

• International tax treaties are bilateral agreements between countries designed to prevent the same income or assets from being taxed twice.
• They aim to facilitate cross-border economic activity by providing clarity on taxing rights and reducing tax barriers.
• Treaties often include mechanisms like tax credit and tax exemption to relieve double taxation.
• Key international organizations like the OECD and the UN publish model conventions that serve as templates for these agreements.
• While beneficial, international tax treaties face challenges related to tax avoidance and treaty abuse.

Interpreting International Tax Treaties

Interpreting international tax treaties requires a careful examination of their specific provisions, as the benefits and rules can vary significantly from one treaty to another. The primary goal of these treaties is typically to allocate taxing rights between the source country and the residence country, ensuring that taxpayers are not subject to withholding tax or other forms of taxation in both jurisdictions on the same income.

For individuals and corporations engaging in international transactions, understanding the applicable treaty is crucial for determining their tax obligations and potential reliefs. This often involves identifying one's tax residency under the treaty's tie-breaker rules and understanding how different categories of income (e.g., business profits, passive income) are treated. The Internal Revenue Service (IRS) provides guidance and forms for taxpayers to claim benefits under U.S. tax treaties.⁷,⁶

Hypothetical Example

Consider Sarah, a U.S. citizen residing in Country A, which has an international tax treaty with the United States. Sarah earns consulting income from clients in Country A and also receives dividends from stocks in a U.S. company. Without a tax treaty, both Country A and the U.S. might claim full taxing rights on her U.S.-sourced dividends, leading to double taxation.

Under the international tax treaty between the U.S. and Country A, there might be a provision stating that the residence country (Country A) has the primary right to tax Sarah's worldwide income, but the source country (U.S.) can impose a reduced withholding tax rate on the dividends. For instance, instead of the statutory U.S. 30% withholding tax on dividends for non-residents, the treaty might reduce it to 15%. Furthermore, Country A would then provide Sarah with a tax credit for the U.S. tax paid on the dividends, preventing double taxation and ensuring she pays tax only once on that income.

Practical Applications

International tax treaties are integral to global commerce and financial planning, appearing in various aspects of international finance:

• Corporate Taxation: Multinational corporations rely on international tax treaties to manage their global tax liabilities. Treaties define how business profits are attributed to a permanent establishment in a foreign country, affecting where and how corporate income is taxed.
• Individual Taxation: For expatriates, foreign workers, and pensioners living abroad, treaties determine how their wages, pensions, and other income streams are taxed, often providing relief from double taxation.
• Investment Income: Treaties set reduced withholding tax rates or exemptions on passive income like dividends, interest, and royalties paid across borders, encouraging cross-border investment.
• Dispute Resolution: Treaties often include mechanisms, such as Mutual Agreement Procedures (MAPs), for tax authorities to resolve disputes arising from the interpretation or application of the treaty, providing certainty for taxpayers. Taxpayers can claim benefits under tax treaties by following specific procedures, often involving forms provided by tax authorities like the IRS.⁵

Limitations and Criticisms

Despite their critical role in facilitating international trade and preventing double taxation, international tax treaties face several limitations and criticisms. A significant concern is the potential for "treaty shopping," a form of tax avoidance where multinational enterprises or individuals exploit treaty benefits unintended by the signatory countries. This often involves establishing shell companies in jurisdictions with favorable treaties to funnel income and reduce tax liabilities.⁴,³

The complexity of these treaties can also be a drawback. Navigating the intricate rules and conditions requires specialized knowledge, leading to increased compliance costs for businesses and individuals. Furthermore, the varying interpretations of treaty provisions across different tax jurisdictions can lead to uncertainty and disputes. In response to these challenges, international bodies like the OECD and G20 launched the Base Erosion and Profit Shifting (BEPS) project, which includes measures specifically aimed at preventing treaty abuse and ensuring that only legitimate residents qualify for treaty benefits.²,¹ Despite these efforts, some critics argue that the inherent structure of some treaties may still inadvertently create opportunities for fiscal evasion.

International Tax Treaties vs. Bilateral Investment Treaties

While both international tax treaties and bilateral investment treaties (BITs) are agreements between two countries aimed at facilitating cross-border economic activity, their primary focus differs significantly. International tax treaties specifically address the taxation of income and assets, seeking to prevent double taxation and fiscal evasion by allocating taxing rights between the signatory states. Their core purpose is to clarify which country has the authority to tax various types of income earned by residents or entities operating across borders.

In contrast, bilateral investment treaties (BITs) focus on protecting and promoting foreign direct investment. They establish safeguards for investors, such as fair and equitable treatment, protection against expropriation without compensation, and mechanisms for investor-state dispute resolution. While BITs can indirectly impact taxation by ensuring a stable and predictable investment environment, they do not directly dictate tax rates or the allocation of taxing rights in the same way that international tax treaties do.

FAQs

Q: What is the main purpose of an international tax treaty?
A: The main purpose of an international tax treaty is to prevent individuals and businesses from being taxed twice on the same income or assets when they have economic ties to two different countries. They also aim to prevent fiscal evasion and promote cross-border investment.

Q: How do international tax treaties prevent double taxation?
A: International tax treaties prevent double taxation primarily through two methods: the tax exemption method, where one country agrees not to tax certain income taxed in the other country, and the tax credit method, where a country allows a credit against its domestic tax for taxes paid in the other country.

Q: Who benefits from international tax treaties?
A: Both individuals and businesses engaged in international activities benefit from international tax treaties. This includes multinational corporations, expatriate workers, investors receiving foreign income like dividends or royalties, and foreign students or researchers who may be eligible for reduced tax rates.

Q: Are all international tax treaties the same?
A: No, while many international tax treaties are based on model conventions (like those from the OECD or UN), each treaty is a unique bilateral agreement. The specific provisions, tax rates, and definitions can vary significantly between treaties signed by different countries.

Q: What is "treaty shopping" and why is it a concern?
A: "Treaty shopping" is a form of tax avoidance where a person or entity not originally intended to benefit from a tax treaty attempts to indirectly claim its benefits by establishing an artificial presence in a treaty country. It is a concern because it can lead to unintended tax reductions and revenue loss for governments.