Tax treaties

What Are Tax Treaties?

Tax treaties, also known as double taxation agreements (DTAs), are bilateral agreements between two countries that aim to prevent double taxation of income. These international taxation agreements establish clear rules for how residents and businesses operating across borders will be taxed by both jurisdictions. They are a fundamental component of international taxation, providing a framework to allocate taxing rights between countries, reduce tax barriers to cross-border investment, and foster economic cooperation.

Specifically, tax treaties address various types of income, such as dividends, interest, royalties, and capital gains, setting forth which country has the primary right to tax certain income, or how that income will be treated to avoid a taxpayer paying income tax on the same income twice.

History and Origin

The concept of international tax coordination emerged in the early 20th century, driven by increasing cross-border trade and investment that highlighted the problem of double taxation. Early efforts to mitigate this issue can be traced to the League of Nations, which published model tax conventions in the 1920s and 1940s. These models laid the groundwork for modern tax treaties by proposing standardized rules for allocating taxing rights between countries. Following World War II, the Organisation for Economic Co-operation and Development (OECD) took over this work, developing its own OECD Model Tax Convention on Income and on Capital in 1963, which has since become the most influential template for bilateral tax treaties worldwide. The OECD Model aims to prevent double taxation while also encouraging international trade and investment.¹¹, ¹², ¹³, ¹⁴, ¹⁵

In parallel, the United Nations (UN) developed its own model convention, the UN Model Double Taxation Convention between Developed and Developing Countries. The UN Model, first published in 1980, typically grants greater taxing rights to the "source country" (where the income arises), often favored by developing nations that are capital importers.¹⁰

Key Takeaways

• Tax treaties are bilateral agreements between countries to prevent the double taxation of income earned by residents or businesses operating internationally.
• They reduce or eliminate withholding tax rates on various income types like dividends, interest, and royalties.
• Tax treaties establish rules for determining tax residency and resolving disputes over tax claims.
• They provide mechanisms for the exchange of information between tax authorities to combat tax evasion and tax avoidance.
• Most treaties include a "saving clause" that allows a country to tax its own citizens and residents as if the treaty did not exist, though exceptions often apply for certain individuals like students or researchers.

Interpreting Tax Treaties

Interpreting tax treaties requires careful consideration of the specific language within each agreement, as their provisions can vary significantly between countries. Generally, tax treaties are structured to define the scope of application, specify taxing rights for different income categories, and outline methods for eliminating double taxation. For instance, a treaty might specify that corporate tax on business profits can only be taxed in the country where a company has a permanent establishment.

Individuals or corporations seeking to benefit from a tax treaty must typically demonstrate their eligibility, often by proving residency in one of the treaty countries. The application of treaty benefits is not always automatic; in many jurisdictions, taxpayers must actively claim these benefits, sometimes by filing specific forms with their domestic tax authorities. For example, in the U.S., taxpayers may need to file Form 8833 to claim treaty-based return positions.⁹

Hypothetical Example

Consider an individual, Sarah, a resident of Country A, who holds shares in a company based in Country B. The company in Country B pays Sarah annual dividends.

Without a tax treaty:
Country B's domestic law might impose a 25% withholding tax on dividends paid to non-residents. Sarah would receive the dividend minus this 25%. Then, Country A, where Sarah is a resident, would also tax her on that dividend income, potentially offering a foreign tax credit for the tax paid to Country B, but this can be complex and may not fully offset the foreign tax.

With a tax treaty:
If Country A and Country B have a tax treaty, it might stipulate a reduced withholding tax rate on dividends, say 10%. In this case, Country B would only withhold 10% of the dividend. Country A, Sarah's country of residence, would then tax the remaining dividend, but typically would provide a foreign tax credit for the 10% already paid to Country B, thereby preventing the income from being taxed twice on the same portion. This reduction in the withholding tax rate directly benefits Sarah by increasing her net income from the foreign investment and simplifying her tax obligations.

Practical Applications

Tax treaties have widespread practical applications in international finance and business. They are crucial for:

• International Investing: Investors engaging in cross-border investment can rely on treaties to understand their tax liabilities on foreign-sourced income, such as dividends, interest, and capital gains. This certainty helps in financial planning and portfolio diversification.
• Multinational Corporations: Businesses with operations in multiple countries utilize tax treaties to determine which country has the right to tax different streams of income, such as business profits or royalties, and to avoid unnecessary tax burdens on their global earnings.
• Expatriate Taxation: Individuals working or residing abroad often depend on tax treaties to clarify their residency status for tax purposes and to prevent their income from being taxed by both their home and host countries. The U.S. has income tax treaties with numerous foreign countries to address such situations.⁷, ⁸
• Dispute Resolution: Treaties typically include "Mutual Agreement Procedures" (MAPs) or provisions for arbitration, allowing tax authorities to resolve disputes over treaty interpretation or application, offering a pathway for taxpayers to address issues of double taxation.

Limitations and Criticisms

Despite their benefits, tax treaties face several limitations and criticisms. A primary concern is their potential for facilitating tax avoidance and tax evasion through "treaty shopping," where individuals or corporations try to inappropriately access treaty benefits by establishing legal entities in a third country solely to exploit favorable treaty provisions.⁶

Moreover, the complexity of negotiating and implementing a vast network of bilateral tax treaties can be substantial, leading to inconsistencies and difficulties in interpretation. Developing countries, in particular, sometimes criticize existing tax treaties for disproportionately favoring capital-exporting developed nations, which may result in a loss of potential tax revenue for the developing countries where economic activities or investments are taking place.⁴, ⁵

In response to these challenges, international bodies like the OECD and G20 launched the Base Erosion and Profit Shifting (BEPS) Project. The BEPS project aims to address strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. This initiative seeks to update international tax rules, including those embedded in tax treaties, to ensure profits are taxed where economic activities and value creation occur.¹, ², ³

Tax Treaties vs. Double Taxation

Tax treaties are a mechanism explicitly designed to mitigate or eliminate double taxation, whereas double taxation is the problem that arises when the same income is taxed in two different jurisdictions. Double taxation can occur due to overlapping tax claims where both the country of source (where the income is generated) and the country of residence (where the recipient lives) assert their right to tax the income. This overlap can significantly deter international trade and investment due to the increased tax burden.

Tax treaties address this by either assigning exclusive taxing rights to one country, providing for a reduced tax rate in one country, or obliging the country of residence to offer a foreign tax credit or exemption for the tax paid in the source country. Essentially, tax treaties are the solution, and double taxation is the problem they seek to resolve, ensuring a more predictable and equitable international tax environment.

FAQs

What is the primary purpose of a tax treaty?

The primary purpose of a tax treaty is to prevent the double taxation of income earned by individuals or businesses that operate across international borders. They achieve this by allocating taxing rights between the two signatory countries and providing mechanisms for tax relief.

How do tax treaties reduce tax burdens?

Tax treaties reduce tax burdens by setting reduced withholding tax rates on certain types of income (like dividends, interest, and royalties) or by granting exclusive taxing rights to one country, ensuring that the same income is not taxed twice. They also provide for methods like the foreign tax credit or exemption.

Do all countries have tax treaties with each other?

No, not all countries have tax treaties with each other. Tax treaties are bilateral agreements, meaning they are negotiated and signed between two specific countries. Therefore, the existence and terms of treaties vary widely across the globe.

Can tax treaties be changed?

Yes, tax treaties can be changed. They are formal agreements that can be renegotiated, amended through protocols, or even terminated by either signatory country. Changes often occur to reflect evolving economic conditions, international tax standards, or to address new forms of tax avoidance.

Do tax treaties cover all types of taxes?

Generally, tax treaties primarily cover income tax and capital taxes. They typically do not cover all types of taxes, such as consumption taxes (like VAT or sales tax) or local property taxes, unless specifically stated within the treaty.