The avoidance of double taxation

Many countries have bilateral tax treaties with other countries, mainly to avoid double taxation.

In 1921 the League of Nations commissioned a report concluding that double taxation interfered with “economic intercourse and ...the free flow of capital”.The report put forward some rules for determining when tax should be paid to the country in which income is generated and when it should be paid to the taxpayer’s home country.The outcome of this exercise was a model treaty that was subsequently adopted and modified by the OECD to become what is known as the OECD Model Tax Convention.

Double taxation of the same funds is invariably detrimental to international trade and investment.One way of avoiding double taxation is tax credits, which allows a firm to claim tax relief against the tax paid by its foreign subsidiaries.A subsidiary may be required to pay income tax and withholding tax in the host country.If the income received by the multinational firm is also subject to income tax in the home country, then there will be double taxation.A key point to realize here is that a tax must be considered to be income tax as a precondition for the underlying taxpayer becoming eligible for tax credit.Unlike income tax,VAT is eligible for deduction, not for credit.The problem is that what is considered as income tax in one country may not be so in another.

Differences in philosophy on how income should be taxed have given rise to treaties between countries to minimize the effect of double taxation on the taxpayer, protect each country’s right to collect taxes and provide ways to resolve jurisdictional issues.Tax treaties specify the classes of income that are not subject to tax, can reduce the rate on income and/or withholding taxes, and can specifically deal with the issue of tax credit.They may also deal with particular types of taxes that could be considered creditable.Tax treaties specify such issues as the taxes covered, the persons and organizations covered, relief from double taxation,the exchange of information between the authorities of the contracting countries and the conditions under which a treaty may be terminated.