Tax treaty
Encyclopedia
Many countries have agreed with other countries in treaties to mitigate the effects of double taxation (tax treaties). Tax treaties may cover income taxes, inheritance taxes, value added taxes, or other taxes. Besides bilateral treaties, also multialteral countries are in place: Countries of the European Union
(EU) have also entered into a multilateral agreement with respect to value added taxes under auspices of the EU, while a joint treaty
of the Council of Europe
and the OECD exists open to all nations. Tax treaties tend to reduce taxes of one treaty country for residents of the other treaty country in order to reduce double taxation
of the same income. The provisions and goals vary highly; very few tax treaties are 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. It is generally accepted that tax treaties improve certainty for taxpayers and tax authorities in their international dealings.
Several governments and organizations have proposed model treaties to use as starting points in their own negotiations. The Organization for Economic Coorperation and Development (OECD, an inter-governmental organization) model treaty is often used as such a starting point. The OECD members have from time to time agreed on various provisions of the model treaty, and the official commentary and member comments thereon serve as a guidance as to interpretation by each member country.
Generally, individuals are considered resident under a tax treaty and subject to taxation where they maintain their primary place of abode. However, residence for treaty purposes extends well beyond the narrow scope of primary place of abode. For example, many countries also treat persons spending more than a fixed number of days in the country as residents. The United States includes citizens and green card holders, wherever living, as subject to taxation, and therefore as residents for tax treaty purposes. Because residence is defined so broadly, most treaties recognize that a person could meet the definition of residence in more than one jurisdiction (i.e., "dual residence") and provide a “tie breaker” clause. Such clauses typically have a hierarchy of three to five tests for resolving multiple residency, typically including permanent abode as a major factor. Tax residency rarely impacts citizenship or permanent resident status, though certain residency statuses under a country's immigration law may influence tax residency.
Entities may be considered resident based on their country of seat of management, their country of organization, or other factors. The criteria are often specified in a treaty, which may enhance or override local law. It is possible under most treaties for an entity to be resident in both countries, particularly where a treaty is between two countries that use different standards for residence under their domestic law. Some treaties provide “tie breaker” rules for entity residency, some do not. Residency is irrelevant in the case of some entities and/or types of income, as members of the entity rather than the entity are subject to tax.
While in general tax treaties do not specify a period of time for which business activities must be conducted through a location before it gives rise to a PE, most OECD member countries do not find a PE in cases in which a place of business exists for less than six months, absent special circumstances. Many treaties explicitly provide a longer threshold, commonly one year or more, for which a construction site must exist before it gives rise to a permanent establishment. In addition, some treaties, most commonly those in which at least one party is a developing country, contain provisions which deem a PE to exist if certain activities (such as services) are conducted for certain periods of time, even where a PE would not otherwise exist.
Even where a resident of one country does not conduct its business activities in another country through a fixed place or business, a PE may still be found to exist in that other country where the business is carried out through a person in that other country that has the authority to conclude contracts on behalf of the resident of the first country. Thus, a resident of one country cannot avoid being treated as having a PE by acting through a dependent agent rather than conducting its business directly. However, carrying on business through an independent agent will generally not result in a PE.
from the payment and remit it to the government. Such income often includes interest, dividends, royalties, and payments for technical assistance. Most tax treaties reduce or eliminate the amount of tax required to be withheld with respect to residents of a treaty country.
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 county 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.
The Working Group consisted of representatives from OECD Member countries as well as delegates from Aruba
, Bermuda
, Bahrain
, Cayman Islands
, Cyprus
, Isle of Man
, Malta
, Mauritius
, the Netherlands Antilles, the Seychelles
and San Marino
.
The Agreement grew out of the work undertaken by the OECD to address harmful tax practices. The lack of effective exchange of information is one of the key criteria in determining harmful tax practices. The mandate of the Working Group was to develop a legal instrument that could be used to establish effective exchange of information.
The Agreement represents the standard of effective exchange of information for the purposes of the OECD’s initiative on harmful tax practices. This Agreement, which was released in April 2002, is not a binding instrument but contains two models for bilateral agreements. A number of bilateral agreements have been based on this Agreement.
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
(EU) have also entered into a multilateral agreement with respect to value added taxes under auspices of the EU, while a joint treaty
Convention on mutual administrative assistance in tax matters
The Convention on mutual administrative assistance in tax matters is a convention developed by the OECD and the Council of Europe which is open to members of both organizations. The convention regulates information exchange between states parties on the exchange of information regarding to tax...
of the Council of Europe
Council of Europe
The Council of Europe is an international organisation promoting co-operation between all countries of Europe in the areas of legal standards, human rights, democratic development, the rule of law and cultural co-operation...
and the OECD exists open to all nations. Tax treaties tend to reduce taxes of one treaty country for residents of the other treaty country in order to reduce double taxation
Double taxation
Double taxation is the systematic imposition of two or more taxes on the same income , asset , or financial transaction . It refers to taxation by two or more countries of the same income, asset or transaction, for example income paid by an entity of one country to a resident of a different country...
of the same income. The provisions and goals vary highly; very few tax treaties are alike. Most treaties:
- define which taxes are covered and who is a resident and eligible for benefits,
- reduce the amounts of tax withheld from interest, dividends, and royalties paid by a resident of one country to residents of the other country,
- limit tax of one country on business income of a resident of the other country to that income from a permanent establishment in the first country,
- define circumstances in which income of individuals resident in one country will be taxed in the other country, including salary, self employment, pension, and other income,
- provide for exemption of certain types of organizations or individuals, and
- provide procedural frameworks for enforcement and dispute resolution.
The stated goals for entering into a treaty often include reduction of double taxation, eliminating tax evasion, and encouraging cross-border trade efficiency. It is generally accepted that tax treaties improve certainty for taxpayers and tax authorities in their international dealings.
Several governments and organizations have proposed model treaties to use as starting points in their own negotiations. The Organization for Economic Coorperation and Development (OECD, an inter-governmental organization) model treaty is often used as such a starting point. The OECD members have from time to time agreed on various provisions of the model treaty, and the official commentary and member comments thereon serve as a guidance as to interpretation by each member country.
Fiscal (Tax) Residency
In general, the benefits of tax treaties are available only to persons who are residents of one of the treaty countries. In most cases, a resident of a country is any person that is subject to tax under the domestic laws of that country by reason of domicile, residence, place of incorporation, or similar criteria.Generally, individuals are considered resident under a tax treaty and subject to taxation where they maintain their primary place of abode. However, residence for treaty purposes extends well beyond the narrow scope of primary place of abode. For example, many countries also treat persons spending more than a fixed number of days in the country as residents. The United States includes citizens and green card holders, wherever living, as subject to taxation, and therefore as residents for tax treaty purposes. Because residence is defined so broadly, most treaties recognize that a person could meet the definition of residence in more than one jurisdiction (i.e., "dual residence") and provide a “tie breaker” clause. Such clauses typically have a hierarchy of three to five tests for resolving multiple residency, typically including permanent abode as a major factor. Tax residency rarely impacts citizenship or permanent resident status, though certain residency statuses under a country's immigration law may influence tax residency.
Entities may be considered resident based on their country of seat of management, their country of organization, or other factors. The criteria are often specified in a treaty, which may enhance or override local law. It is possible under most treaties for an entity to be resident in both countries, particularly where a treaty is between two countries that use different standards for residence under their domestic law. Some treaties provide “tie breaker” rules for entity residency, some do not. Residency is irrelevant in the case of some entities and/or types of income, as members of the entity rather than the entity are subject to tax.
Permanent Establishment
Most treaties provide that business profits (sometimes defined in the treaty) of a resident of one country are subject to tax in the other country only if the profits arise through a permanent establishment in the other country. Many treaties, however, address certain types of business profits (such as directors' fees or income from the activities of athletes and entertainers) separately. Such treaties also define what constitutes a permanent establishment (PE). Most but not all tax treaties follow the definition of PE in the OECD Model Treaty. Under the OECD definition, a PE is a fixed place of business through which the business of an enterprise is carried on. Certain locations are specifically enumerated as examples of PEs, including branches, offices, workshops, and others. Specific exceptions from the definition of PE are also provided, such as a site where only preliminary or ancillary activities (such as warehousing of inventory, purchasing of goods, or collection of information) are conducted.While in general tax treaties do not specify a period of time for which business activities must be conducted through a location before it gives rise to a PE, most OECD member countries do not find a PE in cases in which a place of business exists for less than six months, absent special circumstances. Many treaties explicitly provide a longer threshold, commonly one year or more, for which a construction site must exist before it gives rise to a permanent establishment. In addition, some treaties, most commonly those in which at least one party is a developing country, contain provisions which deem a PE to exist if certain activities (such as services) are conducted for certain periods of time, even where a PE would not otherwise exist.
Even where a resident of one country does not conduct its business activities in another country through a fixed place or business, a PE may still be found to exist in that other country where the business is carried out through a person in that other country that has the authority to conclude contracts on behalf of the resident of the first country. Thus, a resident of one country cannot avoid being treated as having a PE by acting through a dependent agent rather than conducting its business directly. However, carrying on business through an independent agent will generally not result in a PE.
Withholding Taxes
Many tax systems provide for collection of tax from nonresidents by requiring payors of certain types of income to withhold taxWithholding tax
Withholding tax, also called retention tax, is a government requirement for the payer of an item of income to withhold or deduct tax from the payment, and pay that tax to the government. In most jurisdictions, withholding tax applies to employment income. Many jurisdictions also require...
from the payment and remit it to the government. Such income often includes interest, dividends, royalties, and payments for technical assistance. Most tax treaties reduce or eliminate the amount of tax required to be withheld with respect to residents of a treaty country.
Income from Employment
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.Tax Exemptions for Persons or Entities
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.Harmonization of Tax Rates
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.Provisions Unique to Inheritance Taxes
Generally, income taxes and inheritance taxes are addressed in separate treaties. Inheritance tax treaties often cover estate and gift taxes. Generally fiscal domicile under such treaties is defined by reference to domicileDomicile
*In architecture, a general term for a place of residence or "permanent residence" in legal terms*Domicile , the zodiac sign over which a planet has rulership...
as opposed to tax residence
Tax residence
Definitions of residence for tax purposes vary considerably from state to state. For individuals, physical presence in a state is an important factor. Some states also determine residency of an individual by reference to a variety of other factors, such as the ownership of a home or availability...
. 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 county 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.
Double Tax Relief
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. 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.Mutual Enforcement
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 and other enforcement of their tax rules. Most tax treaties include, at a minimum, a requirement that the countries exchange of information needed to foster enforcement.Tax Information Exchange Agreement
The purpose of this Agreement is to promote international co-operation in tax matters through exchange of information. It was developed by the OECD Global Forum Working Group on Effective Exchange of Information (“the Working Group”).The Working Group consisted of representatives from OECD Member countries as well as delegates from Aruba
Aruba
Aruba is a 33 km-long island of the Lesser Antilles in the southern Caribbean Sea, located 27 km north of the coast of Venezuela and 130 km east of Guajira Peninsula...
, Bermuda
Bermuda
Bermuda is a British overseas territory in the North Atlantic Ocean. Located off the east coast of the United States, its nearest landmass is Cape Hatteras, North Carolina, about to the west-northwest. It is about south of Halifax, Nova Scotia, Canada, and northeast of Miami, Florida...
, Bahrain
Bahrain
' , officially the Kingdom of Bahrain , is a small island state near the western shores of the Persian Gulf. It is ruled by the Al Khalifa royal family. The population in 2010 stood at 1,214,705, including 235,108 non-nationals. Formerly an emirate, Bahrain was declared a kingdom in 2002.Bahrain is...
, Cayman Islands
Cayman Islands
The Cayman Islands is a British Overseas Territory and overseas territory of the European Union located in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac, and Little Cayman, located south of Cuba and northwest of Jamaica...
, Cyprus
Cyprus
Cyprus , officially the Republic of Cyprus , is a Eurasian island country, member of the European Union, in the Eastern Mediterranean, east of Greece, south of Turkey, west of Syria and north of Egypt. It is the third largest island in the Mediterranean Sea.The earliest known human activity on the...
, Isle of Man
Isle of Man
The Isle of Man , otherwise known simply as Mann , is a self-governing British Crown Dependency, located in the Irish Sea between the islands of Great Britain and Ireland, within the British Isles. The head of state is Queen Elizabeth II, who holds the title of Lord of Mann. The Lord of Mann is...
, Malta
Malta
Malta , officially known as the Republic of Malta , is a Southern European country consisting of an archipelago situated in the centre of the Mediterranean, south of Sicily, east of Tunisia and north of Libya, with Gibraltar to the west and Alexandria to the east.Malta covers just over in...
, Mauritius
Mauritius
Mauritius , officially the Republic of Mauritius is an island nation off the southeast coast of the African continent in the southwest Indian Ocean, about east of Madagascar...
, the Netherlands Antilles, the Seychelles
Seychelles
Seychelles , officially the Republic of Seychelles , is an island country spanning an archipelago of 115 islands in the Indian Ocean, some east of mainland Africa, northeast of the island of Madagascar....
and San Marino
San Marino
San Marino, officially the Republic of San Marino , is a state situated on the Italian Peninsula on the eastern side of the Apennine Mountains. It is an enclave surrounded by Italy. Its size is just over with an estimated population of over 30,000. Its capital is the City of San Marino...
.
The Agreement grew out of the work undertaken by the OECD to address harmful tax practices. The lack of effective exchange of information is one of the key criteria in determining harmful tax practices. The mandate of the Working Group was to develop a legal instrument that could be used to establish effective exchange of information.
The Agreement represents the standard of effective exchange of information for the purposes of the OECD’s initiative on harmful tax practices. This Agreement, which was released in April 2002, is not a binding instrument but contains two models for bilateral agreements. A number of bilateral agreements have been based on this Agreement.