The Benefits of Double Tax Treaties
Double tax treaties offer some substantial benefits to individuals and businesses that have international income.
A double tax treaty (DTT) is essentially an agreement between two countries that determines which country has the right to tax you in specified situations. The purpose behind this is to avoid double taxation.
It would be easy for a resident of one country to have income that arises in a second country. In this case both countries may want to tax the income (country 1 on the residence basis and country 2 on the source basis). This is where a DTT may come into play.
A treaty may state, for example, that certain types of capital gains should only be taxed in the country of residence, as opposed to the country where the asset is located. Or it may specifically provide for tax paid in one country to be deducted from the tax bill in another country.
However, the potential benefits of double tax treaties go far beyond this simple example.
I don't know if you've ever looked at a double tax treaty but they can be extremely difficult to follow. Most of the UK DTTs follow the standard OECD formula and below I've highlighted some of the most common provisions. Some of the provisions are self explanatory but are worth stating in case you ever want to review a tax treaty on your own. The first couple of articles usually look at what taxes the treaty will apply to and define any terms that are to be used. It's always worthwhile checking that the tax you're interested in is expressly stated in this section. It will say here exactly which taxes in both states the treaty applies to. So, for example, the UK-Cyprus treaty states that it covers income tax and corporation tax in the UK and just income tax in Cyprus (no mention of capital gains tax). On the other hand, the UK-France treaty covers UK income tax, capital gains tax and corporation tax, along with French income and corporation tax. Note that you won't find inheritance tax covered in these treaties. Inheritance tax treaties are completely separate and not as common as the income and corporation tax treaties. Treaties that cover inheritance tax are usually known as 'estate and gift tax' treaties. These focus on determining in which country an individual is subject to inheritance tax/estate tax and also on the location of assets for the purposes of charging estate taxes as well as providing for various exemptions. In terms of the income tax treaties, it's from Article IV onwards, though, that you'll find the really important stuff. Article IV -- Residence This article will determine where you are resident for tax purposes if you are a resident of two or more countries under the domestic tax laws of the countries concerned (this is commonly referred to as the 'treaty tie-breaker rules'). The OECD model treaty provides that:
So, if you are a resident of two countries based on their domestic rules, you would look at these tests to find out which country you are 'treaty resident' in to determine which country has the right to tax you. Becoming Treaty Resident Abroad An individual who is 'treaty resident' overseas is simply treated as non-resident for the purposes of the treaty. So, in the case of a UK resident individual treated as treaty resident overseas (eg by having their permanent home overseas) this means they are entitled to make claims for relief from UK tax as provided for under the agreement on the basis that they are a resident of the other State. As a result: How the Tie Breaker Rules Apply Permanent Home An individual will be considered resident in the country where they have their permanent home. For individuals with only one permanent home, this is easy to establish. The OECD commentary defines a permanent home as a permanent place of abode. So it could be simply a furnished room but it would need to be available continuously. The OECD commentary states: "As regards the concept of home, it should be observed that any form of home may be taken into account (house or apartment belonging to or rented by the individual, rented furnished room). But the permanence of the home is essential; this means that the individual has arranged to have the dwelling available to him at all times continuously, and not occasionally for the purpose of a stay which, owing to the reasons for it, is necessarily of short duration (travel for pleasure, business travel, educational travel, attending a course at a school, etc.)." Therefore to start with one looks for the country where there is a permanent home. If the individual has a permanent home in more than one country (or in no country) then you would look at the next test. Centre of Vital Interests The centre of vital interests test involves looking at an individual's personal and economic ties to determine to which country they are closer. The OECD commentary states that you need to look at all of the factors surrounding an individual's lifestyle: "The circumstances must be examined as a whole, but it would be nevertheless obvious that considerations based on the personal aspects of the individual must receive special attention. If a person who has a home in one State sets up a second in the other State while retaining the first, the fact that he retains the first in the environment where he has always lived, where he has worked, and where he has his family and possessions, can, together with other elements, go to demonstrate that he has retained his center of vital interests in the first State." Therefore an individual's centre of vital interest does not shift easily from one country to another. Habitual Abode If residency can't be resolved based on either of the above tests, then residency is determined based on the individual's habitual abode. An individual's 'habitual abode' is the state where the individual spent the most time. According to OECD commentary, the comparison must cover a sufficient length of time for it to be possible to determine whether the residence in either of the two states is habitual and to establish the intervals at which the stays took place. Nationality If a habitual abode exists in both states (or in neither) you'll assess treaty residence based on the country of citizenship. If an individual is a citizen of both states (or neither) treaty residence would usually be settled by the tax authorities of the relevant countries. Note though that not all agreements will follow these tie breaker rules. The agreement with the Gambia for instance provides: "…For the purposes of this Convention, the term 'resident of a territory' means subject to the provisions of paragraph (2) of this Article, any person who, under the law of that territory, is liable to taxation therein by reason of his domicile, residence, place of management or any other criterion of a similar nature. The terms 'resident of the United Kingdom' and 'resident of The Gambia' shall be construed accordingly…" This is therefore stating that an individual is a resident of one country if he is liable to tax due to his domicile, residence, place of management or any other criterion of a similar nature. This means there are no tie breaker rules as above and reinforces how important it is to actually check the terms of any particular treaty. Article V -- Permanent Establishment This looks at the definition of a permanent establishment. This is crucial for international traders as it will frequently dictate the
extent to which overseas trading activities will be taxed in an overseas jurisdiction. We'll look at this in a bit more detail shortly. Article VI -- Income from Real Property Typically real property is land and property, so this article would cover the treatment of rental income. In practically all treaties the source country (where the property is located) is given the right to tax rental income from the property, along with the country of residence. As no exemption is provided in the treaty, relief from double tax will usually be given by way of a tax credit for any overseas tax paid. Article XI -- Interest This article looks at the position where interest is paid by a resident of one country to a resident of another. The treaty between the two countries would usually look to either reduce any withholding taxes paid in the country where the interest is paid from, or state that the interest is exempt in the country of source. Article XIII -- Capital Gains This is the article that is of most importance for property investors looking to emigrate and sell up. It covers capital gains from the disposal of assets. In many cases there is a catch-all provision that capital gains remain taxable ONLY in the seller's country of residence, except for land which can also typically be taxed in the country where the land is located and some shareholdings. Article XIV -- Independent Personal Services This article looks at the taxation of income earned by self-employed people. If an individual has a 'fixed base' in another country, that country may tax any income that arises directly from that fixed base in a similar way that a business is taxed on profits from overseas permanent establishments. Article XV -- Dependent Personal Services This looks at the taxation of employment income. In many treaties if the income is paid by a foreign employer and the employee is not physically present in the UK for more than 183 days, the income will only be taxable in the employee's country of residence. Article XXIV -- Elimination of Double Taxation This allows what is already incorporated into UK tax law: the foreign tax credit. This article is a catch-all that prevents double taxation with respect to income not addressed above and allows a deduction for overseas tax paid. Article XXVII -- Exchange of Information This article is an agreement between the tax authorities to swap information to prevent tax evasion. All in all, the terms of double tax treaties can be immensely complex, although on a simple level they can provide for one country to have primary taxing rights over certain sources of income and gains. This is often more attractive than being subject to tax in both countries and then claiming a tax credit for the overseas tax paid. Permanent Establishment Usually if an individual has business activities in Country X which does not have a tax treaty with his country of residence, Country Y, the domestic tax laws of Country X will apply when deciding where the profits of the business will be taxed. This will usually mean the profits will be fully taxed in Country X. However, if there is a double tax treaty between Country X (country of residence) and Country Y (country where business activities carried out) business profits are not taxed in Country Y if there is no permanent establishment in Country Y -- the profits will only be taxed in Country X where the trader is resident. By contrast if a permanent establishment does exist in the overseas country, only the income derived from that permanent establishment is taxable. This is clearly of great benefit to international traders as it could restrict their tax liability in overseas jurisdictions.
The definition of a permanent establishment varies from treaty to treaty. Generally, the determination of whether a permanent establishment exists depends on two key issues: If a business has a facility such as a branch, an office, a factory, a construction site and so on, it will usually be deemed to have a permanent establishment. However, even if the business has one of these, it will not be deemed to have a permanent establishment if the facility is used solely for 'preparatory or auxiliary' activities. If a business has an agent in a treaty country who operates on its behalf and who exercises authority on its behalf to conclude contracts, this would indicate that there is a permanent establishment. Not all types of agents would be caught within the permanent establishment rules. A notable exception is commission agents who might generate orders but don't have the authority to actually bind the 'principal'. How to Avoid Overseas Activities Being Classed as a Permanent Establishment • Only carry out 'preparatory or auxiliary' activities. As mentioned above, a business won't have a permanent establishment if its activities in the treaty country amount to just 'preparatory or auxiliary' activities. In order to get classed within this category you'd be looking at activities that lead up to future trading -- for example, making enquiries or 'testing the water' in overseas markets. • Shortening the duration of construction, installation or consultancy projects. Whether a construction, installation or consultancy project constitutes a permanent establishment usually depends on how long the project lasts. For example, some treaties provide that a permanent establishment includes activities that continue for a period of more than six months. Provided you can ensure your activity in a particular country is less than this, there may be no permanent establishment. • Using independent agents to carry out business. Tax treaties usually provide that using agents will not constitute a permanent establishment. Typical provisions provide that: "an enterprise of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because it carries on business in that other State through a broker, general commission agent or any other agent of an independent status, provided that such a person is acting in the ordinary course of his business." In view of this, it's worth considering the advantages of using independent agents to carry out business in other countries. (Note that in addition to the potential tax benefits, there are other benefits in using independent agents to carry out business, for example better knowledge of local customers.) Dividends, Interest and Royalties As we've already seen, many overseas countries will not only try to tax your business profits but will also levy a withholding tax on dividends paid to shareholders. As a result, the total foreign taxes payable in an overseas country may be much higher than the income or corporation tax you suffer in your home jurisdiction. This is where tax treaties come to the rescue. They can help to alleviate this problem by providing reduced rates of withholding tax on dividends. Usually tax treaties provide relief in the form of lower tax rates for interest income or royalties and this may give rise to tax planning opportunities. Example Investco, resident in Country 3, is thinking of investing in Country 1. Investco also has a subsidiary (Subsidco) in Country 2. If the withholding tax rate between Country 1 and 2 is lower than that between Country 1 and the 3, Investco may consider using its subsidiary in Country 2 to carry out the investment, to take advantage of the lower withholding tax rate. At this point it's worth mentioning 'treaty shopping'. If the arrangement in the above example has no commercial purpose other than avoiding taxes, it might be regarded as 'treaty shopping'. Treaty shopping involves the use of a tax treaty by a person who is a resident of a third country (in other words not a resident of one of the two countries covered by the tax treaty). A common example of this is the use of the Netherlands to route royalty income to benefit from the lower rates of withholding tax. The problem of treaty shopping is worst for countries like the US which has withholding taxes which vary from treaty to treaty. As a result taxpayers have frequently taken advantage of the most favourable treaty.
However, all recent tax treaties entered into by the US include what's known as a limitation on benefits article. The main purpose of this article is to deny treaty benefits to a company that is resident in one of the treaty countries but is in effect serving as a channel for residents of a third country. If the article applies it will prevent the lower withholding taxes applying. So this could easily scupper any plans for using treaties to obtain lower withholding taxes. Note this problem only arises if there is a limitation of benefits article. Elimination of Double Taxation One of the basic objectives of tax treaties is to prevent income being taxed twice. This objective is generally achieved by an 'elimination of double taxation' provision which usually has similar wording to the following clause from the double tax treaty between the UK and Spain: "Where a resident of Spain derives income which, in accordance with the provisions of this Convention, may be taxed in the United Kingdom, Spain shall allow as a deduction from the tax on the income of that person an amount equal to the tax paid in the United Kingdom -- such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is appropriate to the income derived from the United Kingdom. The tax paid in the United Kingdom shall also be allowed as a deduction against the corresponding Spanish prepayment taxes. In essence this ensures you aren't taxed twice on the same income. In the case of the UK this provision is actually pretty superfluous as the UK operates its own system of double tax relief. This means that even if there is no double tax treaty in existence, a UK resident with overseas income would still usually get double tax relief. The elimination of withholding taxes makes an effective treaty network a valuable weapon in any tax minimisation 'arsenal'. This is particularly the case for offshore groups and for international trading, particularly in a group structure. This is where many tax havens fail to deliver as they are unlikely to have
any established treaty network. Instead countries such as the UK, Cyprus, Ireland and Gibraltar offer great opportunities. Overseas Workers If you're going overseas on a secondment you should also look at the relevant double tax treaty to see if it can yield any tax benefits. In the case of the UK, overseas workers who come to the UK and spend between six and twelve months in the UK may be able to make use of a suitable double tax treaty with the country they come from. Certain treaties will allow salary to be exempted from UK tax if a worker's presence in the UK is less than 183 days during the tax year. However, in order to qualify for this exemption the worker will need to satisfy a couple of conditions: Each treaty is different so you'll need to examine the particular treaty between your home country and where you'll be working to see if you qualify. Some treaties prevent tax year straddling by specifying that the presence in the UK must be for less than 183 days. Avoiding Capital Gains Tax (CGT) UK residents usually pay CGT on their worldwide capital gains. Tax planners used to suggest becoming non-resident/not ordinarily resident for one tax year and disposing of assets before returning to the UK. The UK Government subsequently tightened up the rules and now it is pretty much impossible to escape capital gains tax by leaving the country for a short time.
A UK resident would now normally need to be non UK resident for five complete tax years to avoid paying capital gains tax on profits. In the period to April 5th following your departure, your gains are taxed in the year the gain arises. From April 6th after your departure to the date of your return, your gains are usually taxed in the year you return (unless your are not resident for five full tax years or the gain is from assets bought and sold while not resident). Therefore if you're UK resident, you'll be subject to the five year non residence requirement to avoid UK capital gains tax, irrespective of what any double tax treaty says. He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice. He is now a full time tax author.
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Article I - Taxes Covered
What is a Permanent Establishment?About the Author
The Author of this article is our site Editor, Lee Hadnum. Lee is a rarity among tax advisers having both legal and chartered accountant qualifications. After qualifying a prize winner in the Institute of Chartered Accountants exams, he also went on to become a chartered tax adviser (CTA).
