International double taxation results when the same income is being taxed twice: once in the state where the income arises (Country of Source) and another time in the state where the income is received (Country of Residence).
International double taxation arises because each country has its own sovereign right to tax income and own set of tax rules. The areas in which two countries’ tax systems could differ include:
Some countries are on the territorial system whereas others have adopted a worldwide taxation basis.
The source rules determine whether income is sourced in the state where income arises, or in the state where the income is received. Conflict of source rules can result in an income having a source in both countries.
- Rules for determining the tax residence of an individual or a company.
- Measures provided for under a country’s domestic laws to relieve double taxation.
Double taxation invariably increases the burden of tax on foreign income. This has a negative impact on cross-border movements of investment, technology and expertise.
To mitigate the effects of double taxation on its residents deriving income from outside its own national boundary, one measure that a country can take is to conclude a Double Tax Treaty (“DTT”) on a bilateral basis with other countries.
The DTT is an agreement usually entered into between two countries seeking to avoid double taxation. The main objective of a DTT is to provide certainty regarding when and how tax is to be imposed in the country where the income-producing activity is conducted or payment is made. In a DTT, the taxing right of each country is defined and there are provisions for one of the countries to give tax credit or exemption to eliminate double taxation.
Under a DTT, the taxation rights over income derived by a resident of one country from the other country can be allocated in any of the following ways:
- full rights to tax only in one country, i.e., the other country exempts the income. The full rights may be allocated either to the country of source or residence;
- full rights to tax by both countries but with tax in the source country limited to no more than a specified level and the country of residence giving a credit for tax paid in the source country. This form of allocation normally results in a sharing of tax between the two countries;
- full rights to tax by both countries without limitation and the country of residence giving a credit for tax paid in the source country.
Although an item of income may be deemed to be sourced in a particular country under that country’s domestic laws, that country could give up totally or partially the source taxation by agreeing to share the rights to tax with the DTT partner.
