Many countries sign double taxation agreements with other countries to protect their citizens. Governments also want themselves to protect against tax avoidance and double taxation issues.
Two countries signing a DTA would need to agree on the terms and conditions. In particular, both countries would need to arrange the tie-breaker rules for DTAs.
Let us discuss the double taxation agreements and see how they benefit taxpayers and regulatory authorities.
Double Taxation Agreement – DTA
A double taxation agreement (DTA) or a double tax treaty is an agreement signed by two countries to avoid tax complications for their citizens and businesses.
A DTA has mainly two objectives; avoiding double taxation and avoiding tax evasion. The agreements are often bilateral but they may exist under compliance of a group or organization.
Double taxation treaties set rules for the collection of taxes from citizens and residents of both countries working across the borders. DTAs also define the tax rates for income tax, capital tax, estate, wealth, and other tax types.
DTAs are applicable for individuals as well as for the corporate sector. However, rules to define an individual resident and a resident business can differ drastically. Although the working mechanism and the idea remain the same for both.
How Does a Double Taxation Agreement Work?
Individuals and businesses work across borders all the time. It means there are at least two countries involved in the tax collection system. The first country is the source country (foreign) and the second is the residence country(home).
Both countries may have different tax regulations. Tax rates may also differ from one jurisdiction to another. Thus, individuals and businesses would like to pay taxes in a country with lower tax rates.
Two countries can arrange an agreement to collect taxes with mutual cooperation. They define rules for tax collection (tie-breakers), taxation rates, residency rules, and wealth repatriation.
Both countries can develop a mutual tax treaty or agreement. Most countries either follow the OECD or the UN double taxation models. Both of these taxation models provide certain benefits to the tax importing and exporting countries. Both countries in a DTA can take advantage of these rules if they have significant trade and/or overseas communities working across the border.
Defining Tie-Breaker Rules in DTAs
Tie-breaker rules help tax regulatory authorities in defining tax residency and tax collection procedures. Otherwise, both countries would have a claim on taxes due from an individual or a business.
Some general points regarding tie-breaker tax rules are listed here.
- Tie-breaker rules only apply if there is a double tax agreement or treaty between two countries. These rules may apply to individuals and businesses.
- The permanent home of the taxpayer is the primary criteria under the tie-breaker rules.
- If a tax payer has a permanent residency in both countries, then, tax authorities may need to determine the “center of vital interest” criteria. It means to determine the family, culture, wealth, and other interests of the taxpayer.
- If these steps cannot determine the tie-breaker, then the habitual country of residence of the taxpayer is determined.
- Both countries can determine tax residency based on the nationality of the taxpayer as well.
- Finally, if tax authorities cannot determine tax residency based on the tie-breaker rules, they can mutually agree on the tax collection arrangements of an individual.
Generally, tie-breaker rules would apply to individuals. Tax regulatory authorities may also set similar rules to determine the tax residency of corporate entities.
Why Do Countries Sign Double Taxation Agreements?
Double taxation agreements are signed to protect governments’ right to collect taxes. In practice, DTAs protect governments as well as taxpayers. Unlike the common notion, taxpayers can feel secure with a tax treaty.
Here are a few major motives to sign double tax agreements for most countries.
Avoiding Double Taxation
A government signs a double tax treaty with another country to protect its citizens and businesses against the risk of double taxation.
When there is a DTA between two countries, taxpayers would pay taxes in one jurisdiction only. Thus, saving them from additional costs of taxes.
Avoiding Tax Evasion
Perhaps the most important motive for governments to sign tax treaties is avoiding tax evasion. Taxpayers may evade taxes if they are tax residents of more than one country. They may do it deliberately or due to a lack of legislative enforcement.
Facilitation in Tax Collection
Double tax treaties make it easier for regulatory authorities to collect taxes. Without a strong tax collection system, governments wouldn’t achieve results.
Governments and regulatory authorities can work together to facilitate each other in tax collection. It can increase tax revenue for both countries significantly.
Compliance with International Regulatory Requirements
Another top reason why governments enter into double tax treaties is to stay compliant with the international regulatory requirements. For instance, countries in the EU region have to comply with tax regulations imposed by the EU.
Help in Anti-Money Laundering
Money laundering along with tax evasion are daunting challenges for many governments around the world. Double tax treaties can help governments with effective anti-money laundering and proper tax compliance.
Important Considerations with Double Taxation Agreements
Double tax treaties do not mean all taxpayers of both countries are granted tax relief. An individual or a business still has to go through the procedures of applying for tax relief under a DTA.
Both countries can agree on several requirements to declare an individual a tax resident in one country. Similarly, they may define corporate, income, wealth, and estate tax rates to be applied for tax residents of both countries across the border.
Another important consideration is to decide on the withholding tax. Both countries can decide on the withholding tax rates that are applicable for dividends and interest income earned in both countries.
Generally, two countries will adopt the same withholding tax rates (adjusted for exchange rates) to avoid tax evasion.
Examples
Let us consider a few hypothetical scenarios to understand how double tax agreements work.
Example Scenario 1:
Suppose an individual Mr. A is a citizen of the UK. He works in UAE and earns taxable income. Both countries have a double tax treaty.
Following information regarding Mr. A’s taxable income and income tax rates in both countries is available.
Taxable Annual Income = $ 10,000
Tax rate in the UK = 20% Tax rate in the UAE = 15%
The double tax framework would work as:
| Details | Amount $ | Amount $ | Amount $ |
| In UK – Home country | |||
| Income | 10,000 | ||
| Tax @ 20% | 2,000 | ||
| DTA relief | (1,500) | ||
| Net Payable | 500 | ||
| In UAE – Source Country | |||
| Income | 10,000 | ||
| Tax @ 15% | 1,500 | ||
| Total Tax Payable by Mr. A | 2,000 |
Example Scenario 2:
Suppose Mr. A is a citizen of the UK and has a job that requires him to work for 180 days in Spain. In the absence of a DTA between the UK and Spain, Mr. A would not be liable to any income tax during his 180 days stay in Spain.
In that scenario, tax collection authorities of both countries would lose tax revenue. Thus, a DTA would enable Spain to collect taxes from Mr. A on a temporary basis as well.
Benefits for Residents and Businesses
Unlike the common notion, double tax agreements are not a sword for residents and businesses across the globe. In practice, double tax agreements are as beneficial for taxpayers as they are for the regulatory authorities.
For instance, an individual has a pension income in one country (say with a tax rate of 10%) and residence in another country (say with 8%). In the absence of a DTA, the individual would be taxed twice on the retirement income.
In many scenarios, a taxpayer has the option to choose the lower of the two tax regimes. It can save money for individuals and help businesses stay competitive.
Benefits for Tax Regulatory Authorities
Double tax agreements offer many benefits to governments and regulatory authorities. As discussed above, avoiding tax evasion is the foremost motive for governments to sign DTAs with other countries.
DTAs also help governments in tax collections from taxpayers. Particularly, DTAs can help in tax collections from corporate taxpayers. In the absence of DTAs and other arrangements, corporate taxpayers would avoid taxes.
Another benefit for countries participating in DTAs is to attract investors. When investors know they have the protection of double tax treaties, they can invest in other countries freely.
Governments can also protect their citizens from double taxation costs with DTAs. In return, it helps governments to reduce the export of taxes to other countries.
Concluding Remarks
Double tax agreements are beneficial for taxpayers and tax authorities. DTAs can help avoid double taxation costs and tax evasion problems for both sides.
These arrangements also help governments increase their tax collections. Also, they can attract more foreign investors when they are protected against double taxation costs.
