ELIMINATION OF DOUBLE TAXATION
By: Maria Cristina Lima

WHAT IS DOUBLE TAXATION?

Defining double taxation is important. Thus, we can define the word taxation as the imposition a burden to the income of persons which was gained by the realization of a certain economic activity. The imposition of taxes derives from the sovereignty of a country that has the right to exercise it. Therefore double taxation can be found both in a domestic sphere and in the international one.

For the purpose of this article we are only referring to the international aspects of double taxation. We will only then be discussing “international double taxation” on its juridical and not on its pure economic sense.

In order to have an international double taxation the following elements must be present:

1. The imposition of the same or comparable income tax.

2. The existence of only one taxable person to which this tax is imposed in both countries.

3. That the imposition of mentioned tax is applied by two or more different authorities, in our case two different countries.

4. That mentioned tax is imposed on the same item of income, meaning that the cause that creates the tax is the same, and

5. That all above mentioned elements exists in the same tax period. This means that the taxes due will be applied simultaneously.

In other words, international double taxation can be defined as the imposition of the same or comparable tax imposed on a person by two different countries on the same item of income and on the same taxable period. This juridical definition is the most accepted by tax authors like Brian J. Arnold and Michel McIntyre where the time period and the source of income play a decisive roll.

METHODS OF ELIMINATING DOUBLE TAXATION

International double taxation cannot be eliminated completely but it can be avoided in different ways. For example, different methods can be applied such as the deduction method, the foreign tax credit method, and the exemption method. Application of either of these methods is decided by each sovereign country.

It is up to each country to decide how further their tax laws will reach its citizens or residents and this is why the international double taxation is an important juridical problem that touches different countries simultaneously.

Bilateral and multilateral treaties are also a way to harmonize the differences between different tax systems and avoid double taxation. International tax treaties are usually above the internal law of each country and sometimes even in a constitutional level.

Below is an explanation of the three methods above mentioned:

1. DEDUCTION METHOD

This method applies a deduction of the taxes that have to be paid in the country of residence of the taxpayer if the source of the taxable income is in another country and it has been already paid there.

Not many countries apply this method and this method it is not applied in the model treaties of the OECD and by the United Nations model. For this reason the deduction method will be not discussed further on this paper.

2. FOREIGN TAX CREDIT METHOD

This method applies a credit against taxes already paid in another country; mentioned credit is applied by the country of the residence of the tax payer. This method will consider a credit on the foreign taxes paid limiting it to the amount of the same domestic tax payable on the income of foreign source.

Foreign tax credit method is applied in countries mostly where the worldwide tax system is applied. Worldwide tax system is the one where all the citizens or residents of one country are subject to income tax but it doesn’t matter where they have earned their money (inshore or offshore.)

It is important to note that the worldwide tax system is related to the “capital import neutrality” and this means that they create a fair environment and invites local investments.

Foreign tax credit method can be complex and it is important that the tax laws of the countries involved are compatible in order that both of them applies a fair treatment for the taxpayer. I consider that this methods requires good bilateral or multilateral tax treaties in order to function well since good and effective tax treaties are vital to fight tax evasion and reduce tax avoidance.
Each sovereign country that applies the foreign tax credit method has to determine which people are considered residents or citizens and this is also a complication of the application of this method due to the fact that there are different approaches to said concepts.

3. EXEMPTION METHOD

This method proposes the non taxation of the income derived from a source outside of the country of residence of the taxpayer. In the exemption method only the domestic-source income is taxable.

This aid for international double taxation is mostly applied by countries with a territorial tax system. Territorial system is the one that imposes taxes according to the source of its related income, this means that a country can tax all persons (individual, corporation or any other juridical form) if the source of their incomes can be located in its territory.
Territorial system is also related to the “capital import Neutrality” where two players in the same country must pay the same taxes on the moneys earned in that country.

We can say that the exemption method is beneficial for the country that applies it because it encourages foreigners to invest in said country. For the tax authorities this method can be easy to administrate because it only requires good tax internal laws and do not depend on other countries.

A problem that we can find in applying this method is that sometimes the residents on the country that apply this method can end up paying more taxes than the foreign investors which can be considered unfair.

4. SIMILARITIES AND DIFFERENCES BETWEEN THE CREDIT METHOD AND THE EXEMPTION METHOD

Among the similarities of both systems we can find the following:

a. Both the tax credit method and the exemption method can produce similar results.

b. Both methods are accepted and used by the OECD and UN tax treaties models.

c. Both methods work for the relief of international double tax.

d. Both methods support the neutrality that has to be achieved by tax law.

Some of the differences between both tax systems are the following:

a. Foreign tax credit method can be very difficult to administrate by the countries authorities.

b. Foreign tax credit method can attract tax shopping which is not a good practice.

c. Foreign tax credit can be applied unilaterally and with the aid of bilateral agreements, exemption method is applied unilaterally.

WHICH METHOD IS BETTER?

Harmonization of different juridical systems and uniformity of international or internal taxation law is hard to achieve and each country applies the method that most suits them.

Countries that apply different systems have been done that for a reason and for very long time some of them because they have decided to do so and sometimes because they have inherited their tax system from the countries that once colonized them.

Both methods have its “pros” and “cons” because when one can be more effective but more complex and the other one can be less effective but less complex and easier to be administered.

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