07-12-2012

Double Tax Treaty

Authors

  • Angelos Exadaktylos, Attorney at law - Legal Consultant
    Associate at Papantoniou & Papantoniou LLC, Member of the European Law Firm,
    Advocates and Legal Consultants

Introduction:

It is very well known that International Taxation is one of the most difficult and complex matters to assemble and simplify. The internationalization of business, the multiplicity of taxpayer’s contracts with different countries, the functional, organizational and economic complexities associated with modern commerce, brought various challenges to the notion of the international tax order. Also, the numerous diverse tax provisions that many countries impose to resident and non-resident business entities, had nested many hazards. For example the increase of tax evasion, the potential discouragement to trade with other entities around the world, deterioration between countries good relationships and most important of all, a serious decline on the economic interests of business. Therefore, the path that significantly mitigates the potential aforementioned perils in this globalized environment is the mutual signature, ratification and implementation of Double Tax Treaties.

What is Double Taxation?

Double taxation is the systematic imposition of two or more taxes, on the same income (in the case of income tax), asset (in the case of capital taxes), or financial transactions (in the case of sales taxes). In other words 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.

The term ‘double taxation’ was used the first time in the USA. It was made in order to describe the fact that corporate profits are taxed and the shareholders of the corporation are subject to further personal taxation when they receive dividends or distributions of those profits.

What is the history behind Double Tax Treaties?

Tax Treaties derived from the late 19th and early 20th century from the “friendship, commerce and navigation” treaties. The League of Nations (first permanent international organization whose principal mission was to maintain world peace) sponsored the formative work on international tax issues, in order to avoid unjustified obstacles on business trading. This project was significantly influenced by the fundamental understanding that countries have an interest, both for themselves as nations and on their businesses, in avoiding hurdles that damage the trading relationships and commercial activities, occasioned by uncoordinated multiple taxation on the same income which the taxpayer must bare. Over the years, since the first treaties were negotiated at the beginning of the 20th century, Double Tax Treaties have become more standardized pursuant to the work of the OECD (Organization for Economic Co-operation and Development), which prepared its first draft Model Convention on income and capital in 1963. Although the Model Convention and its commentaries are insignificant to be a starting point in negotiating and interpreting Double Tax Treaties, it was used as guidelines in order to implement it in domestic law. Several governments and organizations have proposed model treaties to use as starting points in their own negotiations. The OECD members have from time to time agreed on various provisions of the model treaty, and the official commentary and member comments thereon served as a guide on implementing it by each member country. Several governments and organizations have proposed the Model treaties to use as starting points in their own negotiations.

How Corporate Double Taxation occurs?

On a globalized corporate essence, double taxation occurs because corporations are considered separate legal entities from their shareholders. Hence, corporations pay taxes on their annual earnings (company’s income: profit, dividends), just as individuals do. When a corporation from a resident country pay out dividends to shareholders and investors who reside in another country, those dividend payments incur income-tax liabilities for the shareholders who receive them, even though the earnings that provided the cash to pay the dividends were already taxed at the corporate level. Consequently, the country’s tax provisions may clash with the other country’s tax provisions and as a result corporations, shareholders and investors are burdened with more taxes and uncertainty.

What is a Double Tax Treaty (DTT) and how it applies?

DTT is a reciprocal/bilateral arrangement between two countries not to retax the repatriated income that a firm or person domiciled in one country earned in (and paid taxes on) the other. Also, a DTT may generally determine the amount of tax that a country can apply to a taxpayer’s income and wealth. DTTs 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. Therefore a credit is usually allowed against the tax imposed by the country in which the Company taxpayer resides for taxes imposed in the other treaty country and as a result the taxpayer pays no more than the higher of the two rates.

For example, Article 11 of the DTT between Cyprus and the United Kingdom provides that Dividends derived from a company, which is resident of the United Kingdom by a resident of Cyprus may be taxed in Cyprus. Where a resident of Cyprus is entitled to a tax credit in respect of such a dividend may also be charged in the United Kingdom and according to the laws of the United Kingdom on the aggregate of the amount or value of that dividend.

Furthermore the DTTs comprise the following functions:

  • 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

What are the advantages of the application of DTTs?

DTTs allow international business transactions to be handled with a high degree of certainty to the benefit of the individuals, corporate entities and partnerships involved. Also, the resolution of conflicts and uncertainties is also to the benefit of the governments of the relevant contracting states. In addition, the stated goals for entering into a DTT often include the elimination of tax evasion and encouraging cross-border trade efficiency.

The main advantages of DTTs can be identified as the following:

i) Clarification of taxing rights of each State

DTTs allow elucidation of taxation rights between states. The taxing rights given under the treaty only apply to residents of a particular country, and only in respect of taxes stated within the treaty.

ii) Avoidance of double international taxation

International double taxation is where the same profits are taxed in two or more States on the same legal or natural person (corporate or individual).

iii) Prevention of financial evasion by anti-avoidance provisions

DTT encourages the exchange of information and thus enables countries to obtain information in order to ensure its taxing rights are preserved. The various articles individually legislate wherever possible to prevent tax avoidance in clarifying what would be considered business profits, acceptable interest deductions, etc.

iv) Provides mechanisms on resolving issues that might arise on taxation

The Mutual Agreement Procedure Article is a very strong example. Where a resident of one Contracting State considers that has been imposed additional taxes by any of the two Contracting States, then it may present his case to the competent authority of the Contracting State that he is a resident. Thus, there is no need to seek any remedies from the other Contracting State that he is not a resident at. Also, the Article provides that the competent authorities of both Contracting States may communicate directly in order to exchange information on giving effect to the provisions of the DTT. This enhances the exchange of tax information of each country and eases the path to resolve potential issues that might arise.

v) Provide encouragement on exchanging information between countries on taxation matters

DTT contain provisions that have the tendency to enhance the exchange of tax information between countries. As a result commercial relationships on a global level become stronger and it brings the development of mutual understanding of different tax regimes.

Which countries are parties to DTTs?

Theoritically and practically high tax countries, have no reason to enter into DTTs with tax havens such as Bermuda and British Virgin Islands because those countries do not levy tax on profits. Also, Hong Kong, which has a source system taxation, may not worry about double taxation since non-local source profits are exempt from tax.

Low Tax countries which they are also characterized as tax havens because they offer several fiscal concessions may have double tax treaties but either they are few in number, or the countries with whom they negotiate may demand to impose limitations within the treaties. Countries such as the Channel islands, Leichtenstein, Malta and Cyprus have been a bright example on engaging into DTTs with other countries.

What makes Cyprus exceptionable, from other countries in the DTTs?

High tax countries need the widest range of DTTs to limit international double taxation. Their resident corporations require clarification as to what profits will be taxed and where. Also, high tax countries will often permit certain activities either to be exempt or impose a reduce rate of local tax through the DTT mechanism in order to stimulate international trade. Consequently, such countries will require anti-avoidance provisions to enable them to protect their tax revenue.

Cyprus is one of the few countries, which has generally been able to negotiate a wide range of treaties without limitations, although some exist in certain Cyprus treaties. For example, the treaties with the United Kingdom, United States of America, France, Germany and Canada, are comprised with a restrictive clause denying the benefits of the reduced rates to Cyprus offshore companies, but even these treaties may, in a number of cases, provide important tax advantages. Although British and French treaties exclude international business companies (IBC) from benefiting of the lower withholding taxes applicable to British and French dividends, royalties and interest, these treaties still have advantages to provide to IBCs, under the business and shipping profits articles, as well as for individuals.

Which countries has Cyprus signed DTTs?

Cyprus today has signed Double Tax Treaties with almost forty-eight countries and is still

negotiating with many others. The countries in an alphabetical order are: Azerbaijan, Armenia, Austria, Belarus, Belgium, Bulgaria, Canada, China, Czech Republic, Denmark, Egypt, France, Germany, Greece, Hungary, India, Ireland, Italy, Kuwait, Kyrgyzstan, Lebanon, Malta, Mauritius, Moldova, Norway, Poland, Qatar, Romania, Russia, San Marino, Serbia and Montenegro, Seychelles, Singapore, Slovakia, South Africa, Sweden, Swiss Confederation, Syria, Tadzhikistan, Thailand, United Arab Emirates, United Kingdom, United States of America, Uzbekistan.

What are the latest developments on Double Taxation?

In November 2011 the European Commission has issued a Communication titled Double Taxation in the Single Market. According to the EC, the double taxation in a cross-border context (different tax jurisdictions) represents an obstacle to the healthy function of the single market.

EC recognized that double taxation may increase the overall tax burden and therefore can have a negative impact on capital investment. Empirical research suggests that corporate taxation has a non-negligible impact on foreign direct investment location decisions. This suggests that double taxation within the EU may discourage non-EU investments and jeopardize the competitiveness of EU enterprises.

Moreover, the EC acknowledged that in the absence of actual tax data provided by national administrations, it is difficult to obtain completely reliable estimations on the direct impact of double taxation. In fact, taxpayers, if they have the choice, will avoid double taxation by adapting their conduct to the actual circumstances. Therefore, double taxation becomes not just a burden but even a barrier to economic activity.

Furthermore, the EC accepted that sometimes the elimination of double taxation, even when legally possible, would involve an excessive burden both in time and administrative costs. In addition, the accumulation of taxes imposed by more than one State might lead to results that, in some Member States at least, would be considered as confiscatory and thus unlawful.

Last but not least, the EC recognised that the existing instruments to relieve double taxation do not always function in an effective manner. In particular, the DTT provisions are not interpreted and implemented consistently by the Member State concerned. Such conflicting practices mainly concern the definition on royalties, business income, dividends and permanent establishment. As a result, taxpayers may suffer double taxation, contrary to the objective pursued by the DTT.

What possible solutions the EC is considering?

The EC recognized that the different double taxation problems may be addressed differently, some through bilateral tax conventions, some possibly through EU legislation, or in other ways through specific solutions and instruments.

The Commission considers that there is a need to complete the framework of a universal Double Tax Convention (DTC) between the 27 Member States and will encourage dialogue between them in case of a dispute impeding the conclusion of a DTC.

The Commission intends to examine with Member States and experts ways of addressing triangular situations and how to treat entities and taxes not covered by DTC within the EU. Also, one of the main aims is to accelerate and improve the procedures on resolving disputes that arise from double taxation.

What are the general conclusions on the developments of DTTs?

In general, Double Taxation is a problem that harms the business world and the financial markets. DTTs are eventually very well-built instruments that mitigate the negative effect that Double Taxation carries with. However the DTTs are not perfect practical instruments and contain some disadvantages too. At the moment, the European Commission recognizes the faults of the treaties and is planning to develop a more effective and extensive DTC. Cyprus has succeeded on signing a respectable amount of DTTs with many countries around the world. Hence Cyprus could be also a key player on assisting the European Commission on developing and improving a universal DTC, by providing the vast amount of experience that it gained from becoming an international financial center.

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