How to Avoid Double Taxation: Tax Agreements

We’ll be diving into how to avoid double taxation when living abroad. First we will talk you through some theoretical issues. Next we will see how it applies to different countries, like the US and the UK.

First and foremost, what is double taxation?

Double taxation occurs when a taxpayer is taxed on the same income by more than one country. It happens to retirees living abroad, that my be taxed in their country of citizenship and in the country of residence.

Tax treaties To avoid double taxation, countries sign tax treaties. There are two main models for double taxation treaties:

While the UN (United Nations) Model Tax Convention on Income and on Capital is another influential model, it is more commonly used by some developing countries. As an example, Both the United States and the United Kingdom negotiate their double tax treaties based on the OECD Model.

How does it work?

Now, let’s discuss some practical tips individuals to avoid falling victim to double taxation. There are two regulations that complete the issue on non-residents:

1. Tax Administrations have tax conventions signed with different countries.
2. Tax administrations usually have their own regulations that will apply if there is not tax convention on the matter or there are some gaps on the tax convention.

If you need updated information, both the IRS and HMRC offer user-friendly online portals that make accessing information on tax agreements convenient. You can also find Tax Agreements in Spanish Tas Agency, AEAT.

Individuals are usually taxed based on their residency status. Tax treaties often include specific criteria for determining residency.

Conventions for Avoiding International Double Taxation in Detail

The most significant treaties and conventions in international direct taxation are the Conventions to Avoid International Double Taxation (CDI).

These are agreements between States, usually bilateral in nature, that are subject to International Law but also form part of the domestic legal framework.

CDI – Domestic Law Relationship

One issue that arises is the relationship between CDIs and other domestic regulations. It can be said that CDIs have precedence over domestic law. It is common to see articles in various tax laws with phrasing like: “This tax is governed by…without prejudice to what is established in the International Treaties or Conventions that have become part of the domestic framework.”

Processing of CDIs

Negotiating a CDI involves several stages before coming into force. It starts with negotiations between teams from both States, approval by Parliament, and publication in the Official Gazette.

When negotiating a CDI, countries generally use existing models, such as those by the OECD and the UN:

– The OECD Model (MCOECD) is the most widely used, favored by developed countries, and prefers taxation in the State of residence. The principle of worldwide income (taxation in the State of residence) assumes that the taxing power resides with the State where the holder of assets or the income recipient resides or is a national.

– The UN Model (MONU) is favored by developing countries and is more favorable to source taxation. The territoriality principle (taxation in the source State) attributes the power of taxation to the State where the assets are located or where the activity generating taxable profits is performed.

The fact that one of the countries negotiating a CDI uses a specific model does not mean the final agreement will adhere to that model. CDIs are the product of negotiation.

OECD Convention Model (MCOECD)

Background

Developed around 1921, the latest version was published in 2017. The title should encompass both objectives of the Conventions: “Convention to Eliminate Double Taxation on Income and Wealth and to Prevent Tax Evasion and Avoidance.”

– The convention defines two scopes:

  – A subjective scope: which individuals are considered residents.

  – An objective scope: which taxes are covered by the convention.

To consider someone a resident for CDI purposes, the MCOECD requires them to be subject to global income rather than territorial income, i.e., for all their income.

For individuals, it follows these successive criteria for determining residence:

– Permanent home, meaning a home owned, unless the person has a permanent home in both States.

– Center of vital interests if there is no permanent home or it cannot be determined.

– Habitual abode if the person resides in both States or neither.

– Nationality if the person has dual nationality or is not a national of either State.

– Common agreement between the two States if needed.

To Eliminate Double Taxation, the Convention Establishes Two Sets of Rules:

– First, it determines or allocates the respective taxing rights of the source State and the residence State of the income recipient.

– In some cases, exclusive taxation rights are granted to one of the contracting States, typically the residence State.

– For other income and wealth items, taxation rights are shared between the source and residence States.

– Second, when the provisions grant the source State a full or limited taxing right, the residence State must provide relief to avoid double taxation. The Convention allows contracting States to choose among three relief methods:

  – Exemption

  – Credit or offset.

  – Deduction

Classification of Income and Wealth According to the Applicable Regime in the Source State

A. Income and wealth that may be taxed without limitation in the source State

   – Income from immovable property located in that State, capital gains from disposing of such property, and the wealth it represents.

   Example:

   James, a resident of State A, owns a rental property in State B. State B may tax the rental income at a rate determined by its domestic law (without limitation). State A may also tax this income under James’s income tax, and subsequently, allow double taxation relief under the Convention.

   – Income from independent personal services attributable to a fixed base in that State. This concept is not included in the MCOECD because it is considered covered under the permanent establishment concept. However, many older Spanish CDIs retain it.

   Example:

   An architect residing in A receives fees from a company in B for an industrial building project in that State. B may tax the architect’s fees at a rate determined by its domestic law (without limitation). State A may also tax this income, subsequently allowing double taxation relief under the Convention.

   Salaries and pensions paid for public sector employment.

   Example: State A pays a public sector employee who has acquired habitual residence in State B. The only State that can tax the remuneration is State A.

B. Income categories subject to limited taxation in the source State:

   – Dividends: when the shares generating dividends are not effectively linked to a permanent establishment or fixed base in the source State, that State must limit its tax rate:

      – 5% on the gross amount of dividends if the beneficial owner is a company holding at least 25% of the paying company’s capital,

      – 15% in other cases (Article 10).

   Example: James, a resident of State A, holds shares in a company in State B. B can tax dividend distributions up to 15%. State A may also tax this income under James’s income tax, subsequently allowing double taxation relief under the Convention.

   – Interest: under the same conditions as for dividends, the source State must limit its tax to 10% of the gross amount.

C. Remaining income or wealth elements

   These cannot be taxed in the source State and are generally only taxable in the taxpayer’s residence State.

   Examples include:

   – Royalties,

   – Gains from disposal of shares and other securities,

   – Private sector pensions,

   – Amounts received by students for their studies or training,

   – Wealth

Methods for Eliminating Double Taxation with Examples

The MCOECD also regulates this matter.

If a taxpayer in a contracting State derives income from sources in the other contracting State or owns assets located in that other State, which, under the Convention, can only be taxed in the residence State, there is no double taxation issue since the source State must waive taxation on such income or wealth.

If, on the other hand, the income or assets may be taxed in the source State under the Convention, the residence State must eliminate double taxation using one of the exemption or credit methods discussed earlier.

Solutions to Eliminate Double Taxation in this scenario

• Income in country A: 1,000
• Income in country B: 5.000

– Exemption Method

The exemption method means the income is taxed in only one of the countries and is exempt in the other.

Two forms of exemption:

  – Full exemption: The residence State fully exempts income from the source State.

  – Progressive exemption: The residence State excludes foreign income from its tax base but considers it to determine the progressive rate applied to remaining income.

Full Exemption Example

– Credit Method

The credit method means the residence country includes global income in its tax calculation but allows the deduction of tax paid in the source country.

Two credit types:

  – Full credit: the residence country allows deduction of all tax paid in the source.

  – Ordinary or limited credit: the residence country sets a limit on the deductible tax.

   Full Credit Example

– Deduction Method

The deduction method allows the residence country to treat the foreign tax as a deductible expense from the taxable income in the residence country, reducing the tax base rather than the tax liability.

This method provides less relief than exemption or credit methods as it compensates only a proportional part of the foreign tax.

Deduction example