What is a Double Taxation Treaty?

A Double Taxation Treaty (DTT), is a bilateral agreement between two countries that aims to prevent the same income from being taxed twice by both nations.

Key Takeaways:

• DTTs prevent the same income from being taxed twice by establishing which country has the right to tax different income types (e.g., business profits, dividends, interest, etc.) based on factors like permanent establishment and tax residency.
• As DTTs are negotiated on a bilateral basis, the specific provisions can vary between different treaty pairs.
• DTTs incorporate mechanisms like mutual agreement procedures to resolve disputes between taxpayers and tax authorities. 

Tax Residency Rules 

Determining tax residency is the first step in applying the provisions of a double taxation treaty. Essentially, it's how a country claims the right to tax an individual or entity. These rules involve a combination of factors, including:

• Physical Presence: The amount of time an individual spends in a country is a primary factor in determining residency, with DTTs specifying a minimum number of days within a tax year to trigger residency.
• Domicile: An individual's domicile, or permanent home, can also be a determining factor, such that even if an individual spends significant time abroad, their domicile may still be in their home country, making them tax resident there as a result.
• Economic Interests: For both individuals and businesses, the location of economic interests, such as investments, property ownership, and business activities, can play a role in determining tax residency.
• Center of Vital Interests: Some treaties consider the location of an individual's family, social ties, and other personal interests as a factor in determining residency.

Methods for Eliminating Double Taxation in Treaties

As mentioned above, the main purpose of a double taxation treaty is to prevent different countries from taxing the same income twice. The two main methods for doing so are the exemption and credit methods.

Under the exemption method, the country where the taxpayer resides (the residence country) exempts certain types of foreign-sourced income from taxation. This means that the income is only taxed in the country where it is earned (the source country). This method is often used for income that is considered to be more closely connected to the source country, such as business profits earned through a permanent establishment in that country. Exemptions under this method can be full (meaning that the residence country completely exempts the foreign income from taxation) or partial (which is when only a portion of the foreign income is exempt, or the exemption is subject to certain limitations).

On the other hand, the credit method allows taxpayers to offset the taxes they paid on foreign-sourced income against their tax liability in their residence country. This means that the taxpayer receives a credit for the foreign taxes paid, reducing their domestic tax bill. The credit method is often used for income that is considered to be more closely connected to the residence country, such as employment income earned by a resident while working abroad temporarily. As is the case with the exemption method, the credit method can be applied in different ways. For example, some countries provide a full credit for foreign taxes paid, while others may limit the credit to the amount of domestic tax that would be payable on the foreign income.

Taxation of Different Income Types

DTTs not only address general principles like residency and methods for avoiding double taxation, but they also address how different categories of income are taxed:

• Business Profits: Business profits are often taxable only in the country where the business has a "permanent establishment" (a fixed place of business, such as an office or factory). This prevents businesses from being taxed in a country simply because they have sales or other activities there without a physical presence.
• Dividends: Treaties often reduce the withholding tax rate that the source country can impose on dividends paid to residents of the other treaty country to make it more attractive for investors to hold shares in foreign companies. (Note that dividends differ from business profits in that they represent a distribution of profits to investors, as opposed to business profits, which refers to income generated directly from business operations).
• Interest: Similar to dividends, treaties may reduce the withholding tax rate on interest payments to residents of the other treaty country.
• Royalties: These are payments made for the use of intellectual property, such as patents, copyrights, and trademarks. DTTs often reduce or eliminate withholding tax on royalty payments to encourage the cross-border transfer of technology and knowledge.
• Capital Gains: These are profits from the sale of assets, such as real estate or shares. DTTs may specify which country has the right to tax capital gains depending on the nature of the asset and the residency of the seller.

Dispute Resolution Mechanisms

Even with comprehensive treaty frameworks, disagreements can arise between taxpayers and tax authorities regarding treaty interpretation or application. To address such issues, DTTs include mechanisms to resolve disputes that may arise between taxpayers and tax authorities or between the tax authorities of the two contracting states, the primary of which are mutual agreement procedures (MAP), which allows certain designated officials (referred to as “Competent Authorities”) of the two countries to negotiate an agreement on the interpretation or application of the treaty.