Double taxation agreements: what they are and how they work
Everybody who deals with the topic of taxes will come into contact with a double taxation agreement at some point and will realize: it is not as bad as it sounds. This article is intended to provide an insight into this topic and to make it easier for anyone interested to get started.
In order to understand what a Double Taxation Agreement (DTA) is, and why DTAs are necessary, it is first necessary to understand the basic problem. This is especially true nowadays, when more and more people work internationally and generate income not only in one country, but in several countries or when multi national companies have worldwide operations and create profits and distribute dividends internationally. The basic situation already arises for individuals and for companies. For example if someone works in one country but lives in another country. In this respect, there is no internationally uniform regulation. It would be possible, for example, that everyone is taxed according to the source principle, i.e., the income is taxed in the country of origin, or according to the residence principle, i.e. the income is taxed in the country where the taxpayer lives or usually resides. Instead, the world income principle applies in many countries, which means that each country has a right to tax the income of residents, whether generated in its own country or not, and at the same time a right to tax income generated in its own country by non-residents.
In order to avoid this, however, DTAs are concluded between countries. In simple terms, a double taxation agreement assigns the right of taxation for selected sources of income to one country, provided that the income has a cross-country connection.
The Organization for Economic Cooperation and Development (OECD) has drawn up a model for double taxation agreements (“OECD-MA”), which many double taxation agreements have taken as a template. According to this model, usually the country of residence has the right to tax the income. Exceptionally, however, in the case of certain income, the source country is entitled to tax the income, such as in the case of artists, athletes or immovable assets.
II. Function of a double taxation agreement
Before any thought can be given whether a DTA can be applied and how, the following conditions must first be met.
a. Existence of a double taxation agreement
First of all, there must be a DTA in place. Even today, this is not necessarily the case. For example, there is no double taxation agreement between Germany and Hong Kong.
b. Tax residence in double taxation agreement taxation jurisdiction
In addition, the person concerned must also be resident in a contracting Country of the DTA, Art. 4 I OECD-MA. Please note that DTAs follow the rule that an individual or a legal person can only be a tax resident in one of the DTA jurisdictions, not in both. Thus, it might be quite complicated in certain cases to establish the tax residency of the person, which will then lead to the taxation or non-taxation of the income.
c. Existence of double taxation
As a final condition, it must be checked for both countries under consideration of the respective national law whether both countries are taxing the respective income. For more detailed assistance we refer to the picture at the end of the article. A DTA is only required if the same income is taxable in both DTA countries; given the fact for instance Hong Kong does not [SS1] impose tax on dividend, capital gains and interest, there might be cases that a DTA that Hong Kong concluded with another country might not be applicable because the dividend, capital gain or interest is only taxed in the other country but not in Hong Kong.
2. Avoidance of double taxation
a. Structure of DTA
In the following, the structure of a double taxation agreement, based on the OECD model, will be explained:
In the beginning, a double taxation agreement comes the scope of application. This is to check the applicability of the double taxation agreement, the personal, factual and temporal scope of the respective agreement must first be checked.
The rules about the scope are followed by definitions. For a simpler and clearer handling or understanding of certain terms, also in the international area, certain terms are first defined after the clarification of the scope. In particular, the establishment of a taxable permanent establishment is explained here, Art. 5 OECD-MA. This might be important because it can be the connecting factor for the taxation of corporate profits.
The main part of a double taxation agreement are the allocation norms, Art. 6-22 OECD-MA, which generally establish which of the parties have the right to tax certain income and profit. The allocation norms will be discussed in more detail below as they are the most important part of a DTA. The allocation norms are followed by the Tie-Breaker rule, which can usually be found in Art. 22 or Art. 23, which are required for cases where even after application of the allocation norm a double taxation exists.
In addition to the allocation for taxation, the OECD model also regulates procedural issues related to taxation, such as claims for information, and the relationship between the contracting parties.
b. Allocation norms, Art. 6-22 OECD-MA
In the allocation norms it is determined which contracting country is entitled to the right of taxation. The allocation of the right of taxation is based on the different types of income or profit. Thus, an allocation norm essentially consists of the type of income , followed by a rule to distinguish certain income from each other, the attribution to a taxpayer and finally the allocation of the right of taxation to one of the DTA countries.
With regard to the allocation, it should be noted, however, that insofar as a fact is so closely connected with a country, one cannot relinquish the right of taxation to another country.
For example, according to Art. 15 I OECD-MA, income from employment is taxed in the country of residence, but can also be taxed in the source country, if both country’s’ national tax law provide for the taxation of salary. Only Art. 15 II OECD-MA provides for a clear taxation in the country of residence, if the employee does not stay in the country of employment for more than 183 days within one tax year, and if the salary is not paid by or for an employer resident abroad and if the employer is not a resident of the employee's country of residence and if the salary is not borne by the permanent establishment in the source country.
The situation is similar with dividends Art. 10 OECD-MA, when a subsidiary distributes dividends to its shareholding entity in the other DTA countries. Here, too, the Article provides that the dividends may be taxed in the source country (country of the subsidiary) as a withholding tax as well as in the country of residence of the shareholding entity, if both national tax laws provide for the taxation of dividends
Further, Art. 10 II OECD-MA caps the right of taxation of the country in which the subsidiary resides (= withholding tax) under the following conditions: If the beneficial owner is a legal person and holds at least 25% of the subsidiary , then the withholding tax may not exceed 5% of the gross amount of the dividends. If, on the other hand, these conditions are not met, the withholding tax may not exceed 15%.
This means that in this case double taxation is possible, but capped for one country.
d. Tie breaker rule
As can be seen from the above examples, the allocation rules may clearly allocate the right of taxation to one of the countries, but must not, i.e., double taxation can still exist.
In order to avoid any double taxation in the allocation rules, two methods can be applied in a double taxation agreement: the credit method (Art. 23B OECD-MA) or the exemption method (Art. 23A OECD-MA). Under the OECD-MA, the exemption method is the method to be applied in principle. The credit method, on the other hand, is only applied to dividends and interest under the OECD-MA. Nevertheless, since the credit method is more favourable for the national tax authorities (as explained below), countries usually prefer to opt for the credit method when concluding DTAs.
By the exemption method, the income that is already taxed in one country, will not be taxed again in the other country, i.e. it is exempted from taxation there, and the income is not included in the tax base of the country.
Whereas the credit method, the tax payer, who paid already tax in the first country will only be allowed to credit the tax already paid against the tax payable in the other country.
For the taxpayer, the exemption method is the better option. This is due to the fact that with this method, the tax is not even incurred in the second country . On the other hand, with the credit method, it is quite possible that the taxpayer will also have to pay tax on the income in the other country, even if part of it is credited, so that the bottom line is that the taxpayer will in summary pay the tax on the income in the amount of tax that the higher taxing country will charge. In addition, the credit method leads to further obligations on the part of the taxpayer: the taxpayer must prove, on the basis of the tax assessment notice of the primary taxing country, that the taxes have already been paid to that effect and also in what amount. This task may involve linguistic hurdles as well as comprehension hurdles, which makes it much more unpleasant for the taxpayer.
3. Treaty Override
If a country deliberately disregards an existing double taxation agreement and taxes on income although it is not entitled to the right of taxation under the double taxation agreement, this is known as a "treaty override". The legal consequence is clear: the double taxation agreement is invalidated. The problem lies rather in the fact that in practice it is not always entirely clear when a treaty override is involved and when it is not. The OECD has tried to counteract this by issuing a report listing several situations that can lead to a treaty override. This can happen, for example, when a country enacts legislation that conflicts with the double tax agreement or when definitions are unilaterally changed.
In this context, for example, the German Federal Constitutional Court ruled in its decision 2 BvL 1/12 on December 15, 2015, that international agreements require a federal act to become effective. This means that these international agreements do not already apply upon ratification or entry into force, but require an act of implementation in the form of a federal law. This in turn means that the subsequent legislature can amend or repeal them. Thus, international agreements do not have a special position within the hierarchy of norms, but are equivalent to a federal law. Neither the constitutional principle of friendliness to international law nor the principle of the rule of law obliges Germany to comply with all international agreements without restriction. Thus, a treaty override can occur years or even decades later, even though everything was in order beforehand.
Even if the subject of taxation is not everyone's favourite topic, and even the term "double taxation agreements" suggests something more complicated behind it, overall, it is a manageable and not too complicated subject. However, to make sure everything has been considered and you are on the safe side, it is always a good idea to consult an attorney.
How to find out whether you need a double tax agreement at all:
Diagramm created by Janine Sauerborn
Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.
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