Introduction to the Law of Double Taxation Conventions
3. Aufl. 2021
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S. 9410. Methods for elimination of double taxation
10.1. The importance of the method article
10.1.1. Relation to the allocation rules
397
The methods for elimination of double taxation are set out as rules in Arts. 23A and/or 23B of the DTCs patterned after the OECD Model. Under the allocation rules, the residence state’s taxing rights are rarely excluded and the source state often keeps its taxing rights as well. The method articles address the residence state. When the residence state’s taxing rights are not excluded and a certain item of income may be taxed in the source state, the provision obliges the residence state to either exempt the income or credit the tax paid in the source state.
398
Example
A German resident company carries on its activity in part through a PE situated in Spain. Under Art. 7 of the Germany–Spain DTC, profits that are attributable to that PE may be taxed by Spain. Germany’s taxing rights with respect to those profits are not excluded by Art. 7 Germany–Spain DTC. Those profits may not be taxed, however, in Germany, according to Art. 22 of the Germany–Spain DTC (equivalent to Art. 23 of the OECD Model), since the exemption method applies with respect to that item of income.
399
The application of the method articles is not always necessary. In some cases, double taxation is avoided by the allocation rules themselves, namely when the allocation rules assign exclusive taxing rights to one state.
400
Example
The profits derived by the above German resident company are profits from the operation of ships or aircraft in international traffic. The place of effective management of the company is situated in Germany. Under Art. 8 of the Germany–Spain DTC, profits from the operation of ships or aircraft in international traffic shall be taxable only in Germany, notwithstanding the fact that a PE exists in Spain. Spain’s taxing rights are therefore excluded by Art. 8 of the Germany–Spain DTC. The application of Art. 22 of that DTC (equivalent to Art. 23 of the OECD Model) is thus unnecessary.
10.1.2. Credit and exemption method
401
Art. 23 OECD Model offers contracting states a choice between two methods for the elimination of double taxation: the exemption method and the credit method. During the negotiations of a DTC, the contracting states agree upon the method they will apply.
402
Commonwealth states, as well as certain African and Asian states tend to prefer the credit method (cf. m.no. 175 and 430 et seq.). In continental European S. 95countries, the exemption method (cf. m.no. 173 and 412 et seq.) is widespread, though the credit method is usually applied with respect to dividends, interest payments and royalties.
403
Under some DTCs, different methods apply depending on the residence state, i.e. on whether the person is a resident of one or of the other state. For example, under some DTCs, the credit method is applicable as far as residents of one contracting state are concerned, while the exemption method is applicable with respect to residents of the other contracting state.
404
Example
Under Art. 23 of the Australia–Austria DTC, different methods to avoid double taxation apply depending on whether the taxpayer is resident in Australia or in Austria. As a general rule, Australia, under the provision of Art. 23(1) of this DTC, shall grant a credit in respect of Austrian tax payable, whereas Art. 23(3) regulates that in Austria for the majority of sources of income the exemption method applies and for specific sources of income the credit method is used.
10.1.3. Switch-over clauses
405
Some states include switch-over clauses in their DTCs to allow a change from the exemption to the credit method in certain circumstances. The aim of these clauses is essentially to avoid double non-taxation, which can arise when the exemption method applies. These clauses can also apply in cases of abuse. Under the switch-over clauses, the residence state retains the right to apply the credit method instead of the exemption method, provided that certain conditions are fulfilled. This change of method can apply, for example, in cases of negative conflicts of qualification, i.e. circumstances in which double non-taxation arises as a consequence of the application of different provisions of the DTC to the same fact pattern by the two contracting states (cf. also m.no. 125).
406
Example
Under Sec. 6(c) of the Protocol to the Germany–India DTC, Germany shall avoid double taxation through the credit method and not through the exemption method where “income is placed under differing provisions … or attributed to different persons”, this conflict cannot be resolved by means of a mutual agreement procedure and this placement or attribution would either result in double taxation or in non-taxation, or inappropriately low taxation in India.
407
Art. 23A(4), added to the OECD Model in 2000, should generally have an effect similar to switch-over clauses as far as negative conflicts of qualification are concerned, i.e. to give the residence state the right to switch from the exemption method to the credit method where different interpretations of the DTC lead to double non-taxation or to the imposition of low taxes because of Art. 10(2) or Art. 11(2) OECD Model on dividends and interest. It is worth noting that the OECD Committee on Fiscal Affairs maintains that cases of negative conflicts of S. 96qualification are partially covered by paragraph 1 of Art. 23A (and of 23B) OECD Model. In particular, according to the OECD Committee, Art. 23A(1) allows a state to address negative conflicts of qualification which arise due to differences in the domestic law between the source state and the residence state, and Art. 23A(4) only covers negative conflicts of qualification that arise as a result of disagreements between the residence state and the source state on the facts of a case or on the interpretation of the provisions of the DTC. This approach is questionable, however, from a legal perspective (cf. m.no. 125 et seq.).
10.1.4. No effect of the method articles
408
The rules regarding the methods for the elimination of double taxation do not apply if, under the domestic law of the two contracting states of a certain DTC, the income is attributed to two different taxable persons, each of whom is a resident of a contracting state. DTCs do not provide any autonomous rules with respect to the attribution of income but rather follow the classification of the contracting states. Cases of double taxation have thus to be accepted if two states attribute the income to different persons.
409
Example
In the case UK, SCITD , Bayfine UK Products v. Revenue and Customs Commissioners (cf. m.no. 12) the income of a UK unlimited company was taxable both in the United Kingdom in the hands of the UK unlimited company itself and in the United States in the hands of the parent company of the UK unlimited company, since the UK unlimited company was classified as a disregarded entity for US income tax purposes. The income of the UK unlimited company was thus attributed to different persons by the two states. The United Kingdom stated that double taxation relief is not to be granted to the UK unlimited company under the UK–US DTC. The OECD Partnership Report (Example 18) proposes that in such a case, the United States is obliged to give credit for the taxes that are levied in the United Kingdom. However, in my opinion, the OECD Model does not grant an indirect tax credit and there is no systematic argument to ignore the treaty principles in this situation (cf. Lang, Partnerships, 95 et seq.).
410
Cases of double taxation may also arise when two contracting states impose tax on the same person but with regard to different situations. This can lead to double taxation that is not always prevented by DTCs.
411
Example
In 2009, a resident of State A bought shares in the amount of EUR 100 in a company that does not own immovable property. The person moved from State A to State B in 2017, when the shares had a value of EUR 1,000. The difference of EUR 900 was subject to an exit tax in State A, i.e. it was subject to tax in State A because the person lost her status as a resident of that state. State A claimed its right to tax according to Art. 21 OECD Model since it was the residence state at the time of the transfer of residence. If the person sells the shares in 2019 at EUR 1,000, State B has the exclusive right to tax according to Art. 13(5) of the State A–State B DTC patterned after the OECD Model. State B may therefore tax the gain, i.e. EUR 900.
S. 9710.2. Exemption method
10.2.1. Effects
412
The exemption method has effects on the taxable base in the residence state. The foreign income in respect of which a resident must be granted the exemption under the relevant DTC, is excluded from the taxable base. The applicable tax rate is not affected. The residence state may therefore consider the “exempt” foreign income when determining the applicable tax rates in order to safeguard the progression of the taxation.
413
The exemption method guarantees that an entrepreneur investing abroad is subject to the same tax burden as a competitor resident in the country in which the investment is made (“capital import neutrality”). No taxation accrues in the residence state (although the exempt income may be considered to safeguard the progression of the taxation; cf. m.no. 422 et seq.). The tax rate of the source state is therefore decisive.
414
Example
In the residence state the tax rate is 40%. In the source state the tax rate is 30%. If the exemption method applies and the taxing rights of the source state are not limited by any allocation rule, the income from a capital investment is subject to a 30% tax burden in the source state and is not subject to any taxation in the residence state. The residence state, however, may consider that income to determine the applicable tax rate. In contrast to the credit method, the overall tax rate on the income from the capital investment is not increased to 40%.
415
The exemption method applies irrespective of whether the other contracting state actually levies a tax on the income in question. The exemption method can therefore lead to double non-taxation when the source state has taxing rights under the DTC but does not levy any tax under its domestic law, and the residence state has no taxing rights (apart from the progression safeguard) since it must grant the exemption under Art. 23(1) OECD Model. The OECD Partnership Report, however, has led to an amendment of the OECD Commentary on Art. 23 with respect to cases where double non-taxation arises because of conflicts of qualification, which result from different domestic laws of the two contracting states, i.e. cases where the domestic laws of the two contracting states lead to different characterizations of a certain income and, in turn, to the application of different allocation rules by the two states. According to the amended OECD Commentary on Art. 23, in those cases, the residence state is not required to exempt the income pursuant to Art. 23A(1) OECD Model. The possibility for the residence state not to grant the exemption is, according to that statement, the consequence of the fact that the source state legitimately does not allocate the income to the same allocation rule as the residence state. It is not convincing, however, to infer this interpretation from DTCs patterned after the OECD Model (cf. m.no. 125 et seq.)
S. 98
416
If the DTC contains a “subject-to-tax clause”, the exemption will depend on whether taxes are levied in the source state. The OECD Model does not contain such a rule. Subject-to-tax clauses, however, are often found in DTCs. They are usually applicable to particular fact patterns but can also be of a general nature.
417
Example
On 17 Oct. 2007 the German Federal Tax Court issued its decision in a case regarding the subject-to-tax clause contained in the DTC between Germany and Italy (GE, BFH 17 Oct. 2007, I R 96/06). Subject to certain exceptions, Art. 24(3) of that DTC (Art. 23A OECD Model) provides for an exemption of the income that a German resident derives from Italy and that may be taxed in Italy under the DTC. However, Sec. 16(d) of the Protocol to the DTC reads as follows: “For the purposes of Article 24(3) income of a resident of a Contracting State is deemed to be derived from the other Contracting State, if it is effectively taxed in the other Contracting State in accordance with the treaty.” In the case at issue, a capital gain which might be taxed in Italy was not effectively taxed in Italy. The German Federal Tax Court ruled that Sec. 16(d) of the Protocol to the DTC had to be interpreted as a subject-to-tax clause and, consequently, the gain was not to be exempt from German tax under Art. 24(3) of the DTC.
10.2.2. Exemption from tax base
418
One debated issue is whether the exemption method applies with respect to both positive and negative items (profits and losses) or whether it applies only with respect to positive items (i.e. to profits only). In this regard, the courts of many states (e.g. Austria, Belgium, the Netherlands and Spain) have stated that the exemption only applies with regard to positive items, while the courts of other states (e.g. Germany, Greece and France) have instead maintained that it also applies with regard to negative items.
419
Example
An individual entrepreneur is a resident of Germany and carries on his activity in part through a place of business in Poland. The German profits of the individual entrepreneur amount to EUR 10 million. Through the place of business in Poland, however, the entrepreneur suffers losses of EUR 1 million. His worldwide income consequently amounts to EUR 9 million. According to the interpretation of the German courts, the Polish losses are “exempt” from tax in Germany, i.e. they are excluded from the German resident’s taxable base. Thus, the amount of income on which the tax is levied in Germany is EUR 10 million. Under the approach adopted by the courts of other states, the Polish losses should not be “exempt” from tax in Germany, so that the resident’s taxable base would be EUR 9 million.
420
Related to the question of the exemption of losses is the question of the deductibility of the expenses paid in order to obtain certain income that is exempt under the applicable DTC. Controversy often arises in relation to the allocation rule to which expenses should be assigned, since frequently a connection with several allocation rules exists. For example, certain expenses can be connected to either dividends (Art. 10 OECD Model) or capital gains (Art. 13 OECD Model). Expenses S. 99that can be assigned to more than one allocation rule are related to both items of income covered by those rules and no criterion exists to split those expenses between the two items of income. It thus makes sense to consider that these expenses are covered by Art. 7 or Art. 21 OECD Model. Since these allocation rules grant exclusive taxing rights to the residence state, the expenses are not exempt in the residence state under treaty law and therefore may reduce the resident’s taxable base.
421
Example
Under Art. 11(3)(a) of the Bangladesh–Turkey DTC, interest from Turkish bonds paid to the Bangladesh Bank shall be exempt from Turkish withholding tax (10%). However, capital gains from the sale of those bonds shall be taxable only in the state of which the alienator is a resident according to Art. 13(4) of the Bangladesh–Turkey DTC. If the purchase of the bonds is financed through borrowing, the question is whether the outbound financing costs should be added to the interest on the bonds (which is exempt from Turkish withholding tax) or to the capital gain from the sale of the bonds (which is taxable only in Bangladesh). Assigning those expenses to one or the other allocation rule affects the availability of a deduction from the Bangladesh resident’s taxable base.
10.2.3. Progression
422
Arts. 23A(3) and 23B(2) OECD Model contain a rule concerning progression (known as “proviso safeguarding progression”). According to this proviso, where, in accordance with any provision of the DTC, income derived or capital owned by a resident of a contracting state is exempt from tax in that state, that state may nevertheless, in calculating the amount of tax on the remaining income or capital of such resident, take into account the exempted income or capital. This rule does not provide a legal basis for the application of progression in itself. It merely clarifies that domestic rules on the determination of the applicable tax rate which aim to safeguard the progression of taxation are unaffected by Art. 23 OECD Model (cf. Vogel, DTC Art. 23, m.no. 71 et seq. and 208 et seq.).
423
According to the OECD Model, the proviso safeguarding progression is addressed to the residence state. It can therefore be inferred that only the residence state can claim the progression. Implicitly, therefore, the application of progression rules by a contracting state that is not the residence state is arguably excluded (cf. Djanani/Hartmann, IStR 2000, 321 et seq.). However, there are also court decisions in some countries, e.g. Germany, which state that the proviso safeguarding progression also addresses the source state because the provision only clarifies that it can be applied by the contracting states (cf. GE, BFH 19 Dec. 2001, I R 63/00; GE, BFH 15 May 2002, I R 40/01; GE, BFH 17 Dec. 2003, I R 14/02; GE, BFH , I R 110/05; partly discussed in Mössner, IStR 2002, 242; Kippenberg, IStR 2002, 243; Wassermeyer, IStR 2002, 289 et seq.; cf. also Vogel, DBA Art. 23, m.no. 46, 209 et seq.).
S. 100
424
Example
Mr X was a German resident and moved to the Netherlands during the calendar year. He gave up his German home and therefore his status as resident taxpayer in Germany and became a Dutch resident. According to the treaty Germany was not entitled to levy taxes on the income he received from Dutch sources after he left Germany. However, the German Federal Tax Court held that Germany may include that income when calculating the tax rate which was applicable on his German income. According to the Court it is not necessary that the treaty entitles a state to include the foreign income for that person. It is only relevant that the treaty does not forbid it (BFH 15 May 2002, I R 40/01). At the end this means that the proviso safeguarding the progression clause in Art. 23A OECD Model becomes meaningless if not only the resident state but also the other state may calculate the tax rate that way. However, from a systematic point of view it makes sense that both states include the income generated in the other state for calculating the tax rate because otherwise the treaty application would go beyond mere avoidance of double taxation.
425
The effect of the proviso safeguarding progression is that income that is exempt under the DTC may be included in the resident’s taxable base for the purposes of determining the tax rate. The calculation of the tax rate is regulated by domestic law. Normally, the average tax rate applicable is determined with respect to the resident’s entire income. This average tax rate is then applied to the resident’s taxable base, as reduced after the deduction of the income that is exempt under the DTC. Accordingly, the exemption with progression method does not cause the additional effect that the reduction of the resident’s taxable base also reduces the tax rate applicable to the resident’s residual income.
426
Example
The worldwide income of a resident of State A amounts to EUR 1 million, of which 400,000 is derived from residence State A and the remaining 600,000 from the source State B. Under the State A–State B DTC, State A applies the exemption with progression method towards the income derived in other states. Assume that in State A the rate of tax on income of up to 500,000 is 20% and on income above 500,000 40%. In this case, the tax rate applicable to the worldwide income of the resident taxpayer in the amount of EUR 1 million would be 40%. However, due to the application of the exemption with progression method, this rate will only be applicable to the income derived in residence State A. Hence, the tax due in State A will be calculated as follows: 400,000 × 40% = 160,000.
427
The average tax rate may not be applied, however, to that part of income that is subject to a reduced or increased flat tax rate under a specific domestic provision in the residence state. These peculiarities have to be taken into account when determining the taxable base in respect of which the average tax rate has to be applied. In addition, deductible items have to be taken into account in calculating the taxable base in connection with those items of income for which these expenses are paid or incurred. If the deductible items are paid in connection with exempt income, they cannot decrease the residual domestic taxable base. It is different if the deductible items are clearly connected with items of income that form part of the residual domestic taxable base (cf. m.no. 418 et seq.).
S. 101
428
Example
A resident of Austria receives income from employment exercised in Austria and derives business profits through a PE situated in Germany. In so far as certain income from employment is subject to a 6% flat tax rate, it must be excluded from the taxable base to which the average tax rate determined according to the progression clause is applied. In other words, the average tax rate determined by including income that is exempt under the Austria-Germany DTC (business profits derived through a PE situated in Germany) should be applied to income from employment. Yet that income has to be excluded from the taxable base to which the average tax rate has to be applied. Therefore, income from employment remains subject to a 6% flat tax rate.
429
Progression does not usually play any role with regard to the corporate income tax since the tax rate is usually flat. The average tax rate always remains the same. This also holds true in the case of negative progression. However, if the amount of foreign losses corresponds to the amount of domestic source income at such a rate that the worldwide income is zero, one could argue that the average corporate tax rate is 0%. This statement, however, is questionable from a legal standpoint (cf. Vogel, DTC Art. 23).
10.3. Credit method
10.3.1. Effects
430
When the credit method is applied, the residence state first determines the tax due under domestic law on the resident’s worldwide income in the absence of the DTC. This tax is then reduced by the foreign tax paid. The credit method has therefore no effect on the taxable base in the residence state. Positive and negative foreign items are ordinarily taken into account in the calculation of the taxable base. Double taxation is avoided only with respect to the amount of tax levied. If the tax rate is higher in the residence state than in the source state, the total tax burden will be equivalent to the higher rate found in the residence state. This phenomenon is known as “capital export neutrality”.
431
Example
In the source state profits are taxed at an average tax rate of 20%. Thus, if the source state income is EUR 100, the tax burden in the source state is EUR 20. If, however, the average tax rate is 50% in the residence state, taxes in the amount of EUR 50 arise. These taxes are reduced by EUR 20, representing the taxes paid in the source state, and thus equal EUR 30. The overall tax burden, however, amounts to EUR 50.
432
If the source state has a higher tax rate than the residence state, the higher tax burden of the source state remains when the ordinary credit method applies. The taxable base is determined in the residence state under domestic law, the tax is then calculated and the foreign taxes are deducted from that amount of tax. If, however, the tax burden is higher in the source state, the tax paid in the source state is not entirely credited. The overall tax burden corresponds in this case to the tax burden in the source state.
S. 102
433
Example
In the source state the tax rate is 50% whereas the tax rate is only 20% in the residence state. In the source state income in the amount of EUR 100 will be subject to a tax burden of EUR 50. When the credit method is applied, the income is also subject to tax in the residence state. On the basis of the tax rate in this contracting state, the tax burden is EUR 20. Foreign taxes in the amount of EUR 20 can be credited on the taxes of EUR 20, so that there is no actual tax burden in the residence state. However, the total tax burden, given the taxation in the source state, is EUR 50.
434
The credit method applies only with respect to foreign taxes paid by the same taxable person. A credit for the taxes paid by a different taxable person, such as the “underlying tax credit” (also known as “indirect tax credit”), is not granted unless the particular DTC or the domestic law provides otherwise.
435
Example
Company U is a resident of the United Kingdom and controls 50% of the voting power in Company A, a resident of Argentina. According to UK domestic law and to Art. 23(1)(b) Argentina–UK DTC, in cases in which at least 10% of the voting power is controlled, a tax credit shall be granted by the United Kingdom with regard to dividends, not only with respect to Argentinean tax levied in Argentina on Company U with regard to such dividends but also with respect to Argentinean tax paid by Company A with respect to the profits out of which such dividends are paid (“underlying tax”).
436
Similar problems arise when, under the domestic legal systems of the two contracting states, a certain item of income is regarded as belonging to two different taxable persons. In these cases, in my view, there is no legal basis under the DTC for claiming a credit, since the tax is levied in the source state on a different taxable person than that on which the tax is levied in the residence state.
437
Example
An Austrian corporation holds a participation in a Slovak entity, which is regarded as a taxable entity under Slovak law and as transparent under Austrian tax law. For Austrian tax purposes the entity is treated as a partnership and the income is taxed in Austria at the level of the Austrian corporation. In the Slovak Republic the profits are taxed in the hands of the entity. The DTC provides for the credit method. The OECD takes in its Partnership Report the view that in such a situation the Slovak tax may be credited against the tax levied at the level of the Austrian corporation (Partnership Report, m.no 139). In my view this goes too far: I do not see a legal basis to grant a credit for a tax which was paid by a different taxpayer.
10.3.2. Amount of allowable tax
438
The credit method provides for the taxes paid in the source state to offset the taxes to be paid in the residence state. However, only the amount of tax that is legally due in the source state is covered. Taxes erroneously paid to the source state are not required to be credited. Furthermore, taxes raised in the source state in excess of the limits set forth in the DTC do not have to be credited. If the S. 103source state does not refund the taxes erroneously paid, the taxpayer suffers the consequences.
439
Example
In 2007, an Italian resident company rendered services in Kazakhstan for a 7-month period. A withholding tax was levied in Kazakhstan on the payments to the Italian company. The Italian resident company asked the Italian tax authorities to issue a ruling to state that a tax credit was to be granted with respect to the taxes levied in Kazakhstan. The Italian tax authorities, however, denied the right for the Italian resident company to the tax credit (cf. IT, AE , Risoluzione N.277/E). They analysed the Italy–Kazakhstan DTC and found that business profits of Italian resident companies may be taxed in Kazakhstan to the extent they are attributable to a PE situated therein. They also found that for a PE to exist under the Italy–Kazakhstan DTC, services have to be rendered for a period of at least 12 months. The Italian tax authorities therefore concluded that no PE existed in Kazakhstan according to the relevant DTC and, accordingly, tax could not be levied in Kazakhstan on business profits of the Italian resident company. Consequently, they stated that no tax credit was to be granted to the Italian resident company, which should instead ask Kazakhstan for a refund of the tax paid therein.
440
The creditable taxes are limited to those which are effectively levied. If the source state levies an amount of tax that is lower than the maximum amount allowed under the DTC, the credit to be granted by the residence state is limited to the amount of tax effectively levied in the source state.
441
Example
A Spanish resident company holds a 5% participation in an Italian resident corporation. In 2009, dividends were paid by the Italian corporation. The Spanish company was the beneficial owner of those dividends. Under Art. 10(2) of the Italy–Spain DTC, a maximum of 15% withholding tax may be levied in Italy. However, only a 1.375% withholding tax was actually levied in Italy. According to Art. 22 of the Italy–Spain DTC, the credit method applies. Since the creditable taxes are limited to those which are effectively levied, Spain was obliged to grant a credit amounting to 1.375% of the dividends, even though the maximum withholding tax that may be levied in Italy was higher.
442
Some DTCs include exceptions to the above principle. In particular, a “matching credit” is sometimes granted under DTCs concluded with developing countries. Under this kind of credit method, a notional amount of foreign taxes established in the relevant allocation rule or in the method article is deemed to be levied at source and is credited by the residence state even if the tax is not actually levied in the source state or a lower amount of tax is levied. This provision is intended to stimulate capital investments in the developing country. The matching credit prevents the residence state from benefiting, in place of the investor, from the non-taxation or reduced taxation by the source state: in the absence of a matching credit mechanism, the residence state would simply credit less foreign tax and would therefore frustrate the non-taxation or reduced taxation by the source state. Under the matching credit, the benefit goes to the investor, since the residence S. 104state grants a credit on a notional basis irrespective of the amount of taxes paid in the source state. The investor obtains the advantage.
443
Example
A French company derives interest arising in Brazil. Under the Brazil–France DTC, this interest may be taxed in Brazil. According to Art. XXII(2)(c) of the Brazil–France DTC, with regard to interest which has borne Brazilian tax in accordance with the provisions of the DTC, France shall allow its residents receiving such income a tax credit corresponding to the amount of Brazilian tax that has been paid, within the limits which the French tax establishes in such income. Under Art. XXII(2)(d) of the Brazil–France DTC, with regard to interest, the Brazilian tax shall be considered to have been levied at a minimum rate of 20%. The French company deriving interest arising in Brazil is thus entitled to a tax credit corresponding to at least 20% of the interest, irrespective of whether lower tax is actually levied in Brazil.
444
Some DTCs provide for another kind of credit method based on notional amounts, which is known as a “tax sparing credit”. Under the tax sparing credit, when an exemption or reduction is granted in the source state, the residence state grants a credit on the basis of the (fictitious) amount of foreign taxes, which the source state would levy if no exemption or reduction were granted.
445
Example
A Belgian company derives interest arising in India. This interest may be taxed in India under the Belgium–India DTC. According to Art. 23(3)(b)(i) of the Belgium–India DTC, when a resident of Belgium derives interest taxable in India in accordance with Art. 11(2) or (6), the Indian tax levied on that income shall be allowed as a credit against Belgian tax related to such income in accordance with Belgian provisions of law. Art. 23(3)(e) of the Belgium–India DTC also provides that: “For the purposes of sub-paragraph (b)(i) the term ‘Indian tax levied’ shall be deemed to include any amount which would have been payable as Indian tax under the laws of India and in accordance with the provisions of the Agreement for any year …”, except for some exemptions or reductions listed in that provision of the DTC. Based on the above, the Belgian company deriving interest from India is entitled to a tax credit for the amount of taxes that would have been payable as Indian tax, even if no taxes are actually levied in India (unless the non-taxation in India is grounded on those exemptions or reductions that are listed in the Belgium–India DTC).
10.3.3. Maximum credit
446
DTCs generally set forth a maximum credit that must be granted. The amount of tax which must be credited may not exceed the tax that the resident would pay in the residence state on the same (foreign) item of income. This is known as “ordinary credit”. This means that in order for a credit to be granted, a tax on the same (foreign) item of income must first of all be due in the residence state. If no tax is due in the residence state in the same tax period, the tax paid in the source state is not credited. According to the OECD Commentary on Art. 23A and 23B (at para. 32.8), the residence state must nonetheless grant the credit when the lack of tax due in the residence state is the consequence of a timing mismatch.
S. 105
447
Example
An Argentinean corporation derives business profits from a PE in Russia and receives royalties arising in Russia. The royalties amount to RUB 5 million. However, the PE suffers losses amounting to RUB 5 million as well. Under the Argentina–Russia DTC, the ordinary credit method applies. The taxable base in Argentina on the Russian-sourced income is 0, since the losses suffered through the PE offset the royalties. Therefore, in this fiscal year no tax is due in Argentina on Russian-sourced income. Any tax at source which may be raised in Russia in respect of the royalties can, according to the treaty, consequently not be credited against any Argentinean tax.
448
The maximum credit limitation is usually applied according to one of the following approaches: the “overall limitation” and the “per-country limitation”. Under the “overall limitation”, the aggregate amount of taxes paid in all source states may be credited up to the amount of tax due in the residence state on the aggregate amount of items of creditable income from all source states. Under the “per-country limitation”, the tax paid in a certain source state may be credited up to the amount of tax due in the residence state as determined on the aggregate amount of items of income derived from the former state; items of income derived from other contracting states are thus disregarded. Sometimes a “per-item limitation” is implemented in addition to one of the above limitations (the “overall limitation” or the “per-country limitation”). Under the “per-item limitation”, the tax paid per a certain category of income may be credited up to the amount of tax due in the residence state as determined on the aggregate amount of tax paid for a certain category of income.
449
Example
Company A is a resident of State A and has a PE in State A and a PE in State B. Company A also derives income from interest arising in State C. In the fiscal year concerned, no profits are derived through the PE in State A; profits amounting to EUR 1 million are derived through the PE in State B, in respect of which a tax of EUR 250,000 is levied (25%); interest amounting to EUR 500,000 arises in State C, in respect of which a tax of EUR 50,000 is levied (10%). Company A’s worldwide income amounts to EUR 1.5 million and the tax due in State A on this income amounts to EUR 300,000 (20%). If State A followed the “per-country limitation”, the tax credit would be determined as follows. With regard to the tax levied in State B: a tax credit amounting to EUR 200,000 would be granted since the tax due in State A in respect of the profits derived in State B is EUR 200,000 (1 million x (300,000/1.5 million)). With regard to the tax levied in State C: a tax credit amounting to EUR 50,000 would be granted. The total tax credit granted would amount to EUR 250,000, notwithstanding the overall taxes levied abroad amount to EUR 300,000. Hence, taxes amounting to EUR 50,000 would be paid in State A [300,000 (tax due in State A) – 250,000 (tax credit)]. If State A instead followed the “overall limitation”, the tax credit would be determined as follows: items of income and foreign taxes would be aggregated. The tax due in State A in respect of all foreign items of income is EUR 300,000. The taxes paid abroad on those items of income amount to EUR 300,000 (250,000 + 50,000). The foreign taxes may thus entirely be credited; hence no tax would have to be paid in State A.
S. 106
450
The ordinary credit can create difficulties in practice when high expenses are linked to the foreign items of income and the residence state considers the maximum credit to be determined with respect to the amount of the foreign items of income as reduced by those expenses (“net amount”). The tax due in the residence state in respect of the net amount can likely be very low, so that the foreign taxes may largely not be credited. This problem could be resolved by calling the connection of expenses into question.
451
Example
An Austrian corporation has a total income of EUR 1 million. Part of this income is interest arising in Italy amounting to EUR 100,000. The Italian loans, from which the interest derives, are financed through borrowing. The capital costs that are connected with this interest amount to EUR 90,000. The net amount of interest arising in Italy is thus, according to the opinion of the tax administration, EUR 10,000. The tax due in Austria in respect of that net amount is EUR 2,500 (25%). However, under the Austria–Italy DTC, Italy may levy a tax on that interest that does not exceed 10% of its gross amount. The Italian tax at source on the interest therefore amounts to EUR 10,000. It may be credited only up to EUR 2,500; hence EUR 7,500 may not be credited.