Taxand Asia Junior School METHODS FOR THE AVOIDANCE OF DOUBLE TAXATION

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1 Taxand Asia Junior School METHODS FOR THE AVOIDANCE OF DOUBLE TAXATION

2 Outline Methods of eliminating double taxation Exemption methods Credit methods Tax sparing credit Underlying tax credit Participation exemption Limitations of credit relief Points to ponder 1

3 Methods of eliminating double taxation Exemption method Full exemption method Exemption with progression method Credit method Full credit method Ordinary credit method Tax sparing credit Underlying tax credit Participation exemption 2

4 Case study Mr A, a resident of State R, earns income from State S Income Rate of tax State R 80, percent on 80, percent on 100,000 State S 20, percent in Case I - 40 percent in Case II Total 100,000 3

5 Case Study Tax liability of Mr A without any relief Case I Case II State R 35 percent on INR 100,000 35,000 35,000 State S 20 percent in Case I 40 percent in Case II 4,000 8,000 Total tax without relief 39,000 43,000 4

6 Exemption methods State R does not tax income which may be taxed in State S State R does not tax income which shall be taxable only in State S Two approaches Full exemption method - Income taxed in State S is not taken into account at all by State R Exemption with progression method - Income taxed in State S not taxed by State R, but State R takes into consideration the income for tax rate purposes Level of tax in State S does not affect the tax forgone by State R 5

7 Full exemption method Tax liability Case I Case II State R 30 percent on INR 80,000 24,000 24,000 State S 20 percent in Case I 40 percent in Case II 4,000 8,000 Total tax with relief 28,000 32,000 Total tax without relief 39,000 43,000 Tax relief (notional) 11,000 11,000 Rate of tax in foreign jurisdiction matters 6

8 Exemption with progression method Tax liability Case I Case II State R 35 percent on INR 80,000 28,000 28,000 State S 20 percent in Case I 40 percent in Case II 4,000 8,000 Total tax with relief 32,000 36,000 Total tax without relief 39,000 43,000 Tax relief (notional) 7,000 7,000 Level of foreign source income matters 7

9 Credit methods State R includes the income earned in State S for computing total tax liability in State R out of which credit is given for taxes paid in State S Two approaches Full credit method - State R allows deduction of total amount of tax paid in State S Ordinary credit method - State R allows deduction restricted to that part of tax payable in State R which is appropriate to the income earned in State S State R is not obliged to allow a deduction of more than tax due in State S 8

10 Full credit method Tax liability Case I Case II State R 35 percent on 100,000 35,000 35,000 State S 20 percent in Case I 40 percent in Case II 4,000 8,000 Total tax credit (full tax in State S) 4,000 8,000 Total tax after relief 31,000 27,000 Foreign tax is credited to the extent it does not exceed State R taxes 9

11 Ordinary credit method Tax liability Case I Case II State R 35 percent on 100,000 35,000 35,000 State S (A) 20 percent in Case I 4, percent in Case II 8,000 State R tax on foreign source income (B) 35 percent of 20,000 7,000 7,000 Total tax credit (Lower of A and B) 4,000 7,000 Total tax after relief 31,000 28,000 Tax credit is restricted to lower of State R tax or foreign tax on foreign income 10

12 Double taxation relief methods - synopsis Methods of eliminating double taxation shall be taxed only in may be taxed in Exemption method Article on elimination of double taxation Other income Dividend, interest, royalties, FTS Credit method Credit method Exemption method Credit method Credit method 11

13 Tax sparing credit Income exempt in State S as a measure to promote economic development therein (eg special economic zones) Income taxable in State R but State R provides for deemed tax exemption or deemed tax credit of taxes so exempted by State S too Domestic tax laws of countries generally do not provide for tax sparing credit Some treaties provide for tax sparing credit like India-Mauritius tax treaty; India-Singapore tax treaty OECD Model Convention 2008 Generally attached to income like dividend, interest, royalties, foreign branch / permanent establishment income May provide for more or less than the State S tax waived (eg India-Cyprus tax treaty limits tax sparing credit on interest at 10 percent) 12

14 Tax sparing credit Tax liability State R (Income INR 80,000) 13 Tax sparing credit absent Tax sparing credit exists 50 percent on 100,000 50,000 50,000 State S (Income INR 20,000) normal rate 40 percent special rate 10 percent (30 percent exempted) 2,000 2,000 Tax credit tax credit (tax charged in State S) tax sparing credit (tax exempted in State S) 2,000-2,000 6,000 Total tax credit 2,000 8,000 Total tax after relief 48,000 42,000

15 Underlying tax credit A mechanism to eliminate a form of economical double taxation Attached to dividend income Computation Methodology - co-relation of dividends to post tax profits of subsidiary Requirement of substantial shareholding Also applied under controlled foreign corporation regulations Treaties may provide for underlying tax credit (eg India- Mauritius tax treaty; India-Singapore tax treaty) Some countries specify upto how many layers, underlying tax credit can be claimed 14

16 Underlying tax credit Particulars MCO ICO Income 20,000 15,200 Add: tax withheld on dividend Add: corporate tax gross-up - 4,000 Grossed-up income 20,000 20,000 Corporate tax rate 20 percent 30 percent Corporate tax 4,000 6,000 Less: tax credit - WHT credit Underlying tax credit - 4,000 Net tax payable 4,000 1,200 Profit after tax 16,000 18,800 Dividend distributed to ICO 16,000 - Withholding tax rate 5 percent - Tax withheld on dividend Dividend net of taxes 15, India Malaysia 100% ICO 30% MCO 20% Dividend WHT 5%

17 Participation exemption Exemption from taxation to a shareholder on dividends received, and potential capital gains arising on the sale of shares Dividend are distributed out of the post tax profits of a company Shareholders may pay tax on the amount of dividend income received in absence of relief resulting in double taxation A participation exemption provides that certain types of dividends or capital gains or both are not taxed in the hands of shareholders on satisfaction of certain conditions A participation exemption may apply to qualifying shareholdings in overseas companies, domestic companies, or both Exists in Netherlands, Belgium and Sweden 16

18 Limitations on credit relief Overall limitation Per country limitation Per basket limitation (income type) Attribution of expenses to foreign income 17

19 Points to ponder No detailed rules for implementation of relief What if income below basic exemption post treaty relief? Deduction from distributed or undistributed income? Excess credits, excess limitations - carry forward Timing of foreign tax liability - generally State R shall give relief irrespective of when State S levies tax on it Computation of foreign tax attributable to dividends - both withholding tax and corporate tax? Deductibility of foreign taxes 18

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