Different Types and Methods of Double taxation avoidance agreements (DTAA)
International double taxation has adverse effects on the international trade and services. Taxing the same income twice by a two or more countries would disincentivise international taxation. The domestic laws of most countries mitigate the double taxation by providing unilateral relief. But since, there is divergence in rules for determining credit for foreign taxes, countries enter into Double taxation avoidance agreements (“Tax treaties”) to remove tax obstacles that restrict trade and services and movement of capital and persons between the countries concerned.
As mentioned above conflicting rules in two countries regarding chargeability of income based on receipt or accrual, residency status, and other factors necessitate a Double Tax Avoidance Agreement.
Types of Double taxation Avoidance Agreements
Depending on the extent of Trade, and Bilateral relations between countries, the various types of Double taxation Avoidance Agreements that can be entered into are as under : –
- Bilateral Treaties
- Multilateral treaties
- Tax Information Exchange Agreements (TIEA)
- Limited Agreements
- Comprehensive Agreements
1. Bilateral Treaties
As the name implies, a bilateral treaty is an agreement established between only two countries — For instance, the DTAA between India and the United States is a bilateral Treaty, since it is entered into between two countries, India and USA.
2. Multilateral treaties
Treaties signed by many countries are called multilateral treaties — for example, the Convention between APAC or SAARC countries. In tax laws, multilateral convention has been signed amongst various countries, whereby, the existing Treaties stood amended for countries who are signatories to the Multilateral Convention
3. Tax Information Exchange Agreements (TIEA)
TIEA is an initiative by OECD to prevent harmful tax practices such as global tax abuse, corporate tax avoidance and illegal financial flows. These agreements facilitate international cooperation and transparency between nations, through exchange of information related to tax evaders. TIEA can be multilateral or bilateral in nature.
4. Limited Agreements
Limited DTAA’s cover only certain types of income. For instance, the DTAA between India and Pakistan is limited to profits from shipping and airline business.
5. Comprehensive Agreements
Comprehensive DTAAs usually cover all the types of income given in any model conventions. Most of the DTAA’s that India have entered are comprehensive in nature.
Methods used in DTAA for the elimination of double taxation
1) Exemption Approach:
This method allows , income already taxed in the source nation (a foreign country) to be exempt from taxation in the resident country, either in whole or in part. In most cases, DTAA agreed upon between countries has the stipulations that state exemption rules.
A. Full Exemption
In this method, income that is taxed in source country is not considered for calculating taxable income by the Resident Country. Example – In a treaty between State A and State B, income that is taxed in state A is not taken into account by State B.
B. Progressive Exemption
In this method income taxed in the source country is not taxed in the residence country , but is taken into consideration in the residence country for arriving at tax rates. Example – In treaty between State A and State B, income that is taxed in State A will not be taxed by State B, but State B will take into consideration the income, for purposes of arriving at tax rates. This is useful in cases where the country of residence, applies a higher tax rate on income beyond a specific threshold.
2) Credit Method
Under this method the income taxed in the source country is also included in the total income of the residence country , for arriving at the tax liability in resident country. However, from such tax liability, the residence country allows deduction for taxed paid in the source country.
A. Full Credit Method
When the tax is paid in the source country, the resident country provides credit for the tax paid in source country, without placing any restrictions on the same.
B. Ordinary Credit method
This method is adopted in agreements where the credit is allowed against the tax payable in the resident country. The credit may be given only if the income is subjected to tax in the overseas jurisdiction. If the tax that is paid in the overseas jurisdiction is in excess to the tax chargeable in the resident country , the excess tax is ignored and credit is given only upto the amount of tax payable in the country of residence. Further it may be restricted in a manner, that the tax paid in the overseas jurisdiction against each head of income , is allowed to be set off to the extent of tax payable on such income in the country of residence.
3) Underlying Credit Method
Usually the profits earned by the companies, are firstly taxed at their hand , and then again taxed in the hands of the shareholders when the profit remaining after payment of corporate tax is distributed to shareholders as dividend.
In this method credit is allowed to the residents for the taxes withheld against the dividend as well as for the taxes paid on the profits out of which the dividend is paid.
4) Tax Sparing Credit Method
In this method the credit is given in the resident country for the amount of the tax that would have been payable in the overseas jurisdiction. This comes to play when the tax incentives offered by a particular overseas jurisdiction are deemed to have been paid as a foreign tax for the purpose of computing and granting foreign tax credit in the resident country.