The concept of residence is one of the most basic and important parts of any tax treaty. It determines whether a person is covered within the scope of a given treaty and whether they can benefit from its provisions. Typically, tax treaties provide benefits only to residents of the either or both of the Contracting States who have entered into a treaty.

For example : If India and USA, have entered into a treaty, then the benefit of the treaty can be availed by a resident of India or USA or both.

Importance of residency in avoiding double taxation

The concept of residence is particularly important in cases where double taxation arises. Double taxation can occur when an individual is considered a resident in two or more countries under their domestic tax laws. In such cases, the individual may be subject to taxation on the same income in multiple countries.

The concept of residence helps to avoid double taxation by providing a framework for determining which country has the right to tax the income.

Let’s look at an example to illustrate the importance of residence in avoiding double taxation. Imagine an individual who has a home in India and lives there with his family. Due to work, the individual has to spend 200 days in USA during a given tax year. Lets say USA has a rule that if a person spends more than 183 days in their jurisdiction, they will become a resident of USA. At the same time,  India has a rule that if a person spends more than 60 days in India during the relevant PY and more than 365 days in preceding 4 years,  the individual  will be considered a resident of India .

In this case, the individual could be considered a resident of both India and USA, which creates a dual residence situation. How can a person resolve this ?

Article 4 of Tax Treaties provides rules to determine which country has the right to tax the income and avoid double taxation. In other case, if Article 4 was absent, the income earned by the individual may have been taxed in two States, i.e., one in the India State (where income arose) and USA. This will cause double taxation which is resolved through Article 4 of OECD Convention.

Understanding the rules of residence in tax treaties can help individuals and companies avoid unnecessary taxation and comply with international tax laws.

The concept of residence under Tax Treaties under Article 4 of the OECD Model Convention is very pertinent.

Tax Treaties are agreements entered into by different countries to prevent double taxation of income and to promote cross-border trade and investment. These Treaties generally provide benefits to residents of the Contracting States, which is why understanding the concept of residency is so important.

Let’s consider a hypothetical scenario where there are two countries, India and Country Y, which have entered into a Tax Treaty. The Treaty provides that the benefit of  5 percent  withholding tax rate shall be available on interest payments. Now, suppose a third country, Country X, has a company called X LLC, which is a tax resident of Country X. Country X wants any interest payment made by X LLC to suffer a 5% withholding tax rate. Will such a benefit be available?

The answer is no. The benefit of any tax treaty is only given to people who are residents of the Contracting State. X LLC is not a resident of India or Country Y, so it cannot avail of the 5%  tax rate. This is why it’s important to understand what exactly is meant by the concept of residence under Tax Treaties.

It’s worth noting that the definition of residence under a Tax Treaty may be different from what’s available under the domestic tax laws of either the source country or the country of residence. While the provisions of the Tax Treaty generally prevail over the domestic tax laws, if the Tax Treaty refers back to the domestic tax laws, one needs to look at those laws as well.

Under Article 4 of the OECD Model Convention, there are situations it provides the determination of residence has to be as per the local laws of the respective countries. Additionally, if a person becomes a resident of both Contracting States by the application of the domestic tax laws, then a tiebreaker rule needs to be applied.

So, in summary, understanding the concept of residence under tax treaties is crucial.