Resolving conflicts in Double Taxation
Double tax conventions are an established way for States to agree at the international level on a method for reducing or eliminating the risk of double taxation. Double taxation may occur for any of the following reasons:
Residence – Residence Conflict:
Two States may tax a person (individual or company) on his worldwide income or capital because they have inconsistent definitions for determining residence. For example, a corporation may be treated by State A as its resident because it is incorporated therein, whereas State B may treat that corporation as its resident because it is managed therein. As another example, State A may treat an individual as its resident for a taxable year under its domestic tax rules because that individual was present in the State for 183 days during that year. That same individual may be treated as a resident of State B under its domestic laws because the individual has lived in that State for many years and maintains close financial and social ties to that State. Residence-residence conflicts can occur rather frequently with respect to corporations unless a corporation has intentionally made itself a dual resident to obtain the benefit of a loss in more than one State. This type of double taxation can be eliminated on the basis of tax treaties using the tie-breaker rules contained in Article 4 paragraphs 2-3 of the tax treaties, which determine the states, which would qualify as the only country of residence of the person in question.
Source – Residence Conflict:
One State may tax income derived by a person by the application of the residence or nationality principle, whereas another State may tax that same income by application of the source principle. For example, Company A, a resident of State A, may earn income in State B from extensive activities therein. State A would tax Company A on its worldwide income, which would include the income earned in State B. State B would tax the income arising from the activities conducted within its territorial boundaries. A major objective of bilateral tax treaties is to provide for relief from such source- residence double taxation, typically by requiring the residence State either to give up its claim to tax or to make its claim subordinate to the claim of the source State. This type of double taxation can be eliminated by the tax treaties, either on the basis of the exclusive taxing right – where the treaty permits only one country to tax the income or on the basis of the methods for double taxation relief, where the country of residence will have the obligation to provide the relief (exemption or credit) in the way prescribed by the treaty to eliminate double taxation.
Two States may invoke the source principle to tax the same item of income, due to conflicts in the way the source of income is determined under their domestic legislation. For example, the domestic tax laws of State A may provide that sales income of a non-resident corporation is taxable in that State if the sale was made through an office located in that State. In contrast, the tax laws of State B may tax income derived from sales by a non-resident corporation if the transfer of possession of the goods sold takes place within that State. Given this conflict in the tax rules of State A and State B, income derived from a sale made through an office located in State A for delivery in State B would be taxed in both States. Tax treaties may eliminate some of these situations, by providing sourcing rules, which will help to determine only one country of source.
In some cases, a State may have a source-residence conflict with one State and a source-source conflict with another State. For example, assume that Company A is a corporation resident in State A. It has an office in State B and makes sales from that office into State C. Under their domestic laws, State A taxes income from those sales under the residence principle, and State B and State C both tax that income under the source principle. A bilateral tax treaty between State A and State B is likely to solve the residence-source conflict but probably would not solve the source-source conflict. If State B and State C also have a bilateral tax treaty, however, the source-source conflict may also be solved.