MANAGING TAX RISKS : Double tax treaties and implications

In our last article we defined double taxation as an exposure to tax more than once on the same profit or income. We also highlighted the two types of double taxation i.e. economic double taxation and juridical double taxation and also noted that a double tax treaty is an agreement between two taxing states or countries entered into to address the question “which individuals and entities does a particular state have the right to tax?

”We also noted that the first double tax treaty for income taxes was between Prussia and Austria-Hungary entered into in 1899 and that Tanzania has signed and ratified double tax treaties with Sweden, South Africa, Zambia, India, Norway, Italy, Denmark, Canada and Finland. Some few other treaties have also been signed but not yet ratified. We also discussed the purposes of double tax treaties.

Today we focus on the relationship between tax treaties and domestic tax laws; the models on which double tax treaties are based i.e. the OECD Model, UN Model & the US Model; and types of income and capital covered by double tax treaties.

Can tax treaty provisions override domestic law?

Normally the provisions in the tax treaties override those of domestic tax law. Thus if the tax treaty provides a double tax relief by not allowing a state to impose certain taxes to Multinationals, this will not be overridden by any domestic tax provisions.Double tax treaties are governed by international law under the Vienna Convention on the Law of Treaties (1980). Nevertheless treaty override normally occurs and this may result from ignorance or sometimes it may done deliberately by a state. For instance a state may have entered into a double tax treaty but subsequently passes a domestic law to deny tax payers the benefits of the provisions of the tax treaty where there is too much tax revenue at stake.

Models on which double tax treaties are based

Almost all double tax treaties are based on the OECD (Organisation for Economic Cooperation and Development) Model with the exception of the US treaties which are based on the US Model Income Tax Convention. The OECD Model is largely used because of its well established and authoritative Commentary. It is also internationally accepted in countries which are not OECD members. The US Model on the other hand, though based on the OECD Model has some key differences; one being the reservation of the US right to tax its own citizens even if they now reside in other states. This right extends sometimes up to 10 years after the abandonment of the US citizenship. There are also limited benefits in the US Model, no tax sparing agreements and does not allow the exemption method of double tax relief.

The UN Model Tax Convention

The UN Model was developed in 1980 and designed to help developing states to be able to tax a majority of foreign investors’ income as compared to the OECD and UN Model. The model favours capital importing states against capita exporting states. It provides more scope to the source state to tax foreign investors. Overall tax treaties developed under this model give developing countries more room to tax part of the profits of multinationals.

Types of income and capital covered by double tax treaties

As per the OECD Model some types of income and capital may only be taxed in the state of tax payer’s residence. The common ones include business profits (except when a permanent establishment exists in the other state), royalty income, capital and capital gains (except when it is specified), private pensions, some foreign government salaries and pensions and income from independent personal services for a case where there is no fixed base in the source state. In some other cases income may be taxed by both of the two states in a treaty. The income includes business profits from a permanent establishment e.g. a branch, dividends and interest, income and capital gains from immovable property for instance rentals received on a property which is owned by a resident of one state in another state and income earned by sportsmen and artists.

Mr Makundi is a partner with Auditax International