21 Aug 2009

Double Tax Treaties

by Darren

A Double Tax Agreement (DTA) is an agreement between 2 countries in order to avoid double taxation which can result from international transactions, allocate the tax imposed the income between the governments and prevent tax evasion on international transactions. Governments are generally interested in the activities of foreigners within their country as well as the activities of their residents in foreign jurisdictions. There are 2 scenarios for which double taxation can occur: 1. Two governments assert their domestic tax laws to impose tax on income generated by the taxpayer. For example a US citizen is taxed on their worldwide income and earns income in Hong Kong. Hong Kong imposes a tax on any income sourced within Hong Kong and the US charges tax on all income earned by US citizens. 2. A taxpayer can be classified as a dual resident and as such would be taxable on their worldwide income in both countries. For examplee a company is incorporated in USA and has its place of effective management in Australia. Under US law the residence definition is US incorporated companies while in Australia the residence definition is different such that if the place of effective management is within Australia then that company is a resident of Australia. So how does the DTA provide relief from double taxation? 1. The country of residence can offer an exemption from tax on any foreign sourced income. In this case foreign income will not be declared in the annual tax filings and will not be taxed. In certain circumstances foreign income is generally exempt from Singapore tax assuming taxes have been paid on the income prior to repatriating the income into Singapore. 2. The country of residence will tax the foreign income of the taxpayer but in return will allow a credit (not deduction) for any foreign taxes paid. This is deducted after the final amount of tax payable has been calculated. For example: Assume domestic income is $750,000, foreign sourced income is $500,000, total allowable deductions amount to $250,000, foreign taxes paid on foreign Income is $80,000 and tax rate is 30%. The Net Taxable Income is $1,000,000 (750,000 + 500,000 - 250,000). Tax payable on $1,000,000 is $300,000. A credit is then available to the tax payer for the $80,000 paid in foreign taxes resulting in net tax payable of $220,000. Note depending on the country there are rules which limit the amount of the credit available. 3. Offering a tax deduction for the amount of foreign taxes paid. In this situation the foreign tax is deducted from the total income to calculate the net income then tax payable. The reduction on net tax payable is less than in the case of a tax credit. Using the same details as 2 above the calculation is Net income 1,250,000 less allowable deductions $ 250,000 less foreign taxes paid $80,000 resulting in a Net Taxable Income of $920,000. Tax payable on this is $920,000 x 30% = $276,000. The additional tax paid under option 3 is $56,000. Generally Option 2 is the most widely chosen method bu governments to relief the issue of double taxation. In addition to relief through credits and deductions DTA's offer reduced withholding tax rates on certain types of income, namely dividends, inetrest and royalties. Treaties can reduce tax rates to 5%, 10% 15% or even make them tax free.

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