International tax: what is a double taxation?

A s you may have heard through the news across the world, international taxation is in the heart of every thought : SwissLeaks, LuxLeaks, Amazon, Starbucks, Apple… The main reason is that companies are willing to avoid double taxation and to benefit double non-taxation by using aggressive tax plannings.

But what is a double taxation and why is it in the heart of international taxation ?

In this post I will explain you the reasons and the forms of double taxation which arise in cross-border transactions.

At first, double taxation issues arise due to the fact that most countries levy tax on the worldwide income of their tax residents and income created by activities located on their territory. That is why companies and individuals which perform cross-border activities are subjected to different taxes in many countries.

In order to avoid double taxation, States conclude tax treaty which determined the State that is allowed to tax the income or capital at stake. Tax treaties are mostly based on the OECD model convention (I will teach you how to read an OECD model convention in another post).

Double taxation

States are legally justified to tax people and entities due to the principle of sovereignty. Indeed, two aspects of sovereignty are to be considered regarding tax matters :

• National sovereignty which applies to citizens and residents of a State. The sovereignty allows States to tax their citizens and residents wherever they might be.
• Territorial sovereignty in regards to the States’ geographical borders. This allows States to tax non-residents individuals or entities on their income sourced in their territories.

Traditionally, the allocation of tax jurisdiction is determined according two principles : the place of the income source and the one of the taxpayer’s residence. Most fo the States have adopted these two principles, the general rule is that the source State has a primary taxing right while the residence State has a residual taxing right.

The residence State has the ability to levy tax on a individual’s worldwide income on the basis of his residence (principle of residence). Thus, if the source State has not an exclusive taxing right according to the applicable tax treaty), the residence State retains a residual taxing right. The residence State has also an obligation to avoid double taxation.

The source State is able to tax any income generated within its territory (principle of source). However, some States might decide that they will not levy tax on income generated within their territories. These income will be then transferred to the residence State without suffering any withholding taxes. This point makes me think about the Luxembourgish practices. But I will develop this point in another post later on.

Forms of double taxation

• Firstly there is the juridical double taxation. A juridical double taxation includes comparable taxes by more than one state on the same taxpayer in respect of the same income or capital during the same period. The juridical double taxation mainly arises due to the fact that States levy taxes on financial transactions.

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  Secondly there is an economic double taxation which appears when the same income or capital is subject to comparable taxes by more than one state in the same period but in the hand of different taxpayers.

Reasons of double taxation

• A double taxation may arise when an individuals or an entities is tax resident of a State and derives income from another State and both States levy taxes on that income. For instance, A-Co, a company resident in State A, performs income form immovable property located in State B. A-Co is subject to taxes in State A regarding this income due to the national sovereignty principle. However, State B will also levy taxes on this income due to the fact that the immovable property is located on its territory due to the territorial sovereignty principle.

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  A double taxation may also arise when a person is considered as resident by two different States. Each State considers that the person is a tax resident of its State. This person (individual or entity) shall then pay taxes in both concerned States on his worldwide incomes …

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  Another reason for double taxation is when two or more States subject the same peson to tax on income derived from their territories. In order to fully understand this case, please find hereinafter an example : A-Co, a company resident in State A, grants a loan to C-Co, a company established in State C, through its permanent establishment located in State B. In this case, State C may levy taxes on interests payment between C-Co and the permanent establishment in State B. And State B may also levy taxes on distributed income from A-Co’s permanent establishment located in State B to A-Co.

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  Double taxation may further arise when the same circumstances are qualified differently in two different States. That is the case of hybrid entities and hybrid financing instruments. As an example, A-Co, a company established in State A, grants funds to its subsidiary, B-Co, located in State B by using a hybrid financing instrument (it bears in the meantime equity and debt characteristics). State B will consider that this instrument is equity, therefor State B will tax the remuneration to A-Co as dividends (non tax deductible in State B). State A will consider this instrument as debt and will then tax the remuneration as interest income (fully taxable in State A). This is the worst thing to do. However, opposite case is perfect as it will lead to a double non-taxation. I will give you some secrets regarding this double non-taxation in other posts ;-)

You have now got it, double taxation is at stake in international tax.

Tax treaties have been created in order to avoid issues created by double taxation. However, an agressive use of tax treaties may create double non-taxation cases.

Thus, in following posts I will explain you in details what is a tax treaty. Then I will teach you how to read such a treaty. Finally I will give you some tips on how to create double non-taxation cases; tips which are well understood by some countries and companies.