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Relief from international double taxation.

International double taxation represents the imposition of comparable income taxes by two or more sovereign countries on the same income items on the same taxpayer for the same tax period. Bilateral tax treaties often provide solutions to this problem. Most are based on one of three models--the United States Model Income Tax Convention of September 20, 1996 (the U.S. Model), the United Nations Model Double Taxation Convention Between Developed and Developing Countries (the U.N. Model) or the Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income.

Acceptable international practice grants countries a primary right to tax income with a source in that, country. Put simply, the source country's right has priority over the taxpayer's country of residence/citizenship. The taxpayer's "home" country would then provide relief if its taxing jurisdiction (based on residence or citizenship) overlaps the source jurisdiction's right. No international consensus dictates the appropriate relief method; countries commonly use three--the deduction method, the exemption method and the credit method. Countries can use one method or a combination to provide relief from international double taxation.

Deduction Method

The deduction method (such as the U.S., under Sec. 164(a)(3)) allows residents/citizens to deduct foreign taxes paid in computing their taxable worldwide income. This treats the foreign taxes paid as a current expense; it is the least effective means of providing relief. Residents paying and deducting foreign taxes on foreign-source income are taxed at a higher combined rate than on domestic-source income. The deduction method creates an obvious bias in favor of domestic investing, and is not tax neutral in allocating resources between countries.

Exemption Method

Under the exemption method, a taxpayer's home country will tax its residents/citizens only on their domestic-source income. The country of residence exempts the taxpayer's foreign-source income from domestic taxation, leaving it to be taxed by the source country.

Many countries employ variations of this method due to different tax structures worldwide. For example, the exemption on income derived by resident companies through foreign affiliates or branches located in tax-haven countries is often limited. Only if the foreign-source income is subject to a tax by the foreign country will an exemption be available.

The "exemption with progression" is another alternative to a pure foreign-income exemption, under which foreign-source income is accounted for in determining the tax rate applicable to the taxpayer's other taxable income, creating a tax-averaging mechanism.

Although the OECD and the U.N. Models sanction the exemption method (Article 23A of both treaties), that method would not conform to a tax policy's objectives of fairness and economic efficiency if foreign taxes are lower than domestic taxes. As a general rule, resident taxpayers with exempt foreign-source income receive more favorable tax treatment than those with only domestic-source income. Thus, the current exemption system encourages resident taxpayers to invest abroad in countries with lower tax rates (especially tax havens) and divert domestic-source income to those countries.

To avoid this inequity, some countries have adopted a partial exemption system, under which a foreign-source exemption is provided only on income derived from countries committed to imposing a tax structure comparable to that of the resident taxpayer's country. However, this system is effective only if countries can prevent taxpayers from (1) improperly treating income earned in tax-haven countries as derived from exempt countries and (2) artificially shifting deductions from exempt countries to income earned in a tax-haven country.

In the U.S., under Sec. 911, a qualified individual can elect to exclude foreign-earned income and housing costs from his or her gross income for the year, to the extent of the applicable yearly limit ($80,000 for years after 2001). However, the individual must earn the foreign-earned income during a period for which he or she qualifies for an election. In general, the exclusion extends to a U.S. citizen or resident who is present in a foreign country for at least 330 days during a 12-month period.

Credit Method

Under the credit method, any foreign taxes paid by a resident taxpayer on foreign-source income serve to reduce domestic taxes payable by the foreign tax amount. In general, countries using the credit method would not refund taxes if their taxpayers pay foreign taxes at a rate higher than the domestic rate (OECD Model, Article 23B).To boot, a taxpayer cannot even offset the excess foreign tax imposed against his or her domestic income taxes.

In general, the foreign tax credit's (FTC's) dollar-for-dollar tax offset is far more beneficial than a deduction.

Example: U.S. citizen/resident A receives $100 from investing in a foreign country with a 30% tax rate. As A's U.S. tax rate on worldwide income is 35%, a deduction for the foreign country's tax will reduce double taxation, but not eliminate it. If A takes the deduction for foreign taxes paid, his U.S. income tax would be $54.50 (0.35 x ($100-$30), plus $30 in foreign tax).As a result, choosing a foreign tax deduction still leaves a tax burden substantially higher than the $35 in tax that would be paid had A earned the entire $100 (35% x $100) in the U.S. On the other hand, if A chose to use an FTC, the U.S. liability would be reduced from $35 to $5, with the $30 paid to the foreign country credited against A's U.S. tax.

As a general rule, a taxpayer's total tax on foreign-source income is the greater of the (1) pre-credit U.S. tax on the income or (2) foreign tax. This is due to Sec. 904(a), which limits the FTC to the pre-credit U.S. tax on the taxpayer's foreign-source income. In other words, the available FTC is the lesser of the foreign tax paid or the pre-credit U.S. tax on the foreign income.

In the example, under Sec. 904(a), $30 is the maximum FTC available (the lesser of the foreign tax paid ($30) or the pre-credit U.S. tax on the foreign income ($35)). Thus, the total tax equals the greater of the $35 pre-credit U.S. tax or the $30 foreign tax. (The $35 comprises $30 in foreign tax, plus $5 in U.S. tax after the FTC.) However, if the foreign country imposed a 40% tax (or $40) on the $100 foreign-source income, the maximum credit A could receive on a U.S. tax return would be only $35 (the lesser of the 35% tax the U.S. would impose, rather than the $40 (40%) foreign tax). The total tax would be the greater of the $35 pre-credit U.S. tax or the $40 foreign tax (comprised entirely of the $40 foreign tax paid, inasmuch as the FTC would eliminate any U.S. tax on the foreign income).

Two other types of FTCs are available to U.S. taxpayers and other "credit" countries. The U.S. treatment of direct and indirect FTCs is comparable to other treaty countries. The direct FTC is available to U.S. citizens, residents and nonresident aliens; the deemed paid or "indirect" FTC extends only to U.S. domestic corporations that paid foreign taxes indirectly through a 10%-owned foreign corporation (Sec. 902(a)).


In addition to other limits on FTC use, availability rules defray opportunistic, tax-motivated behavior. These rules isolate income into "separate baskets" frequently subject to income taxes at either extremely high or low foreign tax rates, thereby limiting a taxpayer's ability to manipulate the credit limit by averaging rates. Although "separate income limits" and "income baskets" are beyond the scope of this item, their mind-numbing complexity often baffle the brightest of international tax experts. In short, the separate-baskets concept exists to prevent taxpayers from arranging their affairs to maximize the FTC at the expense of U.S. tax on U.S.-source income.

The OECD and the U.N. models only authorize the credit and exemption methods, not the deduction method. Considering tax policy, the credit method is recognized as the best method for eliminating international double taxation.

While the U.S. employs both the deduction and exemption methods, the impact of double taxation is often mitigated with an FTC.

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Author:Beck, Allen M.
Publication:The Tax Adviser
Date:Oct 1, 2002
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