What Is A Double Tax Treaty?

A double tax treaty – also known as DDT, or a double tax agreement (DTA) – is the agreement between two countries (or States) to avoid the imposition of comparable taxes in both states on the same taxpayer, in respect of the same subject matter, and for identical periods of time.

Double tax treaties are designed to do three things:

• Protect against the risk of double taxation where the same income is taxable in 2 states.
• Provide certainty or treatment for cross-border trade and investment.
• Prevent excessive foreign taxation and other forms of discrimination against business interests abroad.

In the absence of a double tax treaty, income that’s distributed across borders would be taxed by both the country it’s been generated and distributed from, AND taxed as income by the country of the investor’s residence. So, for example, a UK individual investing in Nestle shares (which is a Swiss listed company), would be taxed at 35% by the Swiss tax authorities. They would also have to declare and pay tax on that income through their UK tax return. In this scenario, the same payment has been taxed twice, which is clearly not fair for the individual investing.

What Does A Double Tax Treaty Actually Do?

Generally, pairs of countries have signed double tax treaties to describe how they will both avoid double taxation. The details may be different between countries, but typically what happens is that the country of investment (let’s take our example of Switzerland) will tax first, and the country in which the investor is a resident in (the UK in our example) will take the Swiss tax already withheld on the payment into account.

Within the double tax treaty, there will be a set of ‘Articles’ that describe the different types of income, and how the governments want each type to be treated. This would usually include both investment and other income, like:

• Dividends
• Interest
• Royalties
• Capital gains
• Income from employment (important for ex-pats)
• Director’s fees
• Special arrangements for artists, students and high-profile athletes

Along with deciding how these taxes should be applied, double tax treaties also create a definitional basis for many other governmental instruments. This usually includes a definition of a permanent establishment, which is the entity version of substantial presence. A double tax treaty also defines ‘residence; and ‘person’, for the avoidance of doubt here and elsewhere.

Most double tax treaties follow the template or ‘model’ tax convention on income and capital that’s published by the OECD, the latest version of which was released in 2017, and you can read it here.

What Happens In The Absence of a Double Tax Treaty?

At the time of writing this article there are over 6,000 double tax treaties in force, which are changing all the time for all sorts of reasons. Most recently, the US suspended most of their double tax treaty Articles with the Russian Federation due to Russia’s invasion of Ukraine, which means Russian residents investing in US companies will be taxed at 30% on any dividend income, rather than the 10% they enjoyed under the double tax treaty rate. If a country doesn’t have a double tax treaty in place at all (instead of having one that has been suspended), then the countries from which the dividends are issued will tax them at the maximum statutory rate.

The lack of a double tax treaty doesn’t mean that an investor has no right to reduce the statutory rate though. In some cases, there is domestic legislation in place that covers non-resident investors, usually a non-discrimination law. This has been applied in the EU, and where investors are major funds, they can even take a country to the European Court of Justice. Every such ECJ claim is based on the EU’s Non-Discrimination Directive, and has been won by the plaintiff. That means that anyone else who can establish an equivalence between themselves and the original claimant’s case can get a refund, even if there is no double tax treaty.

One other feature of Double Tax Treaties and their surrounding legislation is that, generally speaking, if the income that is taxed in the country of investment can be recovered through a tax reclaim process, then that income cannot be taken into account or offset by the investor against their domestic income tax. So, in our previous example, the Swiss statutory rate is 35% and the UK treaty rate is 15%. Some investors try to offset the difference on their domestic tax return, but that’s not allowed because the difference, 20%, can be reclaimed from the Swiss government. In other words, you can only claim a tax credit for the unrecoverable portion of foreign taxes withheld.

What About Double Non-Taxation?

Yes, this is a thing too! Double tax treaties also deal with non-taxation cases. These cover cases where there is no taxation of the activities, as well as cases where the taxation is extremely low. Double non-taxation cases don’t encompass cases where a company isn’t taxed because the activity is effectively taxed elsewhere.

So, hopefully you can now see that double tax treaties are an important component of international finance, and very important for investors with cross-border portfolios. If you’d like more information on double tax treaties and the refund process associated with them, there’s a great book called Cross Border Withholding Tax – A Practical Guide For Investors And Intermediaries, which you can buy here. Did we mention that our chairman, Ross McGill, wrote it? If you have any questions, why not ask the experts by getting in touch here.