International taxation double taxation

Why can the same income be taxed in two countries?

Because countries may use different tax rules, such as:

• Residence or seat principle

• Source principle

• Effective place of management

• Different definitions of taxable income

What is legal double taxation?

The same taxpayer is taxed by two countries on:

• The same income or taxable object

• For the same period

• With similar taxes

It generally occurs in an international situation.

Memory phrase:
Same person, same income, same time twice

What is economic double taxation?

The same income is taxed twice, but the taxpayers are different.

Example:

1. A corporation pays corporate income tax on its profit.

2. The shareholder pays tax when that profit is distributed as a dividend.

Memory phrase:
Same profit, different people

What is the main difference between legal and economic double taxation?

• Legal: same taxpayer

• Economic: different taxpayers

Both involve the same taxable object, period and similar taxes.

What are the two main methods for avoiding double taxation?

1. Tax-credit method

2. Exemption method

A deduction method may also reduce double taxation, but it does not normally eliminate it completely.

How does the tax-credit method work?

• Foreign income remains included in the German tax base.

• Germany calculates tax on worldwide income.

• Foreign tax paid is credited against German tax.

• The credit may be limited.

Memory phrase:
Include the income, credit the tax

How does the exemption method work?

• Foreign income is excluded from the German tax base.

• Germany taxes only domestic income.

• The foreign country taxes the foreign-source income.

Memory phrase:
Remove the foreign income

What is the key difference between the credit and exemption methods?

Credit method:

Foreign income stays in the German tax base, but foreign tax is subtracted.

Exemption method:

Foreign income is removed from the German tax base.

Memory phrase:

Credit removes tax; exemption removes income

Why might Germany not credit all foreign tax paid?

The foreign tax credit is limited to the German tax attributable to the foreign income.

Germany generally will not give a credit larger than the amount of German tax that would have applied to that foreign income.

What is the simplified formula for the maximum foreign tax credit?

Foreign-source income × German tax rate
= maximum tax credit

The allowable credit is the lower of:

• Foreign tax actually paid

• Maximum German tax credit

Foreign income is €40,000, the German rate is 40%, and foreign tax paid is €20,000. What credit is allowed?

Maximum credit:

€40,000 × 40% = €16,000

Foreign tax paid: €20,000
Maximum credit: €16,000

Therefore:

Allowed credit = €16,000

The remaining €4,000 is not credited.

How does the deduction method work?

• Foreign tax is deducted from the tax base as an expense.

• It is not directly subtracted from the German tax payable.

• Therefore, it usually only reduces double taxation rather than eliminating it.

Memory phrase:
Credit reduces tax; deduction reduces income

When might the deduction method be better than the credit method?

When there is little or no German tax liability against which a tax credit can be used.

Examples:

• Overall losses

• High personal deductions

• No German income-tax liability

Why can a foreign tax credit be useless in a loss situation?

A tax credit can only reduce German tax payable.

If German tax payable is zero, there may be no tax against which the foreign credit can be used.

A deduction may still reduce taxable income or increase the loss.

What is the limited exemption method or exemption with progression?

• Foreign income is excluded from the German tax base.

• However, it is considered when determining the tax rate applied to domestic income.

• This is relevant where tax rates are progressive.

What are the main purposes of a double-tax treaty?

• Avoid double taxation

• Divide taxing rights between countries

  • Prevent tax evasion

What is the first step when applying a double-tax treaty?

Determine whether the person is covered by the treaty.

Normally, the person must be resident in one or both contracting states.

Who is generally considered a resident under a double-tax treaty?

An individual or company subject to unlimited tax liability in one of the contracting states because of factors such as:

• Residence

• Domicile

• Legal seat

  • Effective place of management

What steps should I follow in a treaty question?

1. Is the taxpayer covered by the treaty?

2. Where is the taxpayer resident?

3. What type of income is involved?

4. Which treaty article applies?

5. Which country has the right to tax?

6. Does the other country have a limited taxing right?

7. How is double taxation relieved: credit or exemption?

Memory phrase:

Person → residence → income → taxing right → relief

What is the source state?

The country where the income arises.

Example: rental income from a building in Canada means Canada is the source state.

What is the residence state?

The country where the taxpayer is considered resident for tax or treaty purposes.

The residence state commonly taxes worldwide income but may have to provide a credit or exemption for foreign income.

Under the credit method, foreign income is excluded from the German tax base. (TRUE OR FALSE)

False.

Foreign income remains included. Foreign tax is credited against German tax.

Under the exemption method, foreign tax is credited against German tax. (TRUE OR FALSE)

False.

Foreign income is excluded from the German tax base.

Economic double taxation requires the same taxpayer to be taxed twice. (TRUE OR FALSE)

False.

Legal double taxation involves the same taxpayer. Economic double taxation involves different taxpayers.

The deduction method always eliminates double taxation completely. (TRUE OR FALSE)

False.

It normally only reduces the tax burden because the foreign tax is deducted from income rather than directly credited against German tax.

The foreign tax credit may be limited to the German tax attributable to foreign income. (TRUE OR FALSE)

True.