What is a DTA and how does it work?
DTA is short for double tax agreement. It is also called double tax treaty (DTT). Countries or states sign DTA’s in order to achieve the following major objectives: avoidance of double taxation, allocation of taxing rights, and exchange of information. DTA’s are negotiated bilaterally between two states and drafted by reference to the framework under the OECD Model Tax Convention.
(I) Avoidance of double taxation
A person earning an income is subject to tax in the state of which he is a resident. Alternatively, an income may also be taxed in the state in which the income generating activity takes place. But by the operation of the domestic tax rules, the same income may also be taxed again in another state. Double taxation may arise in any one of the following three ways:
- the conflict of rules adopted by different countries in the determination of tax residence;
- the conflict between residence rule in one country and source rule in the other country, and
- the conflict of rules adopted by different countries on the source of income.
Example - 1
A Hong Kong company assigns a US national, whose wife and kids are working and living in Canada, to work for its subsidiary in Shanghai for two years. In the absence of any DTA signed between respective countries, the same income of the employee may become taxable in four jurisdictions.
First, double taxation arises from the conflicts between residence rules. The above employee is both a tax residence of Canada and the US as per residence rules of each country. One the one hand, the employee suffers income tax due to his family ties with Canada. That is, his family members work and live in that country. On the other hand, he is a tax residence of the US that imposes worldwide tax on its nationals. Second, double taxation arises from the conflict of source rules between Hong Kong and China. The above employee is subject to income tax as he exercises employment in China, while he is also subject to salaries tax in HK because a contractual relationship has been created following the employment agreement concluded between him a HK company. Third, double taxation arises from the conflict between the residence rules and source rules. Where the employee is taxed in Canada because he has family ties with the country, the same income is subject to tax in China because the employee is performing his duty in China.
(II) Allocation of taxing rights between the signing states
(a) Assignment from HK to China
Let’s study the first example on how the problem of double taxation is solved.
In respect of the double tax claims by the US and Canada, the employee of the HK employer can refer to the Article 4 in the US-Canada DTA to solve the dual residence issue. According to the US-Canada DTA, the employee’s personal and economic relationship (the center of vital interest) with Canada shall take precedence over his US nationality in the determination of residence. In respect of the double tax claims by Canadian and Chinese tax authorities, the employee can avoid double tax as he is entitled under Article 21 of Canada-China DTA to the tax credit in Canada for tax paid to the Chinese tax authority on the income earned in China. Article 21 of Canada-China DTA operates to solve the residence-source conflict. In respect of the double tax claims by the tax authorities in HK and China, the employee can avoid the double tax arising from the clash in source rules by submitting an application for a tax exemption in Hong Kong on the strength of the taxes he has suffered and paid in China on the same income.
(b) Presence of employees in the host country
A double tax agreement can resolve the issue whether certain activities performed in one contracting state (country) by the employees of a company in the other contracting state, has created a taxable presence in the latter state. That is, whether the former has a permanent establishment in the latter.
Example - 2
An employee of a Japanese company is assigned to work in China continuously in connection with an engineering project of the PRC subsidiary for a period of 180 days.
There is a double tax problem, and the respective taxing rights of Japan and China are allocated in one of the following ways:
(i) As per DTA between Japan and China, the presence of employee does not create a permanent establishment in China if the following conditions are met: the employee stays in China for a period not exceeding 183 days in any 12-month period; and his income is not paid or borne by the PRC subsidiary. In this case, China does not tax the income; or
(ii) The presence of employee does create a permanent establishment in China where the parent company charges back the employee’s salaries to the PRC subsidiary. In this case, China taxes the income.
(c) Price adjustment
Example - 3
A holding company in country A, in order to reduce its taxable income, purchases goods from its subsidiary in country B at a unit price of USD10, which is above the arm’s length price of USD6. The tax authority later adjusts the purchase price from USD10 to USD6 following the completion of a transfer pricing audit. The group as a whole will be subject to double tax of USD4 per unit of the goods sold, in the absence of a corresponding downward adjustment of the selling price for the subsidiary in country B.
(III) Exchange of information
The exchange of information (EOI) article is provided with an aim to the prevention of fiscal evasion on income and capital, which also deals with double non-taxation of income that arises from the interaction of domestic tax rules of two or more contracting states. Specifically the EOI article operates to override the personal scope (Article 1) and taxes covered (Article 2) as provided in the OECD Model Tax Convention.
(a) Foreseeable relevance
The tax authorities of the contracting state shall exchange such information as is foreseeably relevant for carrying out the provisions of the DTA or to the administration or enforcement of the domestic laws of the contracting states concerning taxes covered by the DTA.
The EOI article is not subject to restriction by the personal scope under Article 1. The scope of information to be exchanged shall include the information in the possession or under control of a person located in the state of the requested authority, who may or may not be the tax resident of either state.
(b) Secrecy provision
Information shall be disclosed only to persons or authorities (including courts and administrative bodies) concerned with the assessment or collection of, the enforcement or prosecution in respect of, or the determination of appeals in relation to the taxes referred to in paragraph (a).
(c) Limitation to relevance and secrecy
The relevance and secrecy provisions are subject to restriction in the following way such that there is no requirement to (i) carry out administrative measures at variance with the laws and administrative practice, (ii) supply information not obtainable under the laws or in the normal course of the administration, of that or of the other contracting state, and (iii) supply information which would disclose any trade secret or process, or information the disclosure of which would be contrary to public policy.
Notwithstanding the provisions in the preceding paragraph, the requested authority should not refuse to do so even if the information is not relevant or needed in the assessment, collection or enforcement of the taxes at home. Equally, the requested state cannot decline the requesting state on ground that the information is held by bank, nominee, person acting in an agency or fiduciary capacity, or it relates to ownership interests in a person.
(IV) Definition of a person
The scope of a person is different between the avoidance of double taxation on income and exchange of information under the DTA articles. A person for purposes of (I) and (II) includes an individual, legal persons and legal arrangements (such as trusts), who are the residents of one or both contracting states. The term "person" for purpose of (III) includes not only residents but also non-residents, who are situated in the requested state and keep or control the tax information of the requesting state. Note that a non-profit (tax-exempt) organization, if it possesses or controls the required information, also falls under the scope of a person under EOI.
China Tax & Investment Consultants Ltd
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18th February 2015