Multilateral Instrument: the Application of Methods for the Elimination of Double Taxation under Article 5 [read]
A Comparison: the Exemption Method and the Credit Method in the Model Tax Convention [read]
OECD Model Tax Convention (2017 version) - Texts of Article 23A and Article 23B [read]
Multilateral Instrument, Article 5 – Application of Methods for Elimination of Double Taxation
Paragraph 1 of Article 5 reads:
"A Party may choose to apply either paragraphs 2 and 3 (Option A), paragraphs 4 and 5 (Option B), or paragraphs 6 and 7 (Option C), or may choose to apply none of the Options. Where each Contracting Jurisdiction to a Covered Tax Agreement chooses a different Option (or where one Contracting Jurisdiction chooses to apply an Option and the other chooses to apply none of the Options), the Option chosen by each Contracting Jurisdiction shall apply with respect to its own residents."
Option A modifies the application of the exemption method to prevent double non-taxation that arises from situations such that a Contracting State grants exemption to an item of income that has also been exempted from tax, or a Contracting State grants the exemption while the tax rate of that income has been limited by the other Contracting State.
Option B modifies the application of the exemption method that a Contracting State has adopted in order to prevent double non-taxation that arises from the "deduction and non-inclusion" situation such that an item of payment is deducted from income in one Contracting State but the same payment is excluded from the income in the other Contracting State.
Option C replicates Article 23B of the OECD Model Tax Convention and lays down the ordinary credit method.
Exemption Method (Article 23A) and Credit Method (Article 23B)
Illustration - Comparing between the exemption methods and the credit methods
Suppose the total income to be 100,000, of which 80,000 is derived from State R (residence R) and 20,000 from the other State (State S). Assume that in State R the rate of tax on an income of 100,000 is 35 percent and on an income of 80,000 is 30 percent under a progressive tax system. Assume further that in State S the rate of tax is either 20 percent - case (i) - or 40 percent - case (ii) - so that the tax payable therein on 20,000 is 4,000 and 8,000 respectively.
If the taxpayer's total income of 100,000 arises in State R, his tax would be 35,000. If he had an income of the same amount, but derived in the manner set out above, and if no relief is provided for in the domestic laws of State R and no conventions exists between State R and State S, then the total amount of tax would be, in case (i): 35,000 plus 4,000 = 39,000, and in case (ii): 35,000 plus 8,000 = 43,000.
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1.
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Exemption methods
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Under the exemption methods, State R limits its taxation to that part of the total income which, in accordance with the various Articles of the Convention, it has a right to tax, i.e. 8,000.
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a)
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Full exemption
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State R imposes a tax on 80,000 at the rate of tax applicable to 80,000, i.e. at 30 percent.
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Case (i)
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Case (ii)
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20%
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40%
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i)
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Exemption relief given by State R
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Tax in State R, 30% of 80,000
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24,000
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24,000
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Add: tax in State S
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4,000
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8,000
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Total taxes
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[1]
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28,000
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32,000
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Note: 20,000 is exempted or excluded from total income.
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Case (i)
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Case (ii)
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ii)
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If no relief is given, then double taxes will be
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Tax in State R, 35% x 100,000
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35,000
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35,000
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Add: Tax in State S
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4,000
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8,000
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Total Taxes
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[2]
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39,000
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43,000
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Tax relief (full exemption)
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[2]-[1]
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11,000
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11,000
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b)
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Exemption with progression
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Because State R adopts a progressive tax system, it imposes a tax on 80,000 at the rate applicable to total income wherever it arises (100,000), i.e. at 35 percent.
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Case (i)
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Case (ii)
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Tax in State R, 35% of 80,000
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28,000
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28,000
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Add: Tax in State S
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4,000
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8,000
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Total Taxes
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[3]
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32,000
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36,000
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Tax relief (Exemption with progression)
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[2]-[3]
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7,000
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7,000
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In both cases, the level of taxes in State S does not affect the amount of tax given up by State R (relief). If the tax on the income from State S is lower in State S than the relief to be given by R - cases a(i), a(ii), and b(i) - then the taxpayer will fare better than if his total income were derived solely from State R. In the converse case - case b(ii) - the taxpayer will be worse off.
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2.
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Credit methods
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Under the credit methods, State R retains the right to tax the total income of the taxpayer, but against the tax so imposed, it allows a deduction of taxes paid on foreign income.
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a)
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Full credit
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State R computes tax on total income of 100,000 at the rate of 35 percent and allows the deduction of the tax due in State S on the income from S.
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Case (i)
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Case (ii)
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Tax in State R, 35% x 100,000
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35,000
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35,000
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Less: tax in State S
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(4,000)
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(8,000)
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Tax due
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31,000
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27,000
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Total taxes
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35,000
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35,000
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Relief has been given
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4,000
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8,000
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b)
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Ordinary credit
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State R computes tax on total income of 100,000 at the rate of 35 percent and allows the deduction of the tax due in State S on the income from S, but in no case, it allows more than the tax portion of tax in State R attributable to the income from S (maximum deduction). The maximum deduction would be 35 percent of 20,000 = 7,000.
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Case (i)
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Case (ii)
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Tax in State R, 35% x 100,000
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35,000
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35,000
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Less : tax in State S
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(4,000)
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Less : maximum tax
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(7,000)
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Tax due
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31,000
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28,000
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Tax in State R
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31,000
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28,000
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Tax in State S
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4,000
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8,000
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35,000
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36,000
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Relief has been given by State R
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4,000
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7,000
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A characteristic of the credit methods compared with the exemption methods is that State R is never obliged to allow a deduction of more than the tax due in State S.
Where the tax due in State S is lower than the tax of State R appropriate to the income from State S (maximum deduction), the taxpayer will always have to pay the same amount of taxes as he would have had to pay if he were taxed only in State R, i.e. as if his total income were derived solely from State R.
The same result is achieved, where the tax due in State S is the higher while State R applies the full credit, at least as long as the total tax due to State R is as high or higher than the amount of the tax due in State S.
Where the tax due I State S is higher and where the credit is limited (ordinary credit), the taxpayer will not get a deduction for the whole of the tax paid in State S. In such event the result would be less favorable to the taxpayer than if his whole income arose in State R, and in these circumstances, the ordinary credit method would have the same effect as the method of exemption with progression.
Table 1 - Total amount of tax in the different cases illustrated above
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A. All income arising in State R
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Total tax = 35,000
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B. Income arising in two State, viz. 80,000 in State R and 20,000 in State S
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Total tax if the tax in State S is
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4,000 case (i)
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8,000 case (ii)
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No convention
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39,000
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43,000
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Full exemption
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28,000
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32,000
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Exemption with progression
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32,000
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36,000
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Full credit
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35,000
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35,000
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Ordinary credit
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35,000
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36,000
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Table 2 - Amount of tax given up by the state of residence
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If the tax in State S is
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4,000 case (i)
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8,000 case (ii)
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No convention
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-
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-
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Full exemption
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11,000
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11,000
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Exemption with progression
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7,000
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7,000
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Full credit
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4,000
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8,000
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Ordinary credit
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4,000
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7,000
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OECD MODEL TAX CONVENTION
Article 23A - Exemption Method
1. Where a resident of a Contracting State derives income or owns capital which may be taxed in the other Contracting State in accordance with the provisions of this Convention (except to the extent that these provisions allow taxation by that other State solely because the income is also income derived by a resident of that State or because the capital is also capital owned by a resident of that State), the first-mentioned State shall, subject to the provisions of paragraphs 2 and 3, exempt such income or capital from tax.
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Explanation 1:
Contracting State may use a combination of the exemption method or the ordinary credit method. Such combination is necessary for a Contracting State R (the residence State) which generally adopts the exemption method in the case of income which under Articles (dividend) 10 and 11 (interest) may be subjected to a limited tax in the other Contracting State S. For such case, Article 23A provides in paragraph 2 a credit for the limited tax levied in the other Contracting State.
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2. Where a resident of a Contracting State derives items of income which may be taxed in the other Contracting State in accordance with the provisions of Articles 10 and 11 (except to the extent that these provisions allow taxation by that other State solely because the income is also income derived by a resident of that State), the first-mentioned State shall allow as a deduction from the tax on the income of that resident an amount equal to the tax paid in that other State. Such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income derived from that other State. [emphasis added]
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Explanation 2:
Article 23A of the Model Tax Convention adopts the exemption with progression method. See the illustration in 1(b) above.
Article 23(3) reads:
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3. Where in accordance with any provision of the Convention income derived or capital owned by a resident of a Contracting State is exempt from tax in that State, such State may nevertheless, in calculating the amount of tax on the remaining income or capital of such resident, take into account the exempted income or capital.
4. The provisions of paragraph 1 shall not apply to income derived or capital owned by a resident of a Contracting State where the other Contracting State applies the provisions of this Convention to exempt such income or capital from tax or applies the provisions of paragraph 2 of Article 10 or 11 to such income.
Article 23B - Credit Method
1. Where a resident of a Contracting State derives income or owns capital which may be taxed in the other Contracting State in accordance with the provisions of this Convention (except to the extent that these provisions allow taxation by that other State solely because the income is also income derived by a resident of that State or because the capital is also capital owned by a resident of that State), the first-mentioned State shall allow:
a) as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in that other State;
b) as a deduction from the tax on the capital of that resident, an amount equal to the capital tax paid in that other State.
Such deduction in either case shall not, however, exceed that part of the income tax or capital tax, as computed before the deduction is given, which is attributable, as the case may be, to the income or the capital which may be taxed in that other State
2. Where in accordance with any provision of the Convention income derived or capital owned by a resident of a Contracting State is exempt from tax in that State, such State may nevertheless, in calculating the amount of tax on the remaining income or capital of such resident, take into account the exempted income or capital.
