TACKLING TAX TREATIES
Q: What is a tax treaty network?
Peter Ni: A tax treaty network generally means that a jurisdiction has entered into double taxation agreements (DTAs) with multiple counterparties. There could be various purposes or reasons behind any particular DTA, including but not limited to reduction of double taxation on the same income, elimination of tax evasion through illegal or suspicious maneuvers and promotion of cross-border tax efficiency on investment and trade.
Q: Who do treaty networks apply to?
Lian Fang: In general, the benefits of a DTA (also referred to as a double tax treaty or DTT) are available only to persons who are residents of one or both contracting states. In most cases, a resident for this purpose is any person that is subject to tax under domestic laws of either of the contracting states by reason of domicile, residence, place of incorporation or similar criteria.
Ni: The particular DTA is applicable to tax residents of the signatory jurisdictions, including individuals, corporations and other forms of entities that are liable for income tax under the domestic laws of such jurisdictions. Foundations and trusts could also be tax residents, as long as the laws of the signatory jurisdictions recognize them. On the other hand, many DTAs tend to preclude partnerships from being recognized as tax residents, since partnerships are treated as pass-through entities bearing no income tax for tax purposes.
Q: What types of transactions benefit from having tax treaties in place?
Ni: Both active service income and passive investment income could receive benefits pursuant to DTAs. Typically, a DTA would lay out thresholds to determine the existence of permanent establishment (PE). To the extent that a foreign company receives actual service income without creating a PE, then it would generally be exempt from income tax on such income in the host jurisdiction. With respect to passive investment income such as dividends, interest or royalties, DTAs normally specify applicable withholding tax rates no more than what are required under the host jurisdiction’s domestic laws.
Fang: A company undertaking business in more than one country might benefit from treaty-based restrictions on the taxation of trading activities conducted outside its country of residence. This could be of particular importance in the context of inherently mobile activities, such as shipping and aviation, but would also potentially benefit a much broader range of industrial and commercial activities undertaken through foreign branch or agency structures. Treaty regimes may also provide a tax saving (and/or administrative simplification) in the case of short-term secondments of employees from one country to another or situations involving the international taxation of specialized activities undertaken by distinguished individuals with particular talents (such as sportsmen, artists, entertainers, university professors, diplomats). Generally speaking, transactions involving local real estate are fully taxed.
Q: What are some key factors to consider when deciding whether to use a jurisdiction based on its treaty network?
Fang: Some key factors to consider include the availability of low tax rates under the treaty in respect to a particular type of income or gains, the definition of “resident” for the purpose of the treaty, other anti-avoidance provisions under the treaty, domestic law and domestic tax rules of the relevant jurisdiction.
Ni: First, you need to make sure that there is a valid DTA in place between the home and host jurisdictions with respect to certain income, regardless of active service income or passive investment income. Second, you should compare applicable withholding tax rates under both the DTA and the domestic laws. It is preferable to see that the DTA is offering lower withholding tax rates. Third, obtaining the tax benefits under the DTA often is conditioned upon satisfaction of both substantive and procedural requirements.
Q: What are some jurisdictions that have well-developed treaty networks?
Fang: Countries such as the Netherlands and Luxembourg have been popular holding company jurisdictions, because of their well-developed treaty networks and simple, transparent domestic tax rules.
Ni: Generally speaking, the existence of a jurisdiction’s tax treaty network demonstrates various factors between the two signatory counterparties, including the alignment of political, economic, geographic, diplomatic and tax interests. For instance, the Netherlands tends to have stronger treaty network with the EU countries, while Cyprus has stronger ties with former Soviet nations.