If a taxpayer has personal relations with one country (Home) and derives income from another country (Host) it can cause a double taxation issue. The host country will most likely assert jurisdiction on the basis of its economic relationship with taxpayer. The home country on the other hand may also assert jurisdiction on income earned based on taxpayer’s relation with the home country. Home country in such a situation will help avoid double taxation. It can let go part or all jurisdiction claim over the foreign source income either through a territorial system or credit system.
Under the Territorial System, the home country allows taxpayers to exclude foreign earned income and only taxes citizens and residents on income derived from sources with in the home country. Under territorial system the foreign income of a Citizen or residents is taxed only one time in the host country.
Under the Credit System the home country will tax foreign source income but allow a credit of foreign taxes paid. This way foreign source income is taxed only one time at the higher of host country’s rate or the home country’s rate.
Example 1:
(Host Country’s Tax Rate is lower than Home Country)
XYZ Corporation derives income of $1000 from foreign source. Assume the home country’s tax rate is 20% and host country’s tax rate is 10%. What are the tax consequences?
Situation 1 = No System to reduce double taxation
|
Home Country |
|
Host Country |
|
|
Taxable Income |
1,000 |
Taxable Income |
1,000 |
|
Tax Rate |
20% |
Tax Rate |
10% |
|
Tax Payable |
200 |
Tax Payable |
100 |
Total Tax Payable = 300
Situation 2 = Territorial System
|
Home Country |
|
Host Country |
|
|
Taxable Income |
0 |
Taxable Income |
1,000 |
|
Tax Rate |
20% |
Tax Rate |
10% |
|
Tax Payable |
0 |
Tax Payable |
100 |
Total Tax Payable = 100
Situation 3 = Credit System
|
Home Country |
|
Host Country |
|
|
Taxable Income |
1,000 |
Taxable Income |
1,000 |
|
Tax Rate |
20% |
Tax Rate |
10% |
|
Tax Payable |
200 |
Tax Payable |
100 |
|
Foreign Tax Credit |
100 |
|
|
|
Total Tax Payable |
100 |
|
|
Total Tax Payable = 100
Example 2:
(Host Country’s Tax Rate is higher than Home Country)
XYZ Corporation derives income of $1000 from foreign source. Assume the home country’s tax rate is 20% and host country’s tax rate is 30%. What are the tax consequences?
Situation 1 = Territorial System
|
Home Country |
|
Host Country |
|
|
Taxable Income |
0 |
Taxable Income |
1,000 |
|
Tax Rate |
20% |
Tax Rate |
30% |
|
Tax Payable |
0 |
Tax Payable |
300 |
Total Tax Payable = 300
Situation 2 = Credit System
|
Home Country |
|
Host Country |
|
|
Taxable Income |
1,000 |
Taxable Income |
1,000 |
|
Tax Rate |
20% |
Tax Rate |
30% |
|
Tax Payable |
200 |
Tax Payable |
300 |
|
Foreign Tax Credit |
200 |
|
|
|
Total Tax Payable |
0 |
|
|
Total Tax Payable = 300
When the host country tax rate is higher than the home country tax rate, territorial and credit systems both produce equivalent results.
Ref Article 11 of the U.S – U.K income tax treaty:
Territorial and credit systems represent ultimate solutions to international double taxation issues. Tax treaties represent bilateral solutions to the international double taxation issues. Under the income tax treaty between the U.S and the United Kingdom, the United Kingdom agrees not to tax U.S residents on any interest derived from sources with in the United Kingdom and in exchange, the United States agrees not to tax U.K residents on any interest derived from sources with in the United States.
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
www.jct.gov/publications.html
http://www.law.cornell.edu
http://www.irs.gov/publications
U.S Taxation of International Transactions by Robert J. Misey, Michael S. Schadewald
Introduction to United states International Taxation by Paul R. McDaniel, Hugh j. Ault and James R. Repetti
International Taxation by Joseph Isenbergh
International Taxation in a nutshell by Richard L. Doernberg.
International Income Taxation, Code and Regulations by Robert J. Peroni – CCH
Mansoor Suhail (Mani)
Accountant
BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
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