TAX TREATIES AS TOOLS TO AVOID INTERNATIONAL DOUBLE TAXATION
By Euney Marie Mata-Perez on September 30, 2021
Foreign investments thrive in a fairly predictable and reasonable international investment climate, and the protection against double taxation is crucial in creating such a climate. Income tax treaties are among the tools against international double taxation.
In Commissioner of Internal Revenue v. S.C. Johnson and Son, Inc.. (GR 127105, June 25, 1999), a decision which was reiterated in the more recent case of Cargill Philippines, Inc. v. Commissioner of Internal Revenue (GR. 203346, Sept. 9, 2020), our Supreme Court recognized that tax treaties aim to reconcile the national fiscal legislation of the contracting parties to avoid simultaneous taxation in two different jurisdictions, and, thus, eliminate international juridical double taxation, which is defined as the imposition of comparable taxes in two or more states on the same taxpayer for the same subject matter and for identical periods. It takes place when a person who is a resident of a contracting state derives income from, or owns capital in, the other contracting state, and both states impose tax on that same income or capital. The rationale for doing away with double taxation is to encourage the free flow of goods and services and the movement of capital, technology, and persons between countries, conditions deemed vital in creating robust and dynamic economies, and, thus, let foreign investments thrive.
To eliminate double taxation, a tax treaty resorts to two major methods: first, by allocating the right to tax between the contracting states; and second, where the state of source is assigned the right to tax, by requiring the state of residence to grant a tax relief either through exemption or tax credit.
Thus, a tax treaty sets out the respective rights to tax of the state of source or situs and the state of residence with regard to certain classes of income or capital. In some cases, an exclusive right to tax is conferred on one of the contracting states; however, for other items of income or capital, both states are given the right to tax, although the amount of tax that may be imposed by the state of source is limited.
Under the second method, whenever the state of source (the state where income is earned or arises) is given a full or limited right to tax together with the state of residence, the treaties make it incumbent upon the state of residence to allow relief to avoid double taxation. Two methods of relief — the exemption method and the credit method – are the leading principles in eliminating double taxation that are being followed in existing conventions between countries
In the exemption method, the income or capital, which is taxable in the state of source or situs, is exempted in the state of residence, although in some instances it may be taken into account in determining the rate of tax applicable to the taxpayer’s remaining income or capital. On the other hand, in the credit method, the income or capital, which is taxed in the state of source is still taxable in the state of residence, but the tax paid in the former is credited against the tax levied in the latter. The basic difference between the two methods is that in the exemption method, the focus is on the income or capital itself, whereas the credit method focuses upon the tax.
Under the exemption principle, full exemption or progression could be adopted. A full exemption is where the state of residence does not account for or does not tax the income from the state of source. With progression, the income which is taxed in the state of source is not taxed by the state of residence, but the state of residence retains the right to consider that income when determining the tax to be imposed on the rest of the income.
Under the credit principle, may be applied by two methods: a full credit, where the total amount of tax paid in the state of source is allowed as a deduction; or an ordinary credit, where the deduction allowed by the state of residence is restricted to that part of its own tax appropriate to the income from the state of source.
Some states have also adopted the so-called “tax sparing” provision, in relation to tax incentives granted under their respective domestic laws to attract foreign investments. With tax sparing, taxes exempted or reduced are considered fully paid. Consequently, a non-resident may obtain a tax credit for the taxes that have been “spared” under the incentive program of the state of source, preserving the economic benefits granted by the state of source.
Another form of tax sparing is the so-called “matching credit,” where the state of residence agrees, as a counterpart to the reduced tax, to allow a deduction against its own tax of an amount fixed at a higher rate.
In some tax treaties or international agreements, a most favored nation clause is added to ensure the contracting states of the benefit of concessions previously or subsequently to be made by either contracting state. This provision guards against oversight during treaty negotiation and obviates the need for subsequent negotiations. It grants the contracting party treatment, which is no less favorable than that which has been or may be granted to the “most favored” among other countries. It thus establishes the principle of equality of international treatment by providing the citizens or subjects of the contracting nations the same privileges accorded by either party to those of the most favored nation. In essence. It allows the taxpayer in one state to avail of more liberal provisions granted in another tax treaty provided that the subject matter of taxation is the same as that in the other tax treaty under which the taxpayer is liable and the subject matter is paid in similar circumstances.
The similarity of circumstances is a fact that must be proven by the taxpayer, failing which the application of the most favored nation clause shall be denied by the courts.
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Euney Marie J. Mata-Perez is a CPA-Lawyer and the Managing Partner of Mata-Perez, Tamayo & Francisco (MTF Counsel). She is a corporate, merger and acquisition, and tax lawyer and has been ranked as one of the top 100 lawyers of the Philippines by Asia Business Law Journal. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. If you have any question or comment regarding this article, you may email the author at info@mtfcounsel.com or visit MTF website at www.mtfcounsel.com