In this article, we have covered the ways in which usually countries provide for double taxation relief. Actually, we will see what is called unilateral relief because it’s given only by one of the two countries. Which one would be in your opinion: the residence or the source state? Let’s discuss methods to relieve double taxation.
Let’s understand with the help of an example- An Australian company selling goods to a Vietnamese company. Now the tax in Vietnam is 20% and the tax in Australia is 30%. So if Vietnam claims taxing rights and applies its 20% tax and Australia claims taxing rights and doesn’t relieve double taxation, what happens is that the Australian company has to include the income twice: the first time in Vietnam at a rate of 20%, and the second time in Australia at a rate of 30%.
So, in the end, it is gonna pay 20 of tax in Vietnam out of 100 of income and 30 in Australia out of still 100 of income, the same 100 of income, and in the end, is gonna pay 50.
Had it carried on business only in Australia it would have paid 30, so this is double taxation. Which methods do countries use to relieve double taxation?
Methods to relieve double taxation
There is actually three methods:
1. Deduction method to provide relief from double taxation
The first one is to let the company deduct the foreign tax, so in this situation, the Australian company will still have to pay 20 to Vietnam, but it could deduct this 20 to the income that it has to declare in Australia, to the income not to the tax, so in the end, you will have to pay 20 to Vietnam, 24 (80*30%) to Australia so the total tax would be 44 instead of 30 so we are still getting double taxation here.
The deduction is not a powerful way to relieve double taxation, it’s just a partial relief from double taxation.
2. Tax credit method to provide relief from double taxation
The tax credit method, much better way to relieve double taxation especially if it’s full credit, we will discuss it now, so in this situation, Australia will let the Australian company deduct the taxes paid in Vietnam against the taxes that it has to pay in Australia. There’s a huge difference here with deduction, this was deduction against the income, this is a deduction against other taxes, so what happens is that the Australian company has to pay as always tax to Vietnam, so 100 x 20%, plus 100 x 30%, which is the tax in Australia but Australia provides for the tax relief which is 20.
The amount of the tax that the Australian company paid to Vietnam, so in the end, the Australian company will pay 20 in Vietnam and only 10 to Australia, so the overall tax burden is 30 and in this situation, double taxation has been fully relieved. So this is a very good way to provide relief from double taxation.
There are two credit methods one is the ordinary credit and the other is the full credit. Now, what happens if the tax in Vietnam is 30% and the tax in Australia is 20%, so under the ordinary credit I can credit only the amount of tax that I would have paid, had I carried out business in my domestic country.
Now under the ordinary credit, the Australian company can credit only the tax that it would have paid in Australia, so it doesn’t matter if Vietnam provides for a 30% tax; if the tax in Australia is 20%, I can only credit 20 and not 30, so in that case, I would still have unrelieved double taxation.
With a full credit method for relief from double taxation, you would be able to claim the full amount of foreign taxes against Australian taxes and if the amount of taxes paid in the foreign country is more than the amount of taxes on that same amount of income that the company would have to pay in its domestic state, well the additional credit can be used against other income or carried forward. The full credit is a very good way to relieve double taxation.
3. Exemption Method for relief from double taxation
Now we go to the third one which is the exemption method, and it is by far the best way to relieve double taxation. Under the exemption method Australia would exempt the income that the Australian company would have earned in Vietnam so that 100 will be included in the Vietnamese tax base, that’s source state so you always have to pay taxes there, so 20, but the amount of the tax in Australia would be zero, either because the income is completely excluded.
So in that situation, this would not even exist, we would have just 20 and that’s it, or because the income is exempted from tax but is still included in the tax base.
Now in this situation, the tax would be 20 so even better than paying taxes only to Australia, in that case, it would be 30, so the exemption method is a very powerful way, especially for countries that are export-oriented, it is used usually by Germany Netherlands, so countries that want to place their own companies in the same tax position as the companies of the country where they export, while the credit method is more used by countries like Italy, France, the United Kingdom.
They want to place their exporting companies in the same position as their domestic companies, their companies making business only domestically. So it’s really a different view, a different approach: the exemption method is for export-oriented countries, the credit method is for countries focused on the domestic market.
But anyway coming back to the exemption method, the difference between the fact that the foreign income might be completely excluded or might be included and exempted has to do with the fact that some countries apply for a progressive corporate income tax rate and in that case even if the income is exempted it will push the overall tax rate higher anyway.
Nowadays almost all countries apply a flat corporate income tax rate so I don’t think it makes a big difference yet this is something to keep in mind. These were the ways in which countries relieve double taxation; so which is the country that has to provide double taxation relief? It’s the residence state, and this is a limit, is a big limit.
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