INTM151030 - Double taxation: concept and principles

Effect of double taxation

Double taxation relief is, as its name suggests, about giving relief so why is double taxation relief given?

Many countries have the same model of taxation as the UK. As indicated at INTM151010, the UK taxes its residents on the whole of their income, wherever in the world it arises. But the UK tax non-residents only on their income that arises in the UK.

Suppose that a UK company wishes to trade abroad and it does so not by establishing a separate company in that country but by running the business as a branch of a UK company within the group. The branch is not resident in the other country; it is merely part of a UK resident company that is physically present there. The UK tax the profits of the foreign branch as part of the worldwide profits of the UK resident company. The other State will tax those same profits because, although the company is not resident there, it has a branch earning profits within its territory. So the profits of the branch are doubly taxed.

Now suppose that the UK company prefers to operate in the other State not through a branch but through a separate subsidiary company that is resident there. The UK does not tax the subsidiary on its profits at the time that they are earned (assuming they are not caught by the UK's CFC legislation) but the other State will. So far, there is no double taxation. But when the subsidiary pays a dividend to the UK parent, the other country may charge a withholding tax as a means of taxing the UK parent on the dividend. If the dividend is 100, the other State may impose a withholding tax of (say) 20. So 80 reaches the UK. On the basis that the UK does not recognise the foreign withholding tax as a deduction in arriving at the amount of the income that is chargeable to UK tax under Case V, the UK will also tax 100. That tax will be 30. So far, the combined foreign and UK tax take on the dividend of 100 is 50 [20 + 30]. The dividend is doubly taxed - just over half of it has gone to the foreign and UK fiscs. In fact the total tax is heavier still, if you remember that the dividend is paid out of the profits of the foreign subsidiary that have themselves already borne corporate tax in that State.

Clearly, if businesses end up paying tax on the same income in more than one country, they will not want to do business overseas. Relieving double taxation is a means of removing barriers to international trade, to the operation of free and open markets and to the free movement of persons and of capital.