A tax treaty is a bilateral (two-party) agreement made by two countries to handle concerns with double taxation of their respective citizens’ passive and active income. Income tax treaties generally govern how much tax a government can levy on a taxpayer’s income, capital, estate, or wealth. A tax treaty is sometimes known as a Double Tax Agreement (DTA).

Some countries are regarded as tax havens. A tax haven is a country or location that has low or no corporation taxes and allows foreign investors to establish businesses there. Tax havens often do not participate in tax treaties.

When an individual or business invests in a foreign country, the issue of which country should tax the investor’s earnings may arise. Both countries–the source country and the residence country–may enter into a tax treaty to agree on which country should tax the investment income to prevent the same income from getting taxed twice.

The source country is the country that hosts the inward investment. The source country is also sometimes referred to as the capital-importing country. The residence country is the investor’s country of residence. The residence country is also sometimes referred to as the capital-exporting country.

To avoid double taxation, tax treaties may follow one of two models: The Organization for Economic Co-operation and Development (OECD) Model and the United Nations (UN) Model Convention.

Here is an example

The Organization for Economic Co-operation and Development (OECD) is a group of 37 countries with a drive to promote world trade and economic progress.

The OECD Tax Convention on Income and on Capital is more favorable to capital-exporting countries than capital-importing countries. It requires the source country to give up some or all of its tax on certain categories of income earned by residents of the other treaty country.

The two involved countries will benefit from such an agreement if the flow of trade and investment between the two countries is reasonably equal and the residence country taxes any income exempted by the source country.

The second tax treaty model is formally referred to as the United Nations Model Double Taxation Convention between Developed and Developing Countries. The UN is an international organization that seeks to increase political and economic cooperation amongst its member countries.

A treaty that follows the UN’s model gives favorable taxing rights to the foreign country of investment. Typically, this favorable taxing scheme benefits developing countries receiving inward investment. It gives the source country increased taxing rights over the business income of non-residents compared to the OECD Model Convention. The United Nations Model Convention draws heavily from the OECD Model Convention.

Withholding Taxes Policy

One of the most important aspects of a tax treaty is the treaty’s policy on withholding taxes because it determines how much tax is levied on any income earned (interest and dividends) from securities owned by a non-resident. For example, if a tax treaty between country A and country B determines that their bilateral withholding tax on dividends is 10%, then country A will tax dividend payments that are going to country B at a rate of 10%, and vice versa.

The U.S. has tax treaties with multiple countries that help to reduce—or eliminate—the tax paid by residents of foreign countries. These reduced rates and exemptions vary among countries and specific items of income.

Read Also: Taxation Policy And Administration in Developing Countries

Under these same treaties, residents or citizens of the U.S. are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries. Tax treaties are said to be reciprocal because they apply in both treaty countries.

Income tax treaties typically include a clause, referred to as a “saving clause,” that is intended to prevent residents of the U.S. from taking advantage of certain parts of the tax treaty in order to avoid taxation of a domestic source of income.

For individuals that are residents of countries that do not have tax treaties with the U.S., any source of income that is earned within the U.S. is taxed in the same way and at the same rates shown in the instructions for the applicable U.S. tax return. For individuals who are residents of the U.S., it is important to keep in mind that some individual states within the U.S. do not honor the provisions of tax treaties.

What Is an International Tax Rule?

International tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden.

Businesses generally follow what makes most sense from an economic perspective when designing their supply chains and investing across borders. However, the economic reasons for a certain structure may need to align with what makes most sense from a tax perspective.

Multinational businesses have employees and operations in countries all around the world. When a company earns profits in a foreign jurisdiction it will often send some of those earnings back to its headquarters, which may distribute a portion to shareholders as a dividend. Each of these activities could trigger one or more international tax rules.

International tax rules define which countries tax the profits of a multinational business. Generally, the purpose is to ensure that the income of companies is taxed once rather than multiple times by multiple jurisdictions. When more than one country taxes the same earnings of a multinational, the result is double taxation, which is a barrier to cross-border investment.

What rules impact multinational companies?

There are three general policy areas that impact the taxation of multinational businesses. These are tax treaties between countries and the withholding tax rates set in those treaties; rules that define what income will be taxed by the country where the headquarters is located; and rules to minimize tax avoidance by multinationals.

Tax treaties are most often agreed to between two countries. Tax treaties define which country will tax income generated by a company that has operations in both countries. Imagine a U.S. company with a factory in France earning profits and paying taxes to French authorities on those profits. The company may send a dividend back to its U.S.-based parent company out of those French profits. The tax treaty between France and the U.S. allows France to place a 15 percent withholding tax on the dividend payment. The company can reconcile the withholding tax with its corporate tax liability with France.

Another set of international tax rules applies to the foreign earnings of companies. A U.S. company that has operations abroad may owe taxes to the U.S. government depending on how it earns its profits and the extent to which those profits are taxed in a foreign country. The U.S. rules for taxing these foreign profits include the tax on Global Intangible Low Tax Income (GILTI) and Subpart F rules. GILTI is designed to tax foreign income of U.S. companies that generally face low rates of tax abroad. Subpart F results in U.S. companies paying tax to the IRS on foreign income from royalties and dividends. In many countries, similar rules are called controlled foreign corporation (CFC) rules, and selectively tax some foreign earnings of companies.

The last set of rules is designed to minimize tax avoidance through international tax planning. These rules look different depending on whether a country operates a territorial or worldwide tax system. Transfer pricing rules regulate how companies price the goods and services they sell across borders from one operation to another. Thin capitalization rules limit opportunities to minimize global taxes by shifting internal debt from low-tax jurisdictions to high-tax jurisdictions. Other anti-avoidance rules include punitive taxes on business structures designed to avoid taxation.

Economic Impacts of International Tax Rules

International tax rules can be designed to allow multinational companies to reach their customers abroad and compete with foreign companies in international markets. They do this best when they provide tax certainty for companies and eliminate double taxation through clear tax treaties and limited rules that require foreign earnings to be taxed in headquarter countries.

However, many countries have been adopting or strengthening their anti-tax avoidance rules on cross-border income in recent years. These policies, like transfer pricing rules, controlled-foreign corporation rules, and thin capitalization rules have been found to decrease tax avoidance behavior. They can also reduce investment and hiring by multinational companies both abroad and in their headquarter countries.

What are the Advantages of International Tax?

International tax planning is the strategic management of cross-border financial operations and structures to minimize tax burdens, eliminate or mitigate double taxation, and optimize tax benefits. It entails a thorough understanding of international tax laws, treaties, and regulations, as well as various tax optimization tactics and technologies within legal frameworks. International tax planning, also known as international tax structures or expanded worldwide planning (EWP), is a foreign taxation component developed to implement directives for many tax authorities.

International tax planning is a strategic practice that analyses the interaction of several tax systems, considering both juridical (legal) and economic double taxation. It incorporates the complicated environment of tax compliance rules across multiple countries. Furthermore, international tax planning entails concerns other than tax liabilities, such as investigating tax incentives and exemptions applicable to overseas revenue, using foreign tax credits, leveraging tax treaties, and adherence to anti-avoidance procedures.

Advantages of International Tax Planning

• Tax Liability Optimization: Reducing tax obligations is one of the main advantages of international tax planning. Individuals and corporations can benefit from the advantageous tax laws, incentives, and deductions that various countries offer by carefully structuring their company activities and transactions. By doing this, they may reduce their tax liability and keep more of their earnings.
• Cost-reduction possibilities: Companies might find cost-saving possibilities by using international tax planning. Companies can reduce their overall tax costs, including corporate income tax, capital gains tax, and withholding tax, by placing activities or assets in tax-efficient countries. Profitability can rise as a result of significant cost reductions.
• Risk Reduction: Organizations can reduce tax-related risks by utilizing international tax planning. Companies may ensure compliance and steer clear of fines, audits, and legal issues by carefully examining and complying with the tax rules in various jurisdictions. This proactive approach to tax administration protects the company’s standing and long-term viability.
• Cross-Border Expansion: Effective international tax planning is essential for cross-border growth. Utilizing tax treaties, regulating transfer pricing, and optimizing their tax structures, enables enterprises to handle the challenges of conducting business across numerous jurisdictions. This opens up possibilities for market expansion and growth on a worldwide basis.

Challenges face in International Tax Planning

• Changing tax Laws and Regulations: As nations work to safeguard their revenue bases and thwart tax evasion, there is an ongoing modification to international tax laws and regulations. Base Erosion and Profit Shifting (BEPS) initiatives and guidelines by organizations like the Organization for Economic Cooperation and Development (OECD) are a few examples of the often proposed new laws and regulatory frameworks. It may be difficult for taxpayers to stay current with these advancements and ensure compliance with changing legislation.
• Complex Tax Structures and Jurisdictional Variations: Tax rates, incentives, and exemptions in various nations can vary significantly. Further complicating factors include the existence of tax treaties, bilateral agreements, and various interpretations of the tax legislation. A detailed grasp of this complexity is necessary to choose the tax-efficient structure and jurisdiction for cross-border activities, which can be time-consuming and challenging.
• Complexity: Complying with the most recent norms and laws is challenging for businesses due to the complex and continuously changing nature of the global tax system.
• Uncertainty: Because tax rules are interpreted differently in different nations, firms are unclear about their tax liabilities.
• Risk: Being audited by tax authorities is a constant possibility, and failure to comply can lead to large fines for enterprises.

The strategic management of tax liabilities and the structuring of cross-border transactions to maximize tax effectiveness for multinational corporations are referred to as international tax planning. It entails following all applicable tax rules and regulations while employing legal strategies to reduce tax liabilities.

International tax planning is essential for multinational corporations to avoid paying excessive taxes and to increase their level of competitiveness. Companies may efficiently deploy resources, keep their profitability, and lower the danger of breaking the law by handling their tax responsibilities well.