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Method of double taxation avoidance
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For the purpose of saving the same income/person from being taxed twice (economic/juridical double taxation)- both in the country of its source as well as in the country of the residence of the tax payer- the following options are available to the tax administration of the residence country: |
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(Source country income exempted from taxation in residence country)
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Full exemption of source country Income No Progression
Exemption with Progression. |
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2. TAX CREDIT METHOD |
(Source country income exempted from taxation in residence country)
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| No limit or Ceiling of Actual |
Overall Worldwide |
Per Item |
Per source |
| Foreign Taxes paid-Full Credit |
Limitations-Progression |
(Income) |
Country |
| For foreign Taxes Paid. |
Method |
Limitation (with reference to |
Limitation |
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Source country |
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Combination (as per choice) |
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3. TAX SPARING METHOD |
(Tax credit granted at a higher rate of grant of tax credit for source country tax not actually period |
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4. DEDUCTION METHOD |
(Source country tax deducted from source country income)
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Under the exemption method, the investor’s country of residence exempts from taxation certain items of the income from foreign sources. In other words, that country grants the country where the income is earned-the source country-the exclusive right to tax that item of income. The exemption so granted might be without any limitation (full) for the foreign source income. Alternately, the country of residence may take into account the foreign source income. Alternatively, the country of residence may take into account the foreign source income together with domestic income in determining the progressive rate of tax applicable to the taxable income. This is known as exemption with progression for the foreign source income. The full exemption of foreign source income from taxation by the country of residence may place the investor in a position of tax equality with residents of the source country, because the tax on that income is determined solely by the level of taxation in the latter country. Thus, the concessions granted by the source country are not reduced or cancelled by the tax of the investor’s country of residence.
The essential feature of the credit method is that the investor’s country of residence treats the foreign tax, within certain statutory limitations, as if it were tax deemed to have been paid to itself. Where the foreign tax rate is lower than the domestic rate, only the excess of the domestic tax over the foreign tax is payable to the investor’s country of residence. Where the foreign tax is on the higher side, the country of residence does not collect any tax. Thus, the effective over all tax burdens is determined by the higher of the domestic or the foreign tax rates. Countries which apply the credit method reduce their normal tax claims on the foreign profits by the amount of the tax, which the investor has already paid thereon to the source country. The credit method is predicated on the premises that tax should be a neutral factor in decisions concerning investment at home and abroad and that taxpayers with identical income should bear an identical tax burden irrespective of the source of their income.
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Under the tax credit method, the deduction of source country tax from the residence country tax may, as per choice, take the following form:
1. Full credit (no limitation) for the foreign taxes paid;
2. Over all world wide limitation with progression;
3. Limitation in terms of per item of income; and
4. Per source country limitation.
Many developed countries, especially in European countries, have provided in their treaties with developing countries for the use of tax sparing method. It is sometimes referred to as matching credit mentioned. The India-Japan tax treaty of 1960 could serve as a good example of tax sparing credit. Under this method, the country of residence grants a tax credit calculated at a higher rate than the tax rate currently applied in the source country. Alternatively, the term ‘tax sparing’ may also refer to the practice of one treaty partner allowing its taxpayers to claim a foreign tax credit for a tax in the other contracting State not actually paid. This means that the country of residence grants a credit not only for the tax actually.
This means that the country of residence grants a credit not only for the tax actually paid in a developing country, but also for the tax spared by incentive legislation in that country. The purpose behind tax sparing is to allow a developing nation to offer foreign investors a tax holidays’ or concessional rate of taxation as an investment incentive without the tax holiday/concessional benefit accruing to the developed nation.
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Under the deduction method, not in wide use source country tax is deducted from the source country income.
Three Methods Compared
Assumption: Investor has only source country income.
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| Exemption Credit Deduction
i. Source Income 100 100 100
ii. Source Tax 20 20 20
iii. Residence Income 0 20 80(i-ii)
iv Residence Tax 0 50 50
(before Credit) 0
v Residence Tax 0 30(iv-ii) 50
vi After tax Income 80 50 30
of the investor (i-ii) [i-(ii+v) (iii-v)
in his residence country |
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As found to be suitable to its individual needs, a country may adopt any of the methods noted above. In practice, however most countries adopt a combination of exemption and credit methods- with one method predominating. The benefit of double taxation avoidance could either be granted unilaterally under the domestic law or in a bilateral through the mechanism of a tax treaty.
To facilitate easy understanding of the two most widely used methods exemption and credit –some examples are given:
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EXAMPLES OF METHODS OF ELIMINATION OF DOUBLE TAXATION
MR. X IS A PRESIDENT OF INDIA
IN 1992, MR. X WORKS 5 MONTHS IN INDIA. HIS SALARY FOR THAT PERIOD IS 100,000.
ON 1 JUNE 1992, HE GOEST TO UNITED STATES WHERE HE WORKS UNTIL 31ST DECEMBER. DURING THESE 7 MONTHS, HIS SALARY IS 150,000. |
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ASSUMPTIONS:
i. BOTH INDIA AND U.S. FOLLOW THE CALENDER YEAR AS THE ACCOUNTING YEAR.
ii. IN INDIA, THE TAX RATES ARE AS FOLLOWS:
1-50,000 : 10%
50001-100,000 : 20%
100000 AND OVER : 40%
iii. IN U.S., THE RATES ARE AS FOLLOWS:
1-10,000 : 15%
10000 AND OVER : 30%
iv. ALL FIGURES ARE IN RUPEES |
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1. NO ELIMINATION OF DOUBLE TAXATION
TAX IN U.S.
INCOME (IN U.S.) 150000
TAX
15% OF 10000 1500
30% OF 140000 42000
TOTAL 43500
TAX IN INDIA
INCOME
IN INDIA 100000
IN U.S. 150000
TOTAL 250000
TAX
10% OF 50000 5000
20% OF 50000 10000
40% OF 150000 60000
TOTAL 75000
TOTAL TAX
IN U.S. 43500
IN INDIA 75000
TOTAL 118500 |
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2. EXEMPTION METHOD (FULL EXEMPTION)
TAX IN U.S.
INCOME (IN U.S.) 150000
TAX
15% OF 10000 1500
30% OF 140000 42000
TOTAL 43500
TAX IN INDIA
INCOME
IN INDIA 100000
IN U.S. 0
TOTAL 100000
TAX
10% OF 50000 5000
20% OF 50000 10000
TOTAL 15000
TOTAL TAX
IN U.S. 43500
IN INDIA 15000
TOTAL 58500 |
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3. EXEMPTION METHOD (WITH PROGRESSION)
TAX IN U.S.
INCOME (IN U.S.) 150000
TAX
15% OF 10000 1500
30% OF 140000 42000
TOTAL 43500
TAX IN INDIA
INCOME
IN INDIA 100000
IN U.S. 150000
TOTAL 250000
TAX
10% OF 50000 5000
20% OF 50000 10000
40% OF 150000 60000
TOTAL 75000
PROPORTIONATE (-) 45000
ELIMINATION OF TAX
ON INCOME FROM U.S. 30000
(150000 X 75000)/25000
= 45000
TOTAL TAX
IN U.S. 43500
IN INDIA 30000
TOTAL 73500 |
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4. CREDIT METHOD
TAX IN U.S.
INCOME (IN U.S.) 150000
TAX
15% OF 10000 1500
30% OF 140000 42000
TOTAL 43500
TAX IN INDIA
INCOME
IN INDIA 100000
IN U.S. 150000
TOTAL 250000
TAX
10% OF 50000 5000
20% OF 50000 10000
40% OF 150000 60000
TOTAL 75000
CREDIT FOR US TAX (-) 43500
31500
TOTAL TAX
IN U.S. 43500
IN INDIA 31500
TOTAL 75000 |
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5. CREDIT METHOD (WITH LIMITATION)
TAX IN U.S.
INCOME (IN U.S.) 150000
TAX
15% OF 10000 1500
35% OF 140000 49500
TOTAL 50500
TAX IN INDIA
INCOME
IN INDIA 100000
IN U.S. 150000
TOTAL 250000
TAX
10% OF 50000 5000
20% OF 50000 10000
40% OF 150000 60000
TOTAL 75000
CREDIT FOR US TAX (-) 45000
-US TAX 50500
-INDIA TAX ON U.S.
INCOME
(150000 X 75000)/250000
= 45000
30000
TOTAL TAX
IN U.S. 50500
IN INDIA 30000
TOTAL 80500 |
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| Rate of 35% is assumed afresh to bring the Foreign Tax (50500) on the higher side in comparison to the proportionate Domestic Tax (45000) on Foreign Income. |
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VARIOUS METHODS OF CREDIT LIMITATION
MR. Y IS RESIDENT OF INDIA
IN 1992, HIS TOTAL INCOME IS THE FOLLOWING:
- SALARY IN INDIA 50000
- DIVIDENDS IN GREE 15000
- SALARY IN RUSSIA 30000
- INTEREST IN FRANCE 5000
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100000
MR. Y HAS PAID THE FOLLOWING AMOUNTS OF TAX:
- ON DIVIDENDS IN GREECE 4500
- ON SALARY IN RUSSIA 12000
- ON INTEREST IN FRANCE 500
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17000
THE TAX IN INDIA BEFORE ANY CREDIT FOR FOREIGN TAX, IS 25000
ALL FIGURES ARE IN RUPEES |
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