date | theme

10. July 2020 | Perpetual Traveler: center of life and habitual residence as a criterion in taxation

13. July 2020 | Limited and unlimited tax liability in Germany

04. January 2021 | Tax easing: Taxes on the departure of business assets abroad

18. December 2020 | Double Taxation Agreement: Purpose / Effect / Benefits (this contribution)

Double taxation agreements, often abbreviated to DTAs, are bilateral, internationally binding treaties between states that seek to prevent double taxation of their citizens at home and abroad. The background to this is that in many countries the amount of taxable income includes all income of a taxpayer worldwide. In addition, domestic income can be taxed even if the taxpayer has neither residence nor habitual residence in the corresponding state. This can also lead to the same income being taxed in more than one country. An agreement to avoid double taxation should also prevent this. Such double taxation agreements regulate in which cases which state has tax jurisdiction. In return, the other Contracting State shall waive the taxation of such income.

1.1. Globalization as a driving force in International Tax Law

1.1.1. Tax evasion = tax evasion?

Today, economic networking has reached a point where many companies take a vital interest in expanding their business beyond their own national borders for granted. But economic globalization is only the visible aspect of these modern times. What too often remains in the background are the fiscal implications of this expansion drive. At most, when reports of tax tricks such as the Panama Papers become known, the public also learns about the tax implications that arise when companies want to pay almost no taxes. Because a lot depends on thinking globally in tax matters, so that you move tax liability to a low-tax country. Many people who are outraged forget that this is neither illegal nor due to loopholes in the law.

1.1.2 Double Taxation Agreement in Response to Tax Evasion

Rather the opposite is the case. Most countries have a system of taxation which obliges their taxpayers to pay tax on all income earned, regardless of the country in which it is earned. This is also called the World Income Principle, which both Liechtenstein and Germany follow, for example. Other countries see all their citizens as taxable. This principle of tax liability regardless of residence applies, for example, in the USA. Be that as it may, the fact that the income (and assets) of a taxpayer are taken into account as fully as possible in taxation may have been tax irrelevant in earlier times when only a few entrepreneurs were global. Nowadays, however, this is hardly a negligible factor.

Therefore, over the last few decades, a trend has developed towards agreement on tax sovereignty, with which states try to protect their nationals from double taxation of their income. This is increasingly seen as both an unjust and an economic obstacle, which in turn affects the economic development of one’s own country. In this way, they also make it possible for entrepreneurs to choose the country in which they prefer to pay taxes.

1.2. The OECD Model Convention on the Prevention of Double Taxation

Out of all these and other contexts, a development has started in the recent past with which a set of rules that is as uniform as possible should serve as a template for future double taxation agreements. These efforts at the international level culminated in the draft OECD Model Convention on the Avoidance of Taxes on Income and Assets, as the document is officially called in German. According to the OECD, this model agreement has now formed the basis of more than 3,000 bilateral agreements worldwide. This clearly underlines the increasing importance of double taxation agreements.

1.3. Double Taxation Agreement of the Federal Republic of Germany: current status

In the meantime, the Federal Republic of Germany has concluded double taxation agreements with about 100 states. Furthermore, derogations have been made in exceptional cases. For example, a treaty borrowed from the OECD Model Treaty with Taiwan has been agreed, although Taiwan as a state has not yet received recognition by the Federal Republic. On the other hand, it should be noted that although a double taxation agreement has been concluded with the People's Republic of China, this does not apply in the special economic zones of Hong Kong and Macao, where the general tax law of the People's Republic does not apply. Of course, the Federal Republic of Germany continues to strive to conclude double taxation agreements with other partner states.

1.4. Further bilateral, tax-relevant contract options

It should be mentioned in passing that in addition to the double taxation agreement, other bilateral agreements with a tax reference are possible. Thus, there is the possibility of an intergovernmental exchange of information, as well as of legal and administrative assistance for the detection and prosecution of tax evasion. Furthermore, special double taxation agreements are also possible within the framework of inheritance tax and gift tax as well as motor vehicle tax.

Compared to the general double taxation agreement, however, these treaties are of little importance. But this could also tend to change in the coming decades for those agreements that regulate the taxation of inheritances and gifts. Because the generation, which is nowadays economically active in the foreground and benefits the most from globalization, will one day also plan its retirement and thus its estate from a global point of view.

2. application of double taxation agreements

2.1 Legal framework for the application of double taxation agreements

Double taxation agreements are thus bilateral, international treaties between states that serve to avoid double taxation of tax objects by the respective tax subjects. This simplified general definition includes the tax objects income and assets. Tax subjects are the respective limited or unlimited taxpayers.

Furthermore, the binding of international law means that double taxation agreements take precedence over national laws. In their case law, courts also have to follow the provisions of the double taxation agreement as a priority. In short, double taxation agreements contain the rules according to which it is decided when which of the states involved may apply its taxation law.

2.2 Double Taxation Agreement: Limited and Unlimited Tax Liability

This brings us to the scope of taxable situations that are regulated under the double taxation agreements. This includes both unlimited and limited tax liability. Because both aspects arise from national law, the application of the rules of double taxation agreements is a priority in a specific case. In fact, the objectives of double taxation agreements are that national law remains unilaterally without application. Conversely, however, this is also an attempt to ensure that taxation takes place at least in one country.

The background to this is that you need a basis for taxation. On the one hand, of course, an income or a fortune serves as a prerequisite for taxation. Although the wealth tax does not currently apply in Germany, this is still common in other countries. On the other hand, taxation also depends on whether the person who is entitled to the taxable income or property is taxable at all in a country. In principle, a distinction must be made between the unlimited tax liability, which is generally valid, and the limited tax liability. The latter concerns persons only if they do not meet any of the criteria for unlimited tax liability (domicile, habitual residence or centre of life in the country), but earn income there which is therefore taxable there (territoriality principle).

2.3 General principles of double taxation agreements

2.3.1. Double taxation agreements are based on common standards

The guideline followed by the rules of double taxation treaties is that, in a given situation, tax sovereignty is in principle granted to the country in which the taxable income arose. Although the fact that the vast majority of national tax laws in the world only partially correspond to each other, there is a great deal of room for divergent interpretations. But this is precisely why double taxation agreements are concluded at bilateral rather than multinational level. This opens up the possibility, within the framework of the negotiations prior to the signing of the agreements, for states to agree on when, how and which rules should apply in certain situations.

2.3.2. Double taxation agreements regulate taxation procedures

Now that the question of tax jurisdiction has been clarified, it is necessary to discuss how the state forgoing taxation has to deal with the calculation or even the refund of taxes already paid twice. There are two options available. On the one hand, the waiver of tax sovereignty can be implemented through an exemption procedure. This simply declares these incomes tax-free. On the other hand, if taxation has already been anticipated in advance, for example by using a withholding tax such as wage tax as a collection procedure, then the tax administration should actually order a repayment. However, the crediting procedure is simpler. As a result, taxes on the income spared by the double taxation agreement are offset against other taxes. However, the crediting procedure can also be used if no withholding tax is applied. In this case, the taxes collected in the third country are taken into account.

To give our readers an example of the application of double taxation agreements, we refer to a case from our professional practice. For easier understanding, we change it in a few points. We also assume an income of EUR 100,000. The tax rate applicable abroad should be 10 % for both income tax and corporate tax. On the other hand, a consideration of trade tax remains just as out of consideration as other supplementary levies (for example solidarity surcharge, church tax).

3.1. Starting situation for our example

At the heart of our example is an entrepreneur who sets up a partnership abroad, choosing a low-tax country. Although the entrepreneur in Germany remains unrestrictedly taxable, he receives his income from business operations from the state in which his business is located. As a result, two states have a legal interest in taxing these commercial incomes. Thus, there would normally be double taxation by both states. However, on our advice, the entrepreneur has decided to set up the company in a country that has concluded a double taxation agreement with Germany.

We also advised to choose a partnership for tax reasons. As we will soon see, compliance with the double taxation agreement leads to independent taxation of the dividend in Germany. Since partnerships distribute profits but not capital gains, this intermediate step does not apply to the partnership.

3.2. Taxation of commercial income under a double taxation agreement

If a corporation had been established instead of a partnership, the profit would first have to be taxed at company level in the third country. Subsequently, a distribution of profits would be taxable at the shareholder level. However, since the shareholder is resident in Germany, the Federal Republic of Germany would receive tax jurisdiction. Therefore, the low tax rates of the third country did not apply to taxation in Germany. In the double taxation agreement, unlike business income, capital gains are awarded to the country in which the taxpayer is taxed without restriction.

By choosing a partnership, however, commercial income must be taken into account in taxation. So here we are following Article 7 of the double taxation agreement, as it is also formulated in the OECD model agreement. This benefits from the low tax rates of the third country. Because in this case, these incomes are to be regarded as tax-free in Germany due to the double taxation agreement. After all, taxation in this case took place exclusively in the third country. Taxes on a corporation compared to a partnership are thus calculated as follows:

Capital company abroad