Double tax agreements (hereinafter referred to as “DTAs”), also known as tax treaties, represent a complex area in the context of international tax. We do not intend to cover the topic in this article comprehensively, but rather to provide a high-level overview on the topic. You will be introduced the main features of DTAs and learn some common terms used in connection with treaties.
A DTA is an agreement or a contract as on the subject of double taxation or rather, the avoidance of double taxation. Speaking from a Malaysian context, a DTA would typically be signed by a cabinet minister representing the country. It is an agreement / contract signed between two countries (hereinafter referred to as “contracting states”), with the purpose of avoiding or alleviating territorial double taxation on the same income in two countries.
When residents (could be individuals, corporations or enterprises) from two different countries trade with each other, cross-border transactions arise.
Illustration 1
Let’s say Johnny, a person from Country A trades with a resident in Country B, and that the profits accruing to Johnny is RM500. This profits of RM500 is likely to be subject to tax in Country A, since he is resident and/or based in Country A, as well as in Country B as such gains are derived from Country B. This means that Johnny’s profits of RM500 would be subject to tax in both Country A and Country B, hence territorial double taxation arises.
Assuming that Country A has a tax rate of 35%, and Country B’s is 25%, Johnny could suffer a total tax of RM300[(35% of RM500) + (25% of RM500)], leaving him with only RM200 after paying for both taxes.
As demonstrated in Illustration 1, territorial double taxation clearly discourages international trade. Who would wish to pay taxes on the same income twice, in two different countries? It would make more sense for a trader to trade only within the state boundaries and suffer tax in one country, rather than two.
Nonetheless, we have a common understanding that international trade is actually beneficial for the countries involved, especially from an economics viewpoint. Hence, countries acknowledging these benefits would attempt to provide a more conducive environment for cross-border trading, by setting rules to eliminate or alleviate territorial double taxation.
This entails that countries would have to gather, negotiate, and to reach a mutual agreement to specific terms and conditions of how these income or profits should be treated, so that these traders would suffer a tax amount that is not worse off than if he were to trade within the same state boundaries.
A standard DTA contains ‘articles’, covering various topics. Countries concerned normally kick off their discussion with a model convention, a standard template with the standard articles and clauses of a typical DTA. Though not a member of the OECD (Organisation for Economic Co-operation and Development), Malaysia usually adopts the OECD model convention, with a few features taken from other model conventions, such as the one by UN.
Each country will then present to its counterparty with its list of conditions and start negotiating until the finally come to a mutual agreement. Hence, every treaty is unique and that specific treaty only applies to the two countries concerned.
As mentioned above that each treaty is unique, Article 1 specifies that only residents of the two countries concerned are covered by the treaty. This means that only the two countries concerned would be relevant to the treaty benefits as stipulated under the treaty.
With the growing impact from globalisation, companies and individuals tend to fulfil residency status in more than one country, this is referred to as having dual residency. This affects the application of a treaty, hence, Article 4 sets out rules specifically to resolve dual residence issue. Outcome of such is that the individual concerned will be deemed to be resident in either one of the two countries.
This is an important concept as a resident of one contracting state, what constitutes a ‘permanent establishment’ (PE) in the other contracting state is dealt with at length. A DTA should provide detailed rules to help identify whether a PE exists. A person (let be an individual or a company) from Country A will only be taxable in Country B, if he fulfils the PE criteria in Country B. In addition to that, only the income attributable to such PE in Country B will taxable in Country B.
One of the main features of a DTA is that the country of residence normally grants a double tax relief.
Illustration 2
Based on scenario as shown under Illustration 1 of the RM500 profit made from cross-border trade, the double tax relief mechanism would work as follows:
Country A (country of residence)
Income 500
Country A - tax@35% 175
Less: Double tax relief - ie. Country B's tax@25% -125
Tax payable in Country A 50
Country B (country of source)
Income 500
Country B - tax@25% 125
Total tax payable 175
Johnny would end up paying a tax of RM175, rather than RM300, for the profit of RM500. The two countries have agreed to share the tax revenue, and the country of residence had given the credit of RM125 to eliminate the double taxation.
Another principle that has been established throughout the years is that a DTA exists with the purpose of avoiding double taxation, rather than to impose tax. Fundamentally, the domestic law, Income Tax Act 1967 for the case of Malaysia, should be the only law to impose a tax liability. A DTA is more like a shield to protect traders from suffering double taxation.
Section 132 of the Act states that if a DTA has been entered into and it has started to take effect, then, so long as the DTA remains in force, the DTA shall have effect in relation to tax under this Act notwithstanding anything in any written law. In other words, DTAs supersede any written law, not limited to only tax laws.
This principle has been reinforced by the courts; if there is a conflict between domestic law and the treaties, the treaties will prevail.
If your business deals with cross-border transactions, it is crucial to have at least a general knowledge of double tax agreements. When you require further guidance from an agreement, you can start by determining which DTA is applicable, and then examine the relevant clauses of that particular DTA. When in doubt as to what a particular phrase implies, it is always helpful to contact our member of staff; we would be more than happy to assist you.