Split the Difference: Understanding Double Taxation Agreements
Dec 13, 2016
Monitoring the traffic of business visitors from abroad is increasingly becoming a requirement for Payroll & HR departments. Regardless of whether visitors are coming on short- or long-term secondments or are frequently visiting another country for a few days at a time, stakeholders must give due consideration as to what the potential tax treatment of such visitors should be.
Why might a visitor have to pay tax in a foreign country? There are two primary factors that should be considered first when determining whether tax is due: The tax residency position of the individual and where his or salary is earned.
Yet many businesses take the erroneous view that because an individual is deemed a ‘non tax resident’ in a country, there cannot be any tax liability on them. That is simply not true: Most countries in the world subject non tax residents to tax in their country, but the scope is usually limited to taxing only income arising in the visited country – rather than worldwide income.
A simple rule of thumb to follow is that if an individual does any work within a country and earns a day’s salary for it, then potentially that country’s tax may be due on that payment. In theory, even the business visitor who is only present for a day in the visited country could have local tax to pay on that day’s salary… but such an approach could act as a major inhibitor to global trade.
To avoid that scenario, the concept of the Double Taxation Agreement (DTA) was created. These Agreements are made in the form of national treaties between two sovereign governments, and are entered into for the following reasons:
- To protect against the possibility of one form of income being subject to two countries’ taxes simultaneously;
- To provide taxpayers (both individuals and companies) with certainty on their tax treatment when transacting with cross-border businesses, thus helping to grow trade between the contracting nations;
- To prevent discrimination for tax payers and businesses when operating abroad;
- To promote co-operation between tax authorities in the two contracting states to counter tax evasion and avoidance; and
- To also assist in the detection and prevention of other cross border illegal activities such as money laundering, drug smuggling, and terrorism.
What's in a Double Taxation Agreement?
There are currently about 3,000 DTAs in operation world-wide. Utilising DTAs to promote world trade is a key policy of the Organisation of Economic Co-operation and Development (OECD): By removing the threat of double taxation the OECD can contribute to encouraging the free movement of capital, goods, and people – ultimately improving the operation of free and open markets.
To encourage the development and use of DTAs, the OECD provides a model treaty designed to be used by nations as a blueprint when commencing negotiations. This is why many treaties have a similarity; members of OECD are obliged to use the model when they wish to negotiate a treaty.
Each treaty consists of a number of Articles detailing the management of specific issues, so the model treaty provides a commentary on the Articles. This commentary is a guide that serves two overarching purposes: 1.) To provide insight to tax authorities on how the wording of the model treaty should be interpreted; and 2.) To indicate areas where two states have flexibility when negotiating a new or revised agreement. (The current OECD commentary is a useful reference guide that can be purchased from the OECD website.)
Not All DTAs are Exactly Alike
Yet the OECD model is not designed as a “one size fits all” approach as the flow of trade, people and capital is likely to be quite different when compared between developed Western economies and those of developing nations. And in addition to the OECD Model, the UN also publishes a suggested model for treaties between the developed and developing world.
So while there are broad similarities between various DTA treaties, at large, it is vital that each relevant treaty text is studied in detail by the global payroll stakeholders at multinational organizations. The first step of reviewing any given treaty should be to check that the Articles cover the general issues applicable to Payroll. Usually, these will be as follows:
- Article 1 – Persons Covered. The article will confirm who exactly is covered by the treaty (usually tax residents of one or both contracting states).
- Article 2 – Taxes Covered. Check that income tax and any relevant payroll taxes in the other contracting state are covered. A DTA will not usually cover the application of any social insurance contributions.
- Article 3 – General Definitions. This article will usually contain the territorial definition of each contracting state.
- Article 4 – Fiscal Domicile. This article usually clarifies the treatment of an individual who is deemed to be resident in both contracting states.
Having clarified these important initial definitions, the Article to focus on when considering the tax treatment of salaries and wages is that covering Employment Income (also referred to as Dependent Personal Services in older treaties), listed as Article 15 in the OECD Model Convention. The Article usually consists of three paragraphs, each of which need to be considered to determine the correct tax treatment of an individual.
Paragraph One of Article 15 usually states that “salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived there from may be taxed in that other State.”
The words similar remuneration are taken to have the broadest possible coverage on all income arising from employment and cover such items as non cash benefits and unapproved share option gains.
The wording of paragraph one makes clear that the tax position of an individual on employment income is initially governed by where the work is undertaken – not by the tax residency position of the individual. It is this paragraph that ensures that even the briefest business visitor is potentially liable for tax on their salary.
The most important word in the final sentence is “may” – in other words, it does not say “will.” Many countries operate their own de-minimus rule to not take up the right that paragraph one gives them to tax visitors – for example South Africa does not seek to tax any visitor to the country with presence of no more than 21 days.
Understanding Exemption Conditions
A potential exemption from taxation in the visited country is then typically provided in Paragraph Two of Article 15.
As an example, consider the wording of Paragraph Two from the Azerbaijan/UK DTA. It states that “Notwithstanding the provisions of paragraph (1) of this Article, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if:
- The recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days within any twelve month period commencing or ending in the fiscal period concerned; and
- The remuneration is paid by, or on behalf of, an employer who is not a resident of the other State; and
- The remuneration is not borne by a permanent establishment or a fixed base which the employer has in the other State.”
What this means in practice for global payroll compliance is that tax residents of one country on a short term visit to the other country can continue to pay tax in their home country (and conversely be exempt from tax in the visited country) if all of the three conditions are applied.
- The first condition looks at a simple “days in country” test. Here each individual DTA must be studied, as the test varies between checking presence of 183 days within a fiscal year to 183 days within any 12- month period.
- The second condition looks at who the effective employer of the individual is, and whether that employer is a resident in the visited country. This test does not simply consider who the legal employer is by reference to the contract of employment or related documentation, such as a letter of secondment (although these will be a strong indication of the circumstances). The level of integration into the visited country business must also be considered – that is, which entity actually bears the risk of what the employee does in their working day, and who reaps the rewards from their efforts.
- The third condition looks at who bears the final salary cost of the individual. Passing the salary onto an entity based in the visited country will usually cause the exemption from host country tax to be lost. Such a cost could be transferred by direct charge or by inter-company journal and could be as straightforward as a direct gross pay charge plus on costs or a more sophisticated charge including an additional percentage for other on-costs. It does not however bar a “charge for the service” which makes no reference to the salary cost from being used.
How a DTA Works in Practice
Consider a few example scenarios at the hypothetical 'Big Forklift' group of companies:
- Cliff is sent to the UK from the USA to learn to install some machinery for the Big Forklift group. He is employed by Big Forklift Inc. in the USA, but is undergoing the training at Big Forklift Ltd. He visits the UK from December 1 to February 18. His salary costs remain charged to Big Forklift Inc. in the USA, which remains his contractual employer. Under the UK/US DTA, Cliff remains taxable in the USA and UK tax may be disregarded.
- Crystal is also sent to the UK from Big Forklift Inc. to monitor the training process. Her contract remains with Big Forklift Inc. and no salary charge is made back to Big Forklift Ltd. However, her visit runs from June 1 of this year to March 15 of the next year. Because Crystal is in the UK for more than 183 days, she therefore must be taxed according to the rules of Paragraph One (i.e., in the country where she performs the work).
- Cody is sent to Big Forklift Ltd. to undertake urgent repairs to machinery used in the UK. He stays for 6 weeks, then returns to the USA. Big Forklift Inc. charges the UK company $20,000 for the repairs. The charge makes no direct reference to Cody’s salary and would have been the same had colleagues earning 10% more or less than Cody been sent on the job. Although the UK entity benefits from having the repair done, the transaction would appear to be an ordinary commercial one between the two entities – Big Forklift Inc. ultimately reap the reward of Cody’s efforts through the fee of $20,000 they charge for the repair. As such Cody remains taxable in the USA, and UK taxation may potentially be disregarded.
Lastly, the final paragraph of Article 15 usually provides an exception limited to employment of mariners. What it usually makes clear is that the country of taxation is that from where the vessel they work on is effectively managed from – not where it travels.
In a January 2017 article, CloudPay will explore how the various tax exemptions offered by DTAs are applied in practice around the globe. For more insights on paying cross-border employees in a compliant way, click here.