On Tuesday, December 20th, I'm offering a free 1-hour course on tax treaties. You can learn more here and sign up here.
Assume that company XYZ -- which is domiciled in the US -- wants to sell goods to Germany. While this looks like a great idea on paper it may wind up being counter-productive. Why? Because the transaction may be subject to double taxation. The US taxes income of its residents on a world-wide basis -- meaning that wherever in the world you earn money, you have to pay US tax on the earnings. In addition, Germany will also tax the transaction because it occurs within its geographic borders. So, if the US company sells a good in Germany, it will pay both a US tax and a German tax on the transaction, making this a possibly money losing proposition.
Thankfully, this problem of double taxation has long been recognized as a possible impediment to world trade and various parties have sought to prevent its effects from happening. In fact, one of the goals of the original League of Nations was to establish international tax norms (this is where the phrase "permanent establishment" was originally developed). This task eventually fell to the OECD, who issued their first tax treaty in 1963 largely in reaction to the post WWII increase in international trade. This treaty was revised in 1977 and again 1992 when it was released in loose-leaf form, allowing for periodic updates and revisions. The UN issued its model treaty in 1979, which was based on the OECD model, but which was more oriented towards capital importers rather than capital exporters. The US issued their first model treaty in 1977, which was replaced in 1981 and again in 1996.
There is a tremendous amount of overlap between the treaties, with the following difference: The US treaty has a "savings clause" which simply means the US reserves the right to continue to tax its "residents" on a world-wide basis. The UN Treaty is considered more beneficial to countries that are capital importers. But aside from these differences, the common ground between the treaties is profound.
The avoidance of double taxation is a primary reason why countries sign double tax treaties. There are many others. First, treaties allocate the right tax between jurisdictions, essentially saying, "country A can tax X and country B and tax Y." Second, tax treaties create certainty. When I'm looking at a possible international transaction, my first question is, "does a tax treaty exist between the two countries." If it does, there are already a number of assumptions I can make about the overall environment. Additionally, because of the large number of treaties already in effect, the underlying concepts of these treaties (who can tax what when) have already filtered down into the national structures of most if not all countries. Finally, all of the preceding points have promoted international trade because we have a better idea of what we can expect when money and business involves two or more jurisdictions.
There is one more point to mention before moving forward: in order to levy a tax, a "nexus" must exist. According to Dictionary.com, a nexus is "a means of connection; tie; link." There are two ways to establish a taxing nexus: residency and through a permanent establishment. Next time, we'll start with an explanation of residency under the OECD tax treaty.
Next time, we'll start to look at some additional basic concepts.
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