How to Navigate Tax Treaties and Double Taxation Agreements Final

Tax treaties and double taxation agreements in Canada might be challenging. Still, they are essential for avoiding double taxation and taking advantage of any tax benefits available to businesses and individuals.

What is Double Taxation?

When two or more tax obligations are imposed on the same revenue stream, this is known as "double taxation." Such a situation arises when a company's profits are taxed at the individual level. In international commerce and investment, double taxation happens when the same income is subject to taxation by more than one country (Kagan, 2022).

Many times, double taxation occurs because of loopholes in the law. It is typically considered an adverse effect on a tax system, and governments strive to prevent it wherever possible (Kagan, 2022).

What is Tax Treaty?

A tax treaty, also known as a double tax agreement (DTA) or a double tax avoidance agreement (DTAA), is an agreement between two nations to prevent or reduce double taxation. These accords may cover various taxes, such as income, inheritance, value-added, and other taxes (Wikipedia, 2022).

Among the stated objectives for entering into a treaty are:

  • The elimination of double taxation.
  • The reduction of tax evasion.
  • The promotion of cross-border trade efficiency.

It is widely acknowledged that tax treaties increase transparency for taxpayers and tax authorities in international transactions (Wikipedia, 2022).

Determining Residential Status

Your Canadian income tax requirements depend on your residency status. You must know your resident status to determine Canadian tax and reporting obligations. All essential factors must be evaluated to resolve your tax residency. These include Canadian residential ties and the length, purpose, intent, and continuity of stays in and out of Canada. Whether you have significant Canadian home ties is the primary factor in determining your income tax residence status. Canadian residential ties include a home, spouse, or dependents (accountants, 2023).

Permanent Establishment (PE)

According to Article V of the Canada-United States Tax Treaty, a "fixed place of business through which the business of a resident of a Contracting State is carried on wholly or partly" is considered a permanent establishment. Mining, oil and gas extraction, quarrying, and other similar operations are all included under this umbrella word, as are administrative buildings, satellite offices, factories, and workshops (Pwc, 2023).

Avoidance of Double Taxation

The problem of being taxed twice is a common one for multinational corporations. When a company earns money abroad and brings it home, it may be subject to double taxation. It might be prohibitively expensive to conduct foreign business in some countries due to the high combined tax rate.

Many of the hundreds of treaties for the avoidance of double taxation that have been negotiated by countries throughout the world to address these issues have been modelled after models developed by the Organisation for Economic Co-operation and Development (OECD). Countries establish treaties to limit their taxation on foreign business to encourage trade and avoid taxing the same goods twice (Kagan, 2022).

Tax Treaty Shopping and Abuses

To "treat shop" means to attempt to take advantage of a tax treaty between two jurisdictions in a way that does not require you to be a resident of either. A non-resident of a jurisdiction party to a tax agreement may use various strategies to try to acquire the benefits that residents of that jurisdiction are afforded under the contract.

By claiming treaty benefits in circumstances when these benefits were not meant to be awarded, taxpayers engaging in treaty shopping and other forms of treaty abuse weaken fiscal sovereignty and deprive governments of tax revenues. Abuses include:

  • The practice of manipulating the supply chain to reduce tax payments.
  • Multiple types of hybridity (instruments, entities, and transfers) are used.
  • Preventing PE artificially
  • Division of Labour Agreements
  • Treaty Shopping

Bilateral and Multilateral Agreement

The number of involved parties is the most notable distinction when comparing bilateral versus multilateral trade agreements. Agreements between two countries are called "bilateral," whereas those between three or more countries are called "multilateral."

These pacts eliminate tariffs and other export restrictions restricting commerce (Exam Prep, 2023).

Methods of Eliminating Double Taxation

Countries participate in Double taxation avoidance agreements ("Tax treaties") to eliminate tax challenges that hinder trade and services and the movement of capital and individuals between the countries concerned, given that there are divergent standards for assessing credit for foreign taxes (Jain, 2023).

1. Exemption Method

The exemption approach provides that the resident jurisdiction does not tax any income that may be subject to taxation in the source (Foreign) jurisdiction. It is further divided into two approaches:

  • Progressive Approach: Income originating in the source jurisdiction is not taxed by the residence jurisdiction, but it is considered when setting the taxpayer's tax rate (DePasquale, Varley, Zurich, & Zurich, 2022).
  • Full Exemption: This strategy excludes source-country-taxed income from Resident Country taxable income. In a treaty between State A and State B, State B does not consider income taxed in State A (Jain, 2023).

2. Credit Method

Under the credit method, the residency state taxes a taxpayer's worldwide income but allows a credit against the residence country's tax liability for taxes paid to the source state. It is further divided into two approaches:

  • Full Credit: Under the full credit system, the residence nation credits the whole amount of source country taxes against its tax due (DePasquale, Varley, Zurich, & Zurich, 2022).
  • Ordinary Credit: This mechanism is used in agreements that provide credit against resident country taxes. The credit is only available if the overseas jurisdiction taxes the income. If the tax paid abroad exceeds the tax charged in the resident country, the excess tax is discarded, and credit is granted just for the remaining tax. It can also be regulated so that the foreign tax paid on each head of income can be written off to the amount of the tax payable in the home country (Jain, 2023).

MUTUAL AGREEMENT PROCEDURE (MAP)

The MAP clause in Canada's conventions enables authorized CRA personnel to handle disputes with foreign tax authorities regarding double taxation and non-conventional taxes. Residents of either country can request help to settle a convention issue under the article (Agency, 2023). 

Canada has tax treaties with several nations, and the Minister of National Revenue has delegated authority to senior CRA officials to mediate any resulting tax disputes. The competent authority is a group of highly qualified government officials. Most of Canada's treaty allies follow a similar practice when granting permission (Agency, 2023).

Withholding Tax

WHT is imposed at a rate of 25% on interest (other than the majority of interest paid to non-arm's-length non-residents), dividends, rents, royalties, specific management and technical service fees, and similar payments made by a Canadian resident to a non-resident of Canada (pwc, 2023).

Canada's network of treaties is constantly being updated and expanded, with some having retroactive effect. The rate of domestic Canadian interest withholding tax could be lowered due to a tax treaty; however, the amount of any potential rate reduction differs for each tax treaty (Peters, 2014). One must examine the treaty first for the WHT rate in a given situation.

Although the treaty has been signed, it has yet to be in effect. Without a treaty, Canada taxes dividends, interest, and royalties at a maximum WHT rate of 25% (pwc, 2023).

Key Takeaway

- Double taxation occurs when the same income is taxed by more than one country.

  • Tax treaties, also known as double tax agreements, are agreements between two nations to prevent or reduce double taxation.
  • Tax treaties aim to eliminate double taxation, reduce tax evasion, and promote cross-border trade efficiency.
  • Determining residency status is crucial in determining Canadian tax obligations.
  • Permanent establishment refers to a fixed place of business through which the business of a resident of a contracting state is carried out.
  • Tax treaties help in avoiding double taxation and encourage trade by limiting taxation on foreign businesses.
  • Tax treaty shopping refers to attempts to take advantage of tax treaties in a way that does not require residency in either jurisdiction.
  • Bilateral agreements involve two countries, while multilateral agreements involve three or more countries.
  • Methods of eliminating double taxation include the exemption method and the credit method.
  • The Mutual Agreement Procedure (MAP) allows for the resolution of tax disputes between countries.
  • Withholding tax is imposed on certain payments made by a Canadian resident to a non-resident of Canada.
  • Canada has a network of tax treaties that are constantly updated and expanded.

References

Exam Prep, B. (2023) Difference between bilateral and multilateral trade. Available at: https://byjusexamprep.com/upsc-exam/difference-between-bilateral-and-multilateral-trade#:~:text=Bilateral%20is%20better%20than%20multilateral,market%20and%20is%20less%20complex.

Wikipedia, F. (2022). Retrieved from https://en.wikipedia.org/wiki/Tax_treaty

Kagan, J. (2022) What double taxation is and how it works. Available at: https://www.investopedia.com/terms/d/double_taxation.asp

Jain, A. (2023). Retrieved from https://sortingtax.com/different-types-and-methods-of-double-taxation-avoidance-agreements-dtaa/#tiea

DePasquale, P., Varley, A., Zurich, B., & Zurich, M. (2022). Retrieved from https://www.itu.int/ITU-D/finance/work-cost-tariffs/events/tariff-seminars/Geneva_Taxation/pdf/DePasquale_Varley-Contribution-e.pdf

Agency, C. R. (2023). Retrieved from https://www.canada.ca/content/dam/cra-arc/serv-info/tax/non-res/map/mp_rprt_2021-en.pdf

pwc, C. (2023). Retrieved from https://taxsummaries.pwc.com/canada/corporate/withholding-taxes

Peters, M. (2014). Retrieved from https://www.mondaq.com/canada/withholding-tax/342134/canadian-tax-fundamentals-withholding-tax-on-cross-border-interest-payments#:~:text=Canada%20levies%20withholding%20tax%20of,is%20%22participating%20debt%20interest%22.

Pwc, C. (2023). Retrieved from https://taxsummaries.pwc.com/canada/corporate/corporate-residence#:~:text=Permanent%20establishment%20(PE),are%20attributed%20to%20that%20PE.

 accountants, O. property. (2023). Retrieved from  https://www.optimiseaccountants.co.uk/how-to-determine-your-residency-status-for-tax-purposes-in-canada/

Written By:
Salman Rundhawa
Salman Rundhawa is the founder of Filing Taxes. Salman provides valuable tax planning, accounting, and income tax preparation services in Toronto, Mississauga, Oakville, and Hamilton.

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