Limitations of Double Tax Treaties

In this article we will discuss about the limitations of double tax treaties.

(i) The other Contracting State does not exercise its allocated rights to tax under a treaty, or

(ii) A tax treaty gives the State the right to tax, but no tax is due under its domestic law.

Only the domestic tax law in each country has the taxing power under its legislative enactment. That law alone dictates the level of taxation, and how it should be computed.

Under the constitutional law of most countries, a treaty can restrict the taxing powers or the amount of the tax due under the domestic law, but not increase them. It sets the maximum tax that may be imposed by a Contracting State, based on the agreement between the two Contracting States when the treaty was concluded.

Thus, it can exempt or reduce taxes, but it cannot create new taxes or assessment procedures, or enlarge or initiate additional or new taxes, or increase the tax burden. As an exception in a few countries, a treaty can expand the scope of its taxes when the domestic law makes the treaty rule the domestic rule. In the Netherlands, a treaty has priority over domestic law even if it is less beneficial.

Generally, a treaty does not provide a basis for a higher tax charge than under domestic law unless the domestic legislation clearly demands that result. In countries that require parliamentary approval, the domestic law would preclude them from imposing additional taxes through tax treaties (Examples: Germany, India, and United Kingdom).

However, it appears that it is at least legally possible for a treaty to impose an additional tax in countries where treaties do not require parliamentary approval. It may impose taxes through a treaty since it does not have to be approved or enacted as domestic legislation.

In addition, the following MC Articles may increase their tax liability:

a. Article 9:

Associated enterprises subject to arm’s length pricing and profits may lead to an additional tax in a Contracting State unless correlative or corresponding relief is granted by the other Contracting State.

b. Article 25:

The mutual agreement procedure on treaty interpretation may deny treaty benefits or impose taxes.

c. Article 26:

The exchange of information may enable the tax authorities to request and to obtain more information than they could obtain under their domestic law, and thus increase the taxpayer’s exposure to tax. Tax treaties are primarily intended to avoid over-taxation on the same income.

They are not meant to grant “double” credit or exemption. A person entitled to benefits from more than one tax treaty can claim the most favourable treaty, but these benefits are mutually exclusive, not cumulative. In cases when the treaty benefits are waived, the taxpayer must not take inconsistent positions to achieve benefits greater than those that can be derived through double tax avoidance.

Treaties usually, but not always, have priority over domestic law. Therefore, as treaties remain unchanged for a period (average fifteen years) and take time to renegotiate, they provide certainty and protection against adverse changes in domestic tax laws. Many jurisdictions also allow the taxpayer to choose either the domestic tax regime or the tax treaty, whichever is more favourable.

This provision may be specifically mentioned in the domestic law (Examples: Belgium, Denmark, India, Luxembourg). Some countries provide a specific “non-aggravation” or “preservation” clause in their tax treaties (Examples: Japan, United States).

This clause preserves the right to apply the domestic law if it is more advantageous. The US tax treaties also contain a “saving clause” that reserves the right of each Contracting State to tax its own citizens and other tax residents, as if the treaty did not exist.