Therefore, DTAs supercede national tax laws and regulations. In our example above, the DTA between the two countries could provide that only country B (where our taxpayer lives and works) has the right of taxation over his income earned. Thus, even though the national law of country A allows taxation of his income, the DTA prohibits it.

Avoidance of Double Taxation

There are two methods to avoid double taxation: The Exemption Method and the Credit Method.

The Exemption Method is generally a more favourable method whereby income is exempted entirely from tax in one of the countries party to a DTA.

The Credit Method requires a taxpayer to declare both income and foreign taxes paid on that income. That income is – broadly speaking – then taxed in full in the tax computation of both countries, with the foreign taxes paid credited against the tax owed in the second country. This method can therefore have the effect of ‘topping up’ the taxpaid in the foreign country, resulting in additional tax being paid.

By way of example, presume our taxpayer is a tax resident of country A, but physically resides and works in country B. He earns €100,000, on which he pays tax of €25,000 in country B. Under the terms of the tax treaty, country B has the first right of taxation. Country A applies a flat tax rate of 35% to employment income and its residents are taxed on worldwide income and assets.

If country A permitted the Exemption Method, the full €100,000 would be declared in the taxpayer’s return and then exempted from income tax in Country A. If the Credit Method was applied, €100,000 would be declared in Country A and €35,000 tax would be calculated. The €25,000 already paid would be credited against this, leaving an additional liability of €10,000 to be paid to country A.

As can be seen, it is not correct to presume that because income has been taxed in one country there is never any tax payable on that income anywhere else! It is also critical to note that, for the application of the Credit Method, the income must have declared and taxed in the other country. Where a taxpayer is unable to prove this, a taxing authority may ignore any foreign tax credit claimed by the taxpayer in assessing the tax due on foreign income.

Transfer Pricing

As briefly mentioned, Transfer Pricing relates to the charging for goods and services across national borders, and serves as anti-avoidance measures. Whilst the concept of transfer pricing is relatively simple, the design and administration of transfer pricing policies increases exponentially with the size and complexity of a (global) business. In this discussion paper we will focus on simple structures most commonly implemented by our clients, namely a cost centre/back office/shared service centre structure.

Under this structure, an entity is set up as the operating entity. Generally this is the entity that invoices customers and recognises revenue. At the same time, an entity is set up in another jurisdiction to bear certain operating costs for the group, such as staff costs.

As is immediately obvious, in the absence of transfer pricing regulations, it would make the most sense to incorporate the revenue generating entity in a low tax jurisdiction to minimise corporate tax and the cost centre entity in a high tax jurisdiction to maximise the tax loss that it would generate. Transfer pricing rules prohibit this, however, and broadly speaking require the cost centre to invoice the revenue entity for services provided at a market related, arm’s length rate.

Strictly speaking, this rate forms the core of transfer pricing strategy and the calculations required involve independent benchmark studies, formal policies and so on. However, for smaller/simpler group structures we tend to see a ‘cost plus’ model applied, whereby the cost centre applies a markup of between 5% and 10% to its costs and invoices this to the revenue generating entity. This results in the cost centre generating a taxable profit, ensuring that there is no undue loss to the fiscus of the taxing authority under which the cost centre operates.

It is important that at least a service agreement is concluded between a cost centre and the entities it services. This agreement should include a description of the services to be rendered as well as the fees to be charged and payment terms. As noted, the more complex a group and the more complex the goods or services supplied (for example, intellectual property rights), the more robust a group’s transfer pricing policies and supporting documentation will need to be.

It is also important that the general tax administration laws and regulations of the underlying countries are adhered to even though the entities are related. For example, a proper tax invoice fully compliant with statutory invoicing requirements should always be generated and recorded in the administrations of both the supplier (cost centre) and customer (revenue centre) entities as it would were the parties independent of each other.