CHAPTER 4

Double Taxation Relief

4.1 INTRODUCTION
As discussed in Chapter 2, most countries tax their residents on their
worldwide income and nonresidents on their domestic source income.
Consequently, foreign source income earned by a resident of a country may
be taxed by both the country in which the income is earned (the source
country) and the country in which the taxpayer is resident (the residence
country). If income tax rates are low, as they were in the early years of the
last century when income taxes were in their infancy, the inefficiencies and
unfairness caused by this double taxation may be tolerable. But when tax
rates reach the levels that now prevail, double-tax burdens can become
onerous and interfere substantially with international commerce. The
necessity for the relief of international double taxation is clear on grounds of
equity and economic policy. However, the type of relief that is appropriate is
a controversial question.
International double taxation can arise in a variety of ways. The
following three types of double taxation arise from overlapping claims by
two or more countries to tax the same income:

– Source-source claims. Two countries assert the right to tax the same
income of a taxpayer because they both claim that the income is
sourced in their country.
– Residence-residence claims. Two countries assert the right to tax the
same income of a taxpayer because they both claim that the taxpayer
is a resident of their country. A taxpayer that is a resident of two
countries is commonly referred to as a “dual-resident taxpayer”.
– Residence-source claims. One country asserts the right to tax foreign
source income of a taxpayer because the taxpayer is a resident of that
country, and another country asserts the right to tax the same income
because the income arises or has its source in that country.
 Of these three types of international double taxation, overlapping
residence-source claims are the most likely to occur. To some degree,
taxpayers can minimize their exposure to the other types of double taxation
through careful tax planning, but residence-source double taxation is difficult
for taxpayers to avoid through tax planning. Therefore, the attempts of the
international tax community to deal with international double taxation have
focused primarily on the elimination of residence-source conflicts.
International double taxation can also occur due to differences in the
way countries define income and in the timing and tax accounting rules they
adopt for computing income. As explained in Chapter 6, international double
taxation may also occur due to disputes between countries about the proper
arm’s-length prices for cross-border transfers of goods and services between
related parties. Other rules adopted to curtail tax avoidance can also produce
double taxation. For example, if one country denies the deduction of interest
paid by a resident corporation to a shareholder in another country pursuant to
thin capitalization rules and treats the interest paid as a dividend, the
amount may be taxable in both countries, as a dividend subject to
withholding tax in one country and as interest included in a resident’s income
by the other country.
Typically, tax treaties provide relief from the three major types of
international double taxation, and from some of the other types as well,
although the relief is sometimes limited. Some cases of double taxation
resulting from overlapping claims based on the source of income are dealt
with by explicit rules for the source of income. For example, Article 11(5) of
the OECD and UN Model Treaties provides a rule that interest is deemed to
arise (i.e., have its source) in the country in which the payer is resident. As
noted in Chapter 2, section 2.3.1, however, most tax treaties do not contain
extensive source rules. Cases involving source-source double taxation that
are not resolved by the specific provisions of a treaty may be resolved
through consultation between the competent authorities of the two treaty
countries under the treaty’s mutual agreement procedure. See Chapter 8,
section 8.8.3 for a discussion of the mutual agreement procedure. Resolution
of such issues is not easy because the competent authorities of most countries
are naturally reluctant to give up their country’s right to tax domestic source
income.
Individual taxpayers almost always obtain relief from international
double taxation resulting from dual residence through the tiebreaker rules in
tax treaties. Cases involving the dual residence of legal entities are also
resolved by treaty. As discussed in section 2.2.3, Article 4(2) of the OECD
and UN Model Treaties provides a series of “tie-breaker” rules to resolve
cases in which an individual is resident in both countries. The dual residence
of a legal entity is resolved under Article 4(3) the OECD and UN Model
Treaties by deeming the entity to be resident in the country where its place of
effective management is located. The mutual agreement procedure is
sometimes used to deal with dual-residence cases that are not resolved
explicitly in the treaty. Since dual-resident entities are often used to avoid
tax, some bilateral tax treaties deny treaty benefits to such entities.
Ordinarily, the residence country grants relief from double taxation
resulting from the imposition of tax on the same item of income by both the
residence country and the source country. In other words, the source
country’s right to tax on the basis of the source of the income has priority
over the residence country’s right.
Three methods – the deduction method, the exemption method, and
the credit method – are commonly used for providing relief from double
taxation. These methods are discussed in section 4.3 below after a brief
explanation of what is meant by the term “international double taxation”.

4.2 INTERNATIONAL DOUBLE TAXATION DEFINED

The term “double taxation” is used in so many different contexts that any
precise definition of the term is not appropriate in all contexts. The term is
not defined in the OECD or UN Model Treaties or in the Commentary on
those Models, although they identify one of their main objectives as “the
avoidance of double taxation with respect to taxes on income and on capital”.
“International double taxation” can be defined as the imposition of
income taxes by two or more sovereign countries on the same item of income
(including capital gains) of the same taxable person for the same period. This
juridical or legal definition of international double taxation is narrow and
does not cover many situations that commentators frequently refer to as
double taxation, although it does identify the essential ingredients of
international double taxation. Even so, under this definition, it is not always
easy to determine whether double taxation exists in a particular case. For
example, questions may arise as to whether the taxes levied by the two
countries are both income taxes or whether the items of income subject to tax
are the same.
The legal definition of international double taxation should be
distinguished from the broader economic concept of double taxation.
Economic double taxation occurs whenever there is multiple taxation of the
same item of economic income. Under the legal definition, taxation of a
subsidiary company by one country and taxation of the parent company on a
dividend from that subsidiary by another country is not international double
taxation because the two companies are separate legal entities. In the
economic sense, however, the parent and the subsidiary constitute a single
enterprise. Economic, but not legal, double taxation also may arise when
income is taxed to a partnership and to the partners or when it is taxed to a
trust and to the beneficiaries of the trust.
Methods for relieving international double taxation are primarily
focused on legal double taxation rather than economic double taxation. The
reason double taxation relief is limited to legal double taxation is that the
definition of economic double taxation is exceedingly broad and difficult to
specify with the precision needed for tax laws. For example, some economic
double taxation occurs when income is taxed when earned and again when
consumed, yet no country is prepared to extend double taxation relief to sales
taxes or other consumption taxes. Similarly, countries are not prepared to
grant relief from the economic double taxation resulting from the imposition
of both an income tax and an estate or wealth tax. However, double taxation
relief is sometimes extended to economic double taxation where taxes are
paid by foreign subsidiaries and other foreign affiliates of a resident parent
corporation despite the fact that the taxes are not paid by the parent.
International double taxation should be distinguished from the double
taxation of an item of income by a single country, which might be termed
“domestic double taxation”. Domestic double taxation may arise, for
example, with respect to income earned by a corporation and distributed to its
domestic shareholders under the so-called classical method of corporate
taxation. It may also arise when tax is imposed on the income of a person by
both the central government of a country and one or more of its political
subdivisions. Double taxation by national and sub-national governments is
not necessarily objectionable – indeed, when the levels of taxation are
properly regulated to avoid excessive tax burdens, such double taxation may
be an inevitable feature of fiscal federalism.
4.3 RELIEF MECHANISMS
No international consensus has been reached on the appropriate method for
granting relief from international double taxation. The following three
methods are in common use. Most countries use all three methods for
different types of international double taxation; a country may use only one
of these methods, or it may use some combination of methods:

– Deduction method. The residence country allows its taxpayers to

claim a deduction in computing income for taxes, including income
taxes, paid to a foreign government in respect of foreign source
income.
– Exemption method. The residence country exempts foreign source
income derived by its residents from residence country tax.
– Credit method. The residence country provides its resident taxpayers
with a credit for income taxes paid to a foreign country against
residence country taxes otherwise payable. Under the credit method,
foreign taxes are deductible in computing the tax payable to the
residence country but not in computing the taxpayer’s income.

Foreign source income earned by residents of a country that uses the

deduction method is taxable at a higher effective rate than it would be under
either the credit method or the exemption method. The exemption method
and the credit method typically give equivalent results whenever the effective
foreign tax rate is equal to or greater than the domestic effective tax rate. The
exemption method is generally the most favorable to the taxpayer when the
foreign effective tax rate is less than the domestic effective tax rate. The basic
results under the three methods are illustrated by the following example.

Example

R, a resident of Country A, earns 100 of income from Country B on which

she pays 40 of tax to Country B. Under the deduction method, R will pay tax
to Country A on net income of 60 (100 – 40). The foreign tax paid to Country
B of 40 is deductible in computing R’s income subject to tax in Country A.
Assuming that R is taxable in Country A at a rate of 50 percent, she will pay
tax of 30 to Country A and a total tax of 70 on her income of 100, for a
combined foreign and domestic rate of 70 percent. If Country A uses the
credit method, R’s tax liability to country A (before any foreign tax credit)
will be 50 percent on her total worldwide net income (100) with no deduction
for the taxes paid to Country B. However, she will receive a credit against the
tax otherwise payable to Country A for the taxes paid to Country B of 40.
The foreign tax paid of 4 is deductible against the tax payable to Country A.
The result is that R will pay tax to Country A of only 10 (50 – 40) and total
tax of 50, for a combined foreign and domestic effective tax rate of 50
percent. Finally, if Country A uses the exemption method, R will pay no tax
to Country A in respect of the foreign source income earned in Country B,
and the total tax payable on the income will be 40, for a combined foreign
and domestic rate of 40 percent. These results are summarized in Table 4.1.

Table 4.1 Comparison of Methods for Relieving Double Taxation

Deductio Credi Exemptio
n t n
Metho Metho Metho
d d d
Foreign source income 100 100 100
Foreign tax (40%) 40 40 40
Deduction for foreign tax 40 nil nil
Net domestic income 60 100 nil
Domestic tax before credit 30 50 nil
(50%)
Less: foreign tax credit nil 40 nil
Final domestic tax 30 10 nil
Total domestic and
70 50 40
foreign tax

Additional information on the operation of the deduction, exemption,

and credit methods is provided below in sections 4.3.1, 4.3.2, and 4.3.3,
respectively, and the exemption and credit methods are compared in section
4.3.4. Section 4.3.5 examines some of the effects of tax treaties on double-
taxation relief.

4.3.1 Deduction Method

Countries using the deduction method tax their residents on their worldwide
income and allow those taxpayers to take a deduction for foreign taxes paid
in the computation of their taxable income. In effect, foreign taxes – income
taxes and other types of taxes – are treated as costs or current expenses of
doing business or earning income in the foreign jurisdiction. As noted above,
the deduction method is the least generous method of granting relief from
international double taxation.
The deduction method was used by a number of countries in the
formative years of their tax systems when worldwide tax rates were low, and
at that time it was an acceptable approach. As tax rates increased in the post-
World War II period, however, most countries adopted either the exemption
method or the credit method as the basic method for relieving international
double taxation. The OECD and UN Model Treaties authorize only the
exemption method and credit method as methods for granting double-tax
relief.
The deduction method has not disappeared. Several countries that have
adopted the credit method have retained the deduction method as an optional
form of relief and as a way of dealing with foreign taxes that, for some
reason, do not qualify for the foreign tax credit. In addition, some countries
use the deduction method for taxes paid with respect to income derived from
foreign portfolio investments.
In effect, countries use the deduction method whenever they tax
residents on the net amount of the dividends they receive from a foreign
corporation, assuming that the foreign corporation has paid some foreign
income tax and a foreign tax credit is not allowed with respect to that tax. For
example, assume that FCo, a foreign corporation, earns 100 of foreign
income and pays foreign income tax of 20. FCo pays its remaining after-tax
income of 80 as dividends to its shareholders, including a dividend of 20 to
R, a resident of Country A who owns 25 percent of the shares of FCo. On
these facts, R has earned 25 of foreign source income through FCo on which
foreign income tax of 5 (25 percent × 20) is paid. If Country A taxes R on
income of 20, it is in effect allowing R a deduction for the 5 of income tax
that was paid by FCo. A country that requires the associated tax to be added
to net dividends is said to “gross up” the dividends to approximate the
before-tax income out of which the dividends were paid. The purpose of a
gross-up rule is to provide equivalent treatment to taxpayers earning foreign
income directly and taxpayers earning such income indirectly through a
foreign corporation. See the discussion of the indirect foreign tax credit in
section 4.3.3.3 below.
The effect of the deduction method is that residents earning foreign
source income and paying foreign income taxes on that income are taxable at
a higher combined tax rate than the rate applied to domestic source income.
As a result, the deduction method creates a bias in favor of domestic
investment over foreign investment whenever the foreign investment is likely
to be subject to foreign income tax. Thus, the deduction method is not neutral
with respect to the allocation of resources between countries. This treatment
may be justified from the viewpoint of national self-interest: not only is
domestic investment encouraged, but also residents with equal net worldwide
income are treated similarly in that they will pay the same amount of
domestic tax. Of course, from the perspective of the total (combined domestic
and foreign) tax burden on a taxpayer’s worldwide income, the deduction
method does not achieve equal treatment of residents. Although residents
with equal net worldwide income will pay the same domestic tax, they may
pay widely differing amounts of foreign tax.

4.3.2 Exemption Method

Under the exemption method, the country of residence taxes its residents on
their domestic source income and exempts them from domestic tax on some
or all of their foreign source income. In effect, the country of residence gives
up its right to tax foreign source income, which consequently is taxable
exclusively by the source country. The exemption method completely
eliminates residence-source international double taxation because only one
jurisdiction, the source country, imposes tax on the income.
Some countries – Hong Kong is a prominent example – have adopted
the exemption method with respect to most or all foreign source income
earned by their residents. In effect, these countries tax only income from
domestic sources. For this reason, they are often said to tax on a territorial
basis rather than a worldwide basis. For most countries using the exemption
method, however, the exemption of foreign source income is limited to
certain types of income, most commonly business income earned in foreign
countries and dividends from foreign affiliates. Further, the exemption
method is sometimes restricted to income that has been subject to tax, or
subject to a minimum rate of tax, by the foreign country.
 Although foreign source income may be exempt from residence country
tax by countries using the exemption method, the income may be taken into
account in determining the rate of tax applicable to the taxpayer’s other
taxable income. This practice is referred to as “exemption with progression.”
In such systems, the foreign source income is included in income for the
limited purpose of determining a taxpayer’s average tax rate as if the foreign
income were taxable; this average rate is then used to compute the actual tax
due on the taxpayer’s other (non-exempt) income. Several countries,
including Belgium, Finland, Germany, and the Netherlands, use the
exemption with progression method.

Example

Assume that Country A levies tax at a rate of 20 percent on the first 10,000 of
income and 40 percent on income in excess of 10,000. T, a taxpayer resident
in Country A, has 10,000 of domestic source income from Country A and
10,000 of exempt foreign source income. T would pay tax of 2,000 (20
percent of 10,000) under a regular exemption system. Under an exemption
with progression system, T must determine the average tax rate that would
apply if his entire income of 20,000 were domestic source income. In this
example, the average rate would be 30 percent ((10,000 × 0.20 + 10,000 ×
0.40) divided by 20,000). The tax payable to Country A would then be
determined by applying the 30 percent average rate to the domestic source
income of 10,000, resulting in tax payable of 3,000.
The exemption method is relatively simple for the tax authorities to
administer and is effective in eliminating international double taxation. The
exemption with progression system is more complex because it requires the
tax authorities to obtain information about the amount of foreign source
income earned by resident taxpayers.
Although the exemption method is widely used and is sanctioned by
both the OECD and UN Model Treaties (see Article 23A of both treaties), it
is inconsistent with the tax policy objectives of fairness and economic
efficiency. To the extent that foreign taxes are lower than domestic taxes,
resident taxpayers with exempt foreign source income are treated more
favorably than other residents. Moreover, an exemption system encourages
resident taxpayers to invest abroad in countries with lower tax rates,
especially in tax havens, and encourages them to divert domestic source
income to such countries. For example, a taxpayer residing in an exemption
country who earns interest on funds invested in that country has a strong
incentive to move the funds to a foreign country that imposes low or no taxes
on interest income.
Because of these deficiencies, as noted above, the application of the
exemption method for relieving double taxation to all foreign source income,
which is equivalent to taxing on a territorial basis, is difficult to justify and is
used by only a few countries. The exemption method can be justified if it is
used as a convenient and simple proxy for the credit method or is limited to
certain types of income. For example, a country might exempt resident
taxpayers on income derived from foreign countries that impose tax at rates
and under conditions that are roughly comparable to its own rates and
conditions. If such an exemption system is properly enforced, the results are
similar to those obtained under a credit system because, in such
circumstances, a country using the credit method would collect little or no tax
with respect to any foreign source income that is subject to foreign tax
comparable to the residence country’s tax. This point is illustrated in the
following example.

Example

ACo is resident in Country A, which levies income tax at a rate of 40 percent.

ACo earns income of 1,000 in each of Country B and Country C, which levy
tax at rates of 40 and 50 percent respectively. Country A has a foreign tax
credit system to relieve international double taxation. Consequently, the
credits for taxes paid to Countries B and C, 400 and 500 respectively, will
completely offset Country A’s tax of 800 on ACo’s total foreign source
income of 2,000. Country A will collect tax from ACo after allowing the
credit for foreign taxes only if ACo’s effective foreign tax rate is less than the
effective tax rate of Country A.
Of course, in the example above, the effective foreign tax rate may be
lower than the Country A rate even if Country B and Country C generally
impose substantial taxes on foreign corporations. For example, one or both
countries may offer some special tax incentives or their tax laws may contain
some loopholes that foreign corporations are able to exploit. In such
circumstances, Country A might collect some tax revenue from ACo in
respect of its foreign source income.
 Several countries use the exemption method for active business income
earned by resident corporations through a foreign branch or permanent
establishment. Several countries also exempt certain dividends received from
foreign corporations in which resident corporations have a minimum
ownership interest, usually 5 or 10 percent. This exemption for dividends is
often referred to as a participation exemption and is discussed in more
detail in section 4.3.3.1 below.
The alleged virtue of the exemption method for relieving international
double taxation is its simplicity: it minimizes compliance costs for taxpayers
and administrative costs for tax authorities. However, for an exemption
system to operate effectively, a country must be able to ensure that the
exemption is limited to foreign source income that is subject to foreign tax
comparable to domestic tax. Thus, an effective exemption system requires
vigorous source-of-income and expense rules. It also requires anti-avoidance
rules to prevent low-taxed foreign source income from qualifying for
exemption. Finally, it requires expense allocation rules or anti-avoidance
rules to prevent taxpayers from deducting expenses incurred to earn exempt
foreign source income against their domestic income.
One often-overlooked weakness of an exemption system is its likely
impact on the shifting of tax burdens from an income earner to the payer in
some circumstances. Assume, for example, that Country A, which has a
corporate tax rate of 50 percent, provides an exemption for foreign source
income. Country B imposes a withholding tax of 25 percent on interest
payments made to nonresidents. ACo, a resident of Country A, makes a loan
of 100,000 to BCo, a resident of Country B. If ACo can earn 10,000 of
interest free of tax by loaning money to a resident of Country C instead of
BCo, ACo is likely to demand that it receive annual payments of 10,000, net
of Country B’s withholding tax from BCo. Therefore, BCo must gross up its
payments to ACo so that ACo ends up with 10,000 after Country B’s 25
percent withholding tax. The effect of this arrangement is that the burden of
the withholding tax of 2,500 imposed by Country B on the payment to ACo is
borne by BCo. This economic effect would be avoided if Country A used the
credit method. In that case, ACo would pay taxes of 5,000 wherever it earned
the 10,000 of interest income. ACo would have no leverage to shift Country
B’s withholding tax to BCo because it would have no opportunity for earning
10,000 free of tax and Country B’s withholding tax would be creditable
against ACo’s tax payable to Country A.
4.3.2.1 Participation Exemption

Most foreign direct investment takes the form of equity or share investments
in foreign or nonresident corporations. Special considerations apply to the
relief of international double taxation with respect to dividends from foreign
corporations and capital gains from the disposition of shares of foreign
corporations. This section discusses the exemption of dividends and capital
gains with respect to substantial participations in foreign corporations. The
indirect or underlying foreign tax credit for dividends from foreign
corporations is discussed in section 4.3.3.3 below. The participation
exemption and the indirect credit are compared in section 4.3.4.
Several countries use the exemption method to eliminate the double
taxation of dividends from foreign corporations. The exemption method has
been the traditional method used by European countries; however, in recent
years Australia, Japan, and the United Kingdom have also adopted
participation exemptions. The United States (US) has been discussing the
possible adoption of an exemption for dividends for many years, but has not
yet done so.
There are 3 key elements in the design of a participation exemption:

– the level of share ownership necessary to qualify for the exemption;

– the nature of the income earned by the foreign corporation out of
which the dividends are paid; and
– the amount of foreign tax on the income of the foreign corporation.

These same three elements are also important in the design of an indirect
foreign tax credit, as discussed in section 4.3.3.3.
The participation exemption is limited to dividends received by a
resident corporation from a foreign corporation in which the resident
corporation has a substantial ownership interest or participation. The level of
share ownership required varies from 5 percent (e.g., in the Netherlands) to
25 percent (e.g., in Japan) and in the Parent-Subsidiary Directive in the EU.
Many countries use a 10 percent ownership threshold. The ownership
threshold can be based on voting shares, the value of shares (or both votes
and value) or all the shares of the foreign corporation.
In theory, an exemption for dividends should be limited to dividends out
of the active business income earned by a foreign corporation. Dividends out
of passive investment income should not qualify for exemption; otherwise,
resident corporations would have an incentive to divert passive income to
their foreign subsidiaries in order to reduce residence country tax. For
example, assume that ACo, a company resident in Country A, has funds
available for investment that could earn passive income of 1 million. If ACo
earns the income by investing in Country A, it will pay tax to Country A of
40 percent. However, if ACo uses the funds to acquire shares in its wholly
owned subsidiary, BCo, resident in Country B, which taxes at a rate of only
10 percent, and BCo earns passive income of 1 million, BCo will pay tax to
Country B of 100,000. BCo can then distribute its after-tax profits of 900,000
to ACo. Assuming that Country A exempts the dividend, this simple tax
planning would result in substantial tax savings for ACo.
Therefore, some countries limit the exemption to dividends out of active
business income of foreign affiliates. Such an approach imposes significant
compliance obligations on taxpayers to keep track of the type of income
earned by their foreign affiliates and requires rules to determine the type of
income from which dividends are considered to be paid. As a consequence of
these problems, some countries have abandoned any attempt to limit their
participation exemptions to dividends paid out of active business income of
foreign affiliates of resident corporations, and instead rely on CFC rules or
other anti-avoidance rule to prevent the abuse of the participation exemption.
For example, under CFC rules, any passive income earned by a controlled
foreign affiliate of a resident corporation is taxable to the resident corporation
when earned by the controlled foreign affiliate without waiting for the
income to be distributed in the form of a dividend. If the passive income is
taxable to the resident parent corporation when earned, any subsequent
dividend out of that income can be exempt from tax. CFC rules are discussed
in Chapter 7, section 7.3.
As noted above, if the income of a foreign affiliate in which a resident
corporation has a substantial participation is subject to foreign tax at a rate
that, when combined with any withholding tax on dividends, approximates
the tax rate imposed by the residence country, the residence country will not
collect any tax on dividends from foreign affiliates in that country even if it
uses the credit method. Therefore, from a theoretical tax policy perspective, a
participation exemption can be justified as a proxy for a foreign tax credit if
the exemption is limited to dividends out of income that is subject to foreign
tax (corporation tax and dividend withholding tax) at a rate that is
comparable
to the residence country’s corporate tax rate.
Some countries have limited their participation exemptions to dividends
from foreign affiliates established in listed comparable-tax countries or to
countries with which they have concluded bilateral tax treaties that provide
an exemption for dividends. In the interests of simplicity, other countries
have abandoned any attempt to limit their participation exemptions to
dividends that are paid out of income that has been subject to foreign tax
comparable to residence country tax. In these countries, the participation
exemption is available even for dividends from foreign affiliates in low-tax
countries. Most of these countries rely on other rules, such as CFC rules, to
prevent abuses of the participation exemption. As noted above, if the income
of a CFC is taxable to its resident parent corporation when earned, any
subsequent dividends out of that income can be exempt from residence
country tax.
Some countries with a participation exemption for dividends from
foreign affiliates also extend the exemption to capital gains on the disposition
of the shares of those foreign affiliates. The rationale for extending the
participation exemption to capital gains is that, from an economic and
commercial perspective, dividends are often a substitute for capital gains with
respect to substantial participations. Thus, if dividends from a foreign
affiliate are exempt from tax by the country in which the shareholder
corporation is resident but capital gains on the sale of the shares of a foreign
affiliate are not exempt, the shareholder corporation can reduce the capital
gain from the sale of the shares of a foreign affiliate by requiring it to pay
exempt dividends before the sale.
For example, assume that ACo, resident in Country A, owns all of the
shares of BCo, resident in Country B. Country A has a participation
exemption for dividends from foreign corporations in which resident
corporations own at least 10 percent of the shares (by votes and value).
However, Country A imposes a tax of 20 percent on capital gains, including
capital gains from the disposal of shares of foreign corporations. ACo is
contemplating a sale of the shares of BCo to an arm’s length purchaser and
expects to make a capital gain of 10 million (proceeds of sale of 14 million
less the cost of the shares (4 million)). The gain would be subject to tax by
Country A of 20 percent of 10 million, or 2 million. If BCo pays a dividend
of 10 million to ACo before the sale, the dividend will reduce the value of the
shares, the proceeds of sale and the capital gain. However, the dividend may
be subject to withholding tax by Country B. If so, the payment of dividends
to reduce the capital gain would be beneficial only to the extent that the
source country’s withholding tax is less that the residence country’s tax on
the capital gain.

4.3.3 Credit Method

Under the credit method, foreign taxes paid by a resident taxpayer on foreign
source income generally reduce domestic taxes payable on that income by the
amount of the foreign tax. For example, if P pays a foreign tax of 10 on some
foreign source income and would otherwise be subject to domestic tax of 40
on that income, the foreign tax credit reduces the domestic tax payable from
40 to 30. Consequently, the credit method completely eliminates international
double taxation of the residence-source type. Under the credit method,
foreign source income is subject to domestic tax whenever the foreign tax
paid is less than the domestic tax payable. In such circumstances, the net
domestic tax is an amount equal to the foreign source income multiplied by
the difference between the two tax rates. In effect, assuming that the domestic
tax rate is lower than the foreign tax rate, the foreign taxes are “topped up”
by domestic taxes so that the combined domestic and foreign tax rate on the
foreign source income is equal to the domestic tax rate.
Invariably, credit countries do not refund foreign taxes paid by their
residents on foreign source income in excess of the domestic tax on that
income; see, for example, Article 23B of the OECD and UN Model Treaties.
Similarly, countries with foreign tax credit systems do not generally allow
excess foreign taxes to offset taxes imposed on domestic income. In other
words, the credit for foreign taxes paid is usually limited to the amount of the
domestic tax payable on the foreign source income. Various limitation rules,
sometimes quite complex in application, as discussed below, are used to
prevent what are perceived to be inappropriate uses of foreign tax credits. As
a result of these limitations on the credit, foreign income is typically taxed at
the foreign tax rate whenever the foreign rate is higher than the domestic rate.
In summary, under the credit method, foreign source income earned by
residents is generally taxed at the higher of the domestic and foreign tax
rates.

4.3.3.1 General Rules

The credit method avoids the shortcomings of the deduction method
described in section 4.3.1: resident taxpayers are treated equally from the
perspective of the total domestic and foreign tax burden on their foreign
source income, except when foreign taxes exceed domestic taxes. Moreover,
subject to the same exception, the credit method is neutral with respect to a
resident taxpayer’s decision to invest domestically or abroad. These points
are illustrated by the following example.
X and Y, who are both residents of Country A, each earn 100 of foreign
source income. The foreign tax on such income is nil for X and 40 for Y. If
both X and Y are subject to tax by Country A at a rate of 50 percent, X will
pay 50 and Y will pay 10 of tax to Country A. In both cases, the combined
domestic and foreign tax paid will be 50. If the foreign tax paid by Y is 60,
however, the combined domestic and foreign tax rate on Y would be 60
percent because Country A would not provide relief for 10 of foreign taxes
paid (60) in excess of domestic taxes (50) on the foreign source income. As a
result, Y would pay tax of 60 and X would pay tax of 50.
Many countries allow foreign income taxes that cannot be credited in the
current year (excess foreign tax credits) to be carried forward and credited
against domestic taxes in future years. The carry forward period varies from
country to country. The limitations on the credit apply to the deduction of
these excess foreign tax credits in future years. Assume, for example, that R
is resident in Country A, which imposes tax at a rate of 30 percent. In year 1,
R earns foreign income of 100 and pays foreign tax of 50. The foreign tax is
allowed as a credit against the Country A tax to the extent of 30, thereby
eliminating completely the tax payable to Country A. To the extent that the
foreign tax exceeds the Country A tax (20), the foreign tax is not creditable,
and R has an excess credit of 20. In year 2, assume that R earns foreign
income of 100 and pays foreign tax of 25. R might be allowed a credit of 30 –
the current foreign tax of 25 plus 5 of the excess credit carried forward from
year 1 for use in future years. The amount of the excess credit from year 1
that is available for carry forward to year 3 and subsequent years would be
reduced from 20 to 15.
On tax policy grounds, the credit method is recognized by many tax
commentators to be theoretically the best method for eliminating
international double taxation. The credit method, however, is not free from
difficulties. Most importantly, the operation of a foreign tax credit system can
be complex from the perspectives of both the government and taxpayers.
Among the difficult questions that must be resolved are the following:

– What foreign taxes are creditable?

– How should the limitations on the credit be calculated? On a source-
by-source, an item-by-item, a country-by-country, or an overall basis,
with various special rules applicable to certain types of income? Or
some combination of these methods?
– What rules should be adopted for determining the source of income
and deductions?

Detailed, technical, and highly complicated legislative provisions are

needed to resolve these and other matters if the credit method is to operate
effectively. The compliance and administrative burdens imposed on
taxpayers and tax authorities as a result of these complex rules are probably
both necessary and justifiable in respect of income earned in no-tax or low-
tax countries – otherwise, domestic tax could be avoided by diverting
domestic source income to these countries.
When resident taxpayers are subject to foreign tax on their foreign
source income at a rate that is comparable to the domestic tax rate, it is
questionable whether the complexity of a credit system is worthwhile. In
such circumstances, a country is unlikely to collect a significant amount of
domestic tax from those taxpayers with respect to their foreign source income
after allowing them a credit for foreign taxes. A foreign tax credit system
used by one country may encourage other countries to increase their taxes on
income earned by residents of that country to the level of tax in that country
(so-called “soak-up” taxes). Such a tax increase would not affect the after-
tax return to nonresident investors and therefore would not discourage
investment from abroad. It would, however, result in a shift of tax revenues
from the country with the credit system to the country in which the income is
earned. For example, assume that Country A imposes tax at a rate of 40
percent and uses a foreign tax credit system, and that residents of Country A
have substantial investments in Country B. If Country B imposes tax on the
income earned by residents of Country A at 25 percent, the residents of
Country A will be subject to tax by Country A on the income earned in
Country B of 15 (40 – foreign tax credit of 25) and total taxes on the income
of 40 (25 to Country B and 15 to Country A). However, if Country B imposes
tax at 40 percent on the income earned by the residents of Country A, those
residents will still be subject to total tax on the income of 40, but the entire
tax will be paid to Country B.
A country is most likely to impose a discriminatory tax on residents of
credit countries when the overwhelming amount of foreign investment in the
country is owned by residents of a few foreign countries, and those foreign
countries have approximately equivalent tax rates. Some countries include
provisions in their foreign tax credit rules to prevent the soak-up taxes from
qualifying as creditable foreign taxes.
Many countries use the credit method to eliminate international double
taxation with respect to at least certain taxpayers and types of foreign source
income. Some countries grant a credit for foreign taxes unilaterally; others
grant a credit only pursuant to their bilateral tax treaties. Most credit
countries grant the credit both unilaterally and by treaty. Still others have
extended their foreign tax credit mechanisms to encompass “tax sparing”.
Tax sparing is discussed in section 4.5 below.

4.3.3.2 Types of Limitations

As noted above, countries that use the credit method limit the credit for
foreign taxes to the amount of domestic tax on the foreign source income. For
this purpose, countries use a variety of limitations.
Under an overall or worldwide limitation, foreign taxes paid to all
foreign countries are aggregated; in effect, the credit is limited to the lesser of
the aggregate of foreign taxes paid and the domestic tax payable on the total
amount of the taxpayer’s foreign source income. This method permits the
averaging of high foreign taxes paid to some countries with low foreign taxes
paid to other countries.
Under a country-by-country or per-country limitation, the credit is
limited to the lesser of the taxes paid to a particular foreign country and the
domestic tax payable on the taxpayer’s income from that particular country.
This method prevents the averaging of high and low foreign taxes paid to
different countries, but it permits the averaging of high and low rates of
foreign tax paid to a particular country on different types of income.
Under an item-by-item limitation, the credit is limited to the lesser of the
foreign tax paid on each particular item of income and the domestic tax
payable on that item of income. This method prevents averaging and is
probably the best method from a theoretical perspective, although few
countries use it in practice. In this context, an “item” of income is some
defined category of income, such as interest income or shipping income. In
principle, a country might define an item of income as any category of
income subject to a special tax regime in a foreign country. For example, a
country might treat business income and interest income arising in a foreign
country as separate items of income for purposes of imposing a limitation on
its foreign tax credit, especially if foreign countries tax interest income
derived by nonresidents at preferential (low) rates.
The results of the overall, per-country, and item-by-item limitations on
the foreign tax credit are compared in the following example. ACo, a resident
of Country A, earns foreign source income and pays foreign taxes on such
income, as shown in the following table.

Table 4.2 Example: Facts

Foreign Income Foreign Tax
Business income from Country X 100,000 45,000
Dividends from Country X 20,000 1,000
Business income from Country Y 50,000 10,000
Interest from Country Z 10,000 1,500

The corporate tax rate in Country A is 30 percent. ACo earns 200,000

domestic source income from its business carried on in Country A. If there is
no limitation on the foreign tax credit, the amount of tax payable to Country
A would be:

Example: No Limitation
Total income 380,000
Tax before credit (30%) 114,000
Foreign tax credit 57,500
Total tax 56,500

Therefore, the total tax payable would be 114,000 (foreign tax of 57,500
and Country A tax of 56,500). If Country A uses an overall, per-country, or
item-by-item limitation, the tax payable would be as follows.
 Table 4.3 Example: Overall Limitation
Overall Limitation
Country A tax before credit 114,000
Credit:
Lesser of:
(1) Foreign tax of 57,500
(2) Country A tax on foreign income (180,000 x 30% 54,000
= 54,000)
Country A tax after credit 60,000
Total tax (57,500 + 60,000) 117,500

Example: Per-Country Limitation

Per-Country Limitation
Country A tax before credit 114,000
Credit:
(a) Country X
Lesser of:
(1) Foreign tax of 46,000
(2) Country A tax on Country X income (120,000 x 30% 36,000
= 36,000)

(b) Country Y
Lesser of:
(1) Foreign tax of 10,000
(2) Country A tax on Country X income (50,000 x 30% 10,000
= 15,000)
(c) Country Z
Lesser of:
(1) Foreign tax of 1,500
(2) Country A tax on Country X income (10,000 x 30% 1,500
= 3,000)
Total creditable taxes 47,500
Country A tax after credit 66,500
Total tax (66,500 + 57,500) 124,000

Example: Item-by-Item Limitation

Item-by-Item Limitation
Country A tax before credit 114,000
Credit:
(a) Country X
(i) business income
lesser of:
(1) Foreign tax of 45,000
(2) Country A tax on business income (100,000 x 30% 30,000
= 30,000)
(ii) dividends
lesser of:
(1) Foreign tax of 1,000
(2) Country A tax on dividends (20,000 x 30% = 6,000) 1,000
(b) Country Y
Lesser of:
(1) Foreign tax of 10,000
(2) Country A tax on business income (50,000 x 30% 10,000
= 15,000)
(c) Country Z
Lesser of:
(1) Foreign tax of 1,500
(2) Country A tax on interest (10,000 x 30% = 3,000) 1,500
Total creditable taxes 42,500
Country A tax after credit 71,500
Total tax (71,500 + 57,500) 129,000

The three methods for limiting the foreign tax credit are not mutually
exclusive. For example, a country could use an overall limitation as the basic
method and also use the item-by-item method for certain types of income
such as active business income and passive investment income. Several
countries use this type of hybrid method, which is sometimes referred to as
the separate-baskets approach.

4.3.3.3 Indirect or Underlying Credit

Some countries, such as the US, provide what is often referred to as an

“indirect” or “underlying” foreign tax credit. The indirect credit is a credit
granted to a resident corporation for the foreign income taxes paid by a
foreign affiliated company when the resident corporation receives a dividend
distribution from its foreign affiliate. The amount allowable as a credit is the
amount of the underlying foreign tax paid by the foreign affiliate on the
income out of which the dividend was paid. Ordinarily, a foreign tax credit is
allowable only for foreign income taxes that a resident taxpayer pays directly.
In effect, the indirect credit rules ignore the separate corporate existence of
the resident and foreign corporations for the limited purpose of allowing the
credit. To claim a credit for taxes paid by a foreign affiliate, the domestic
corporation must usually own a substantial interest, varying from 5 percent to
25 percent, in the share capital of the foreign corporation.
The basic operation of an indirect foreign tax credit is illustrated in the
following example. Assume that ACo, resident in Country A, has a wholly
owned subsidiary BCo, resident in Country B. BCo’s income for the year is
800, and it pays tax to Country B at a rate of 30 percent, or 240, on its
income. BCo distributes all its after-tax profits of 560 (800 – 240) to ACo as
a dividend. ACo is taxable in Country A on 800 – the dividend of 560 and the
underlying tax of 240 (often referred to as the “gross-up amount”). Assuming
that Country A levies tax at a rate of 40 percent and there is no limitation on
the foreign tax credit, the tax payable to Country A would be 80 (320 minus a
foreign tax credit of 240 for the foreign taxes paid by BCo on the income out
of which the dividend was paid).

Table 4.4 Example: Indirect or Underlying Foreign Tax Credit

BCo’s income 800
Country B tax 240
After-tax profit 560
Dividend paid 560
ACo’s income:
 Dividend received from BCo 560
Gross-up amount 240
Total 800
Country A tax before credit (40%) 320
Credit for Country B tax paid by BCo 240
Net Country A tax 80

If the dividend received by ACo in the above example is subject to

withholding tax by Country B, the withholding tax would also usually be
creditable against ACo’s tax payable to Country A, subject to any applicable
limitation rule. The credit for withholding tax is a direct foreign tax credit,
not an indirect credit, because ACo is treated as paying the withholding tax.
The credit method may have the effect of discouraging domestic
corporations that have earned profits abroad through foreign affiliates
repatriating
from these profits as dividend Assume that ACo, resident
distributions.
in Country A, has a wholly owned affiliate, FCo, resident in Country F. The
tax rate in Country A is 35 percent and the rate in Country F is 10 percent.
FCo earns profits in Country F of 100 and pays tax to Country F of 10. If
FCo’s after-tax profits are repatriated to ACo as a dividend of 90, ACo will
get a foreign tax credit of 10 for the underlying foreign tax paid by FCo, but
it will be required to pay a net tax to Country A of 25, as shown below.

Table 4.5 Example: Effects of the Credit Method

Dividend received from ACo 90
Gross-up amount 10
Income of ACo 100
Country A tax before credit (35%) 35
Indirect foreign tax credit for taxes paid by FCo 10
Country A tax 25

By retaining the profits in FCo, ACo can defer indefinitely the potential
Country A tax of 25. This type of tax planning strategy has been adopted by
several US multinationals and has been sharply criticized by some US
politicians.
 To avoid creating a bias against the repatriation of profits, a credit
country could tax the income of foreign affiliates of resident corporations on
an accrual basis (i.e., as the income is earned by the foreign affiliates).
Accrual taxation would eliminate the deferral of residence country tax on the
foreign source income earned by residents through foreign affiliates.
Proposals for a comprehensive accrual system have surfaced from time to
time, but have not yet been adopted in any country, although accrual taxation
is used in some circumstances. Under the controlled foreign corporation
rules and the foreign investment fund rules described in sections 7.3 and
7.4, some countries impose domestic taxes currently on certain income
earned by foreign affiliates and foreign funds in what are perceived to be
abusive situations.
The rules designed to govern the indirect foreign tax credit are often the
most complex part of a foreign tax credit system. The indirect credit is
available only when a resident corporation receives a dividend from a foreign
affiliate. The amount allowable as a credit is the amount of foreign income
tax properly attributable to the dividend. Difficult timing and income
measurement issues must be resolved for this purpose. For example, the
resident corporation must determine the profits of the foreign affiliate out of
which the dividend was paid and the foreign tax attributable to those profits.
Those profits may have been earned over many years in the past and would
usually have been computed in a foreign currency under tax accounting rules
that may differ significantly from the tax accounting rules applicable to the
resident corporation. When these rules are combined with rules for limiting
the foreign tax credit discussed in section 4.3.3.2 above, the level of
complexity causes serious compliance and administrative problems. This
complexity has led several countries to adopt exemption systems for
dividends from foreign affiliates.

4.3.4 Comparison of the Exemption and Credit Methods

The debate about whether the exemption method or the credit method is
better for relieving international double taxation is often vigorous and
emotional. Few countries have either a pure exemption system or a pure
credit system. Costa Rica, Hong Kong and Panama are examples of
jurisdictions that tax on a territorial basis; they tax only income earned or
having its source in their territory and generally exempt all foreign source
income from tax. For most countries using the exemption method, however,
the exemption of foreign source income is often restricted to certain active
business income earned by resident corporations and dividends from foreign
affiliates. Thus, a corporation is often exempt only on its active business
income derived from foreign sources and dividends received out of the active
business income of its foreign affiliates. An exemption is not generally
available for investment income because such an exemption would make it
easy for resident taxpayers to avoid paying taxes on their investment income
by shifting the source of domestic investment income to a foreign country.
With respect to business income, an analysis of the exemption and credit
methods indicates, first, that the two methods raise essentially the same
structural issues, and second, that the two methods are reasonably
comparable if designed properly. The following material compares an
exemption for dividends received out of active business income of foreign
affiliates and an indirect credit for the underlying foreign taxes paid by
foreign affiliates on active business income.
The first point is that the results of these two methods for relieving
international double taxation are the same if the underlying foreign taxes paid
by the foreign affiliate, plus any withholding taxes on the dividends, are at
least equal to the domestic taxes on the dividends. Under the exemption
method, the dividends are exempt from domestic tax, so the total tax is the
sum of the underlying foreign taxes paid by the foreign affiliate on the
income out of which the dividend is paid and any foreign withholding taxes
on the dividend. Under the indirect credit method, the underlying foreign
taxes and the foreign withholding taxes are creditable against the domestic
tax on the dividend. Therefore, if the sum of those foreign taxes equals or
exceeds the domestic tax on the dividend, no domestic tax is payable. This
result is illustrated in the following example.
Assume that Parentco, a company resident in Country A, has a wholly
owned subsidiary, Forco, resident and carrying on business in Country B.
Country A imposes tax on corporate profits at a rate of 35 percent. Country B
imposes tax on corporate profits at a rate of 30 percent. Forco earns profits of
100, pays tax to Country B of 30, and distributes its entire after-tax income of
70 to Parentco as a dividend. The tax results, if Country A uses a
participation exemption or an indirect credit system for relieving
international double taxation of dividends, are shown in the table below.
 Table 4.6 Comparison of Credit and Exemption Methods
Credit Exemption
Forco
Income of foreign subsidiary 100 100
Foreign tax (30%) 30 30
Dividend to parent 70 70
Withholding tax (10%) 7 7
Parentco
Dividend received 70 70
Gross-up amount 30
Taxable income 100 0
Domestic tax before credit 35 –
Foreign tax credit 37 –
Net domestic tax 0 0
Total tax 37 37

Even if the sum of the foreign corporate tax and the dividend
withholding tax is less than the domestic tax, remember that the domestic tax
payable by Parentco is deferred until dividends are received. The longer the
payment of dividends is deferred, the lower the present value of the domestic
taxes on the dividends, assuming that the foreign affiliate can earn a higher
after-tax rate of return on the funds than its parent corporation.
The usual justification for a participation exemption is simplicity: the
reduction of the costs of administration and compliance for tax officials and
taxpayers. However, the benefits of simplification are often overstated or are
achieved only by sacrificing the integrity of the exemption.
If the participation exemption is intended to be a proxy for the indirect
credit, it should be designed to ensure that the exemption is restricted to
foreign source income that is subject to foreign tax rates that are comparable
to domestic tax rates. A properly designed exemption system for dividends
requires complicated rules to protect its integrity. Many of these rules are
strikingly similar to the rules with respect to an indirect foreign tax credit.
For example, both systems require rules dealing with:
 – the resident taxpayers qualifying for the exemption or credit;
(usually, the entitlement to the exemption or credit is limited to
foreign affiliates in which resident corporations have a substantial
interest; (often defined as 10 percent or more of the share capital of
the foreign affiliate))
– the type of income that qualifies for the exemption or indirect credit;
(usually, these rules distinguish between active business income and
other types of income)
– the source of income;
– allocation of expense rules; (see section 4.3.5 below)
– the current or accrual taxation of passive income of foreign
corporations
– controlled by residents; (CFC rules, which are discussed in Chapter 7,
section 7.3 below)
– the treatment of foreign losses; and
– the computation of the income of the foreign affiliate in accordance
with domestic tax rules.

The most important difference between the exemption and indirect

credit methods is that the indirect credit method requires a definition of
creditable foreign taxes, whereas the exemption method requires rules to
determine when foreign source income is subject to a level of foreign tax that
is comparable to domestic tax (assuming that the exemption system is a
proxy for an indirect credit system).
As noted above, many countries achieve the benefits of simplification
with respect to their participation exemptions for dividends from foreign
affiliates only by sacrificing the integrity of the exemption. In many
participation exemptions, the exemption is available for dividends received
from foreign affiliates that have not been subject to foreign tax rates
comparable to domestic tax rates. Sometimes this appears to happen by
inadvertence rather than intentionally. For example, a country may provide
an exemption for dividends from foreign affiliates resident in countries with
which it has entered into tax treaties. If the country enters into tax treaties
with low-tax countries or countries that provide preferential low-tax regimes,
the dividend exemption will be available for dividends from foreign affiliates
in these countries, even though the income out of which the dividends are
paid is not subject to foreign tax rates that are comparable to domestic tax
rates.
Several countries have intentionally adopted participation exemption
systems that do not even attempt to ensure that the income of the foreign
affiliates is subject to foreign tax rates comparable to domestic tax rates. For
these countries, the exemption method is not a proxy for the credit method.
The underlying policy of such an exemption system is not just to eliminate
international double taxation (although it accomplishes that result) but also to
promote the international competitiveness of a country’s resident
multinational corporations. Thus, several countries have adopted exemption
systems under which all dividends received by resident corporations from
foreign affiliates in which they have a substantial interest are exempt from
residence country tax. As a result, multinationals resident in such countries
are able to compete in other countries with corporations resident in those
countries and in third countries because they are subject to tax only by the
country in which the business is carried on.
For example, assume that a multinational corporation, MCo, is resident
in Country A, which imposes corporate tax at a rate of 35 percent. MCo has a
wholly owned subsidiary that is resident and carries on business in Country
B, which imposes corporate tax at a rate of 12.5 percent. If Country A taxes
dividends received by MCo from its subsidiary in Country B, that tax
represents a cost to MCo of carrying on business in Country B (although the
cost is deferred until the dividends are paid) that corporations resident in
Country B and resident in other countries that carry on business in Country B
do not bear (assuming, of course, that those other countries exempt dividends
from foreign affiliates from tax).

4.3.5 Treaty Aspects

As mentioned above, both the credit and exemption methods are authorized
by Article 23 of the OECD and UN Model Treaties. The deduction method is
not authorized by these model treaties. Article 23 of the OECD and UN
Model Treaties establishes the general principles of exemption and credit,
with each country left to establish detailed rules in its domestic law for the
implementation of the general principle.
Some countries provide an exemption for foreign source income or a
credit for foreign taxes paid (and paid by a foreign affiliate) under their
domestic law in addition to providing relief in any treaties that they enter
into. Treaty relief is still important, however, because it may be more
generous than the unilateral relief provided in domestic law and because it
constrains a country’s ability to amend its domestic law to withdraw the
double taxation relief afforded to its residents.
For example, assume that Country A provides an exemption in its
domestic tax law for certain foreign source income earned by residents of
Country A. Country A enters into a treaty with Country B that incorporates
the same exemption. If Country A subsequently repeals the exemption in its
domestic law, it must nevertheless continue to provide the exemption to its
residents that earn income in Country B unless the treaty with Country B is
modified or terminated.

4.4 ALLOCATION OF EXPENSES

Whether a country uses an exemption method or a credit method to provide
relief from international double taxation, it should have rules for allocating a
proper portion of the expenses incurred by its resident taxpayers between
their foreign source gross income and their domestic source gross income.
Most countries recognize the need for such rules for the purposes of taxing
nonresidents on their domestic source income. Thus, expenses incurred by
nonresidents will be denied unless those expenses are properly related to the
earning of the domestic income subject to tax. Similar rules are necessary to
properly apportion the expenses of resident taxpayers between domestic
source and foreign source income for purposes of the foreign tax credit.
For countries that exempt foreign source income, expenses incurred by a
resident taxpayer to earn that income should not be deductible. This result
follows from the fundamental principle of tax law that expenses incurred to
earn exempt income should not be deductible. For example, a taxpayer
should not be allowed to deduct interest expense on borrowed funds used to
earn exempt foreign source income. A country that allows such interest
expenses to be deductible provides its resident taxpayers with an incentive to
earn exempt foreign source income rather than taxable domestic source
income. In effect, the country is providing an exemption not only for foreign
source income but also for a portion of the domestic source income of its
resident taxpayers.
Most countries lack specific rules for attributing expenses to foreign
source income. Two approaches that might be used for that purpose are
tracing and allocation or apportionment. A tracing approach involves a
factual inquiry into the connection between the expenses and the foreign
source income. In contrast, allocation or apportionment involves the
attribution of expenses to foreign source income by formula, either on the
basis of the proportion of the taxpayer’s foreign assets to its total assets or the
proportion of its gross foreign income to its total gross income. Unlike
tracing, allocation or apportionment is based on an assumption that the
relevant expenses were incurred to support all of the taxpayer’s assets or
income-earning activities equally.
Countries that have a foreign tax credit system should allow resident
taxpayers to deduct expenses incurred to earn foreign source income because
those taxpayers are taxable on their worldwide income. As explained above,
however, the foreign tax credit is invariably limited to the amount of a
country’s domestic tax otherwise imposed on foreign source taxable income.
For this purpose, the amount of a taxpayer’s foreign source taxable income
must be computed properly or the limitation on the credit will be improperly
inflated. In order to compute foreign source income properly, the taxpayer
should be required to deduct from its gross foreign source income the
expenses incurred to earn that income.
The need for expense allocation rules can be illustrated with a simple
example. Assume that a resident corporation borrows 1,000 with interest at 8
percent annually and uses the loan proceeds to finance the business activities
of a foreign branch. The foreign branch produces gross income of 280. After
deducting the interest payment of 80, the branch’s net income is 200. The net
income of 200 is subject to foreign tax of 50 percent, resulting in a tax of
100. If the corporation’s domestic source net income is 2,000, the
corporation’s total net income is 2,200. Assuming that the domestic tax rate
is 40 percent, the tax payable, prior to subtracting the allowable foreign tax
credit, is 880 (40 percent of 2,200). Subject to the limitation rules, the
corporation is entitled to a credit for the foreign taxes paid. The credit is
limited, however, to the lesser of 100 (the foreign tax paid) and 80 (880 ×
200/2,200) (the domestic tax on the foreign source income).

Table 4.7 Allocation of Expenses

Gross foreign income 280
Interest expense 80
Net foreign income 200
Foreign tax (50%) 100
Net domestic income 2,000
Total income (200 + 2,000) 2,200
Domestic tax of 40% 880
Credit for foreign tax 80
Total tax 800

In the above example, the interest expense of 80 was applied or

allocated totally against the foreign source income. If it had been applied
against domestic source income, the entire amount of foreign taxes (100)
would have been credIn the above example, the interest expense of 80 was
applied or allocated totallyitable against the domestic tax because the credit
would be limited to the lesser of 100 and 112 (880 × 280/2,200). Assuming
that the interest is properly attributable to the foreign source income, it should
be allocated to that income in computing the limitation on the credit because
otherwise the domestic tax system would be giving a credit for foreign taxes
in excess of the domestic taxes on the foreign source net income. Therefore,
in order to protect the domestic tax base, it is crucial for interest and other
expenses to be allocated properly between domestic source and foreign
source income.
An appropriate amount of expenses should also be attributed to foreign
source income for purposes of computing the limitation on the indirect
foreign tax credit, discussed in section 4.3.3.3. In addition, the indirect credit
raises the issue of the timing of the deduction of expenses incurred by a
resident parent corporation to earn foreign source income through a foreign
affiliate. Residence country tax on foreign source income earned through a
foreign affiliate is generally postponed or deferred until the resident parent
receives a dividend (or other taxable distribution). Interest and other expenses
incurred by the resident parent to earn that deferred income should not be
deductible, at least theoretically, until the income to which the expenses
relate is subject to residence country taxation. These payments should be
deductible when the resident taxpayer receives a taxable distribution out of
the related income from its foreign affiliate. Few countries currently attempt
to deal with this timing issue because of its complexity.
4.5 TAX SPARING
Some tax treaties provide for “tax sparing”,typically through a tax sparing
credit. A tax sparing credit is a credit granted by the residence country for
foreign taxes that, for some reason, were not actually paid to the source
country but that would have been paid under the source country’s normal tax
rules. The usual reason for the tax not being paid is that the source country
has provided a tax holiday or other tax incentive for foreign investors to
invest or conduct business in the country. In the absence of tax sparing, the
actual beneficiary of a tax incentive provided by a source country to attract
foreign investment might be the country in which the investor is resident
rather than the foreign investor. This result occurs whenever the reduction in
source country tax is replaced by an increase in residence country tax.
The shifting of the benefit of an incentive from the foreign investor to its
home country’s treasury in the absence of tax sparing is illustrated by the
following example. Country A, a developing country whose normal corporate
tax rate is 30 percent, offers foreign corporations a ten-year tax holiday if
they establish a manufacturing enterprise in Country A. BCo, a resident of
Country B, establishes a manufacturing plant in Country A. Country B
imposes corporate tax at a rate of 40 percent and uses a foreign tax credit
system to provide relief from international double taxation. BCo earns
income in Country A of 1,000 in the first year. In the absence of the tax
holiday, Country A would impose a tax of 300 on BCo and Country B would
impose a tax of 100 on BCo, determined by subtracting from the tax of 400
otherwise payable a foreign tax credit of 300. The tax holiday eliminates
Country A’s tax of 300. Therefore, BCo’s tax liability to Country B becomes
400 minus the allowable credit, which is zero because BCo did not actually
pay any tax to Country A due to the tax holiday. Thus, the tax revenue of 300
forgone by Country A in granting the tax holiday to BCo goes to the benefit
of Country B and not to BCo.
If Country B were willing to give a tax sparing credit to BCo for the
taxes forgone by Country A, then BCo would get the benefit of the tax
holiday. Its income in Country A would be 1,000, and it would pay no tax to
Country A. It would have an initial tax obligation of 400 in Country B but
would be allowed to reduce that amount by the 300 of tax forgone by
Country A, for a total tax liability of 100. The results are shown in the
following table.
 Table 4.8 Example: Tax Sparing
Country A
Income from Country A 1,000
Country A tax before holiday 300
Tax holiday credit 300
Country A tax 0
Country B
Income from Country B 1,000
Country B tax 400
Tax sparing credit 300
Total Country B tax 100

As the example shows, in the absence of the tax sparing credit, Country
A’s tax holiday will not have any impact on potential investors resident in
Country B because their residence country tax will increase to offset the
benefit of the tax incentive provided by Country A.
Tax sparing is primarily a feature of tax treaties between developed and
developing countries. In the past, many developed countries granted some
form of tax sparing to developing countries by way of treaty as a matter of
course, with some voluntarily granting tax sparing in their treaties with
developing countries as a way of encouraging investment in those countries,
but others granting tax sparing credits only reluctantly. Some developing
countries traditionally have refused to enter into a tax treaty with a
country
developedunless they obtain a tax sparing
credit.
The US is adamantly opposed to tax sparing and has not granted it in
any of its tax treaties. Consequently, for many years it concluded very few
tax treaties with developing countries. The US position is that the grant of a
credit for phantom taxes – taxes not actually paid – is inconsistent with the
efficiency and fairness goals of its foreign tax credit and encourages
developing countries to engage in beggar-thy-neighbor bidding wars through
their tax incentive programs. This position has been characterized as
“arrogant”, “imperialistic”, and “patronizing”, but it is a defensible
assessment of the effects of tax sparing. In recent years, the hard-line view of
many developing countries has softened, and the number of US tax treaties
with developing countries is growing rapidly. Several other developed
countries have recently agreed to tax sparing provisions in their treaties with
developing countries only under stringent conditions.
The merits of tax sparing credits cannot be divorced from the merits of
the tax incentives that they encourage. Although tax incentives have some
enthusiastic supporters in the political arena, they are difficult to justify on
the basis of tax policy principles. Certain targeted incentives aimed at
achieving some identified goal may be justified, but those incentives are so
narrowly drawn to prevent abuse that they tend to generate little political
support. The general conclusion to be drawn from the voluminous tax
literature dealing with tax incentives is that the costs of tax incentives are
typically large, the benefits are always uncertain, and only rarely do the
potential benefits justify the likely costs.
A developing country wishing to use tax incentives to attract foreign
investment is not stymied by a failure to obtain a tax-sparing article in its tax
treaties. Tax sparing obviously is not needed if the country of residence of the
potential investors uses the exemption method to avoid double taxation – for
investors resident in an exemption country, the source country tax is the only
tax. Thus, any reduction in source taxation automatically accrues to their
benefit. Even investors from credit countries may benefit from a source
country incentive with a little tax planning, as the example below illustrates.
BCo, the investor resident in Country B in the preceding example, wants
to obtain for itself the benefits of the tax holiday offered by Country A. To
that end, it organizes ACo, a wholly owned subsidiary, in Country A. ACo
engages in manufacturing activities that qualify for the tax holiday. ACo
earns 1,000 from its manufacturing activities in Country A, which is not
taxable by Country B because ACo is not resident in Country A and the
income is not earned in Country A. BCo would be taxable by Country B on
any dividends received from ACo, but ACo has no obligation to pay such
dividends. Indeed, Country A may benefit more from its tax holiday under
this arrangement than it would from tax sparing because the potential tax on
dividends paid to BCo will provide a strong incentive for ACo to reinvest its
profits in Country A. However, BCo may be reluctant to invest in Country A
if it cannot repatriate any profits generated by its investment without paying
tax.
The above example illustrates only one of several ways that tax
incentives may benefit residents of countries using the credit method in the
absence of tax sparing. Many US multinationals benefit from host country
investment incentives because of the way the US overall limitation on the
foreign tax credit operates. Under this overall limitation, US corporations
that pay high foreign taxes to one country can use what would otherwise
be excess foreign tax credits to offset the US tax otherwise imposed on
foreign business profits that are subject to low foreign taxes in another
country. Assume, for example, that PCo, a US corporation, has an excess
foreign tax credit of 35 from operations in Country A. PCo earns profits of
100 in Country B that ordinarily would be subject to tax in Country B of
35, but that tax is eliminated because of a tax holiday provided by Country
B. PCo benefits from that tax holiday because it can eliminate the US tax
of 35 that would otherwise be imposed on its profits in Country B with the
excess credit of 35 from Country A.
Another problem with tax sparing is the potential for abusive tax
avoidance. For example, generous tax sparing credits in a particular treaty
often encourage residents of third countries to establish conduit entities in
the country granting tax sparing. Tax sparing also puts pressure on the
enforcement of a country’s transfer pricing rules because taxpayers are
encouraged to shift profits to the country providing the tax incentives.
In 1998 the OECD published a report, Tax Sparing: A
Reconsideration, which suggests that the case for tax sparing is not
persuasive. It recommends that tax sparing be restricted to countries
whose economic development is at a considerably lower level than that of
OECD member countries. It also sets out some best practices for the
design of tax sparing provisions to ensure that the provisions are limited to
genuine business investments and are not susceptible to abuse. See
paragraphs 72-78.1 of the Commentary on Article 23 of the OECD Model
Treaty.