Double taxation ; exemption vs foreign credit method.
As part of researching an upcoming training course on Double Taxation, I came across a 2002 Article in the IBFD Bulletin[i] by the famous German commentator on taxation, Professor Vogel, which gave some useful insights on why, in preventing double taxation, some countries operate a policy of tax exemption while others give a foreign tax credit. I summarise the Article , which repays a thorough reading below.
As a sometime historian I always find the historical background quite interesting in understanding the present. Apparently, the first double tax treaty came into force over a hundred years ago between Austria and Prussia , the two states distributed the rights to tax goods and events between themselves, so they were taxed only in the one state and exempt in the other. This might be called the “continental” system.
The United Kingdom, instead, used a credit method for taxes levied by other states of the British Empire on goods and events. The United States introduced a unilateral credit for foreign taxes in 1918.
In the late 1920s, The League of Nations (forerunner to the United Nations) was in the process of producing a model Double Tax Treaty; however, the USA was not a member of the League of Nations and in the pre-war period both the United Kingdom and British Empire states were reluctant to conclude Double tax treaties. Therefore, earlier Continental Double tax treaties used the exemption method. In the post- war period as the United States, United Kingdom and Commonwealth states started to conclude double tax treaties these provided for foreign tax credits. So ,two “rival” systems existed. This is recognised by the OECD Model Treaty which allows for the relief of Double Taxation through either exemption or foreign tax credit, or where states use different methods provide for on state to use exemption and the other to use credit. So we have essentially coasted along with each state using the methods favoured by them.
Professor Vogel was commenting on which of the two systems- credit or exemption was superior. In doing so, he referred to some earlier theories.
Richard Musgrave – distinguished between two types of tax neutrality:
Capital-export neutrality – meaning the investor pays the same total ( domestic plus foreign) tax whether he receives investment income from foreign or dometic sources.
Capital-import neutrality –meaning that capital funds originating in various countries should compete at equal terms in the capital market of any country
Musgrave assumed that only capital – export neutrality comports with the goal of economic efficiency – and the way to achieve this was to tax the worldwide income of foreigners while granting them a credit for foreign taxes paid.. Their theories justified the United States system of giving foreign tax credits,.
Vogel argues that to a certain extent “capital –export neutrality” discriminated against investment in low tax states and promoted fiscal imperialism
Vogel quotes another article by Michael J Graetz and Michael O’Hear which appeared in the Duke Law Journal of 1997 . This article credited Thomas Sewall Adams , a Professor of Economics at Yale university and tax adviser to the US Treasury department with the introduction of the foreign tax credit in the United States. In 1918, the then very low US income tax rates were raised to pay for the costs of the First World War and double taxation became a potentially serious burden. As a result Adams proposed that Americans should get a credit against their US taxes for taxes paid in a foreign country. The Revenue Act 1921 limited the foreign tax credit to a proportion of the taxpayer’ s overall US tax liability equal to the proportion of his global income derived from foreign sources. Adam’s basic goal was to establish equity for both the taxpayer and the state of source. He chose credit rather than exemption as a method, since he considered residence as the most important backstop to source- based taxation.
According to Vogel, the foreign tax credit was not introduced to preserve residence state taxation, nor to attain capital-export neutrality, rather the idea was to give primacy to taxation in the state of source and to prevent double non-taxation. However, Vogel regards these aims as being better achieved by exemption with progression and that “At any rate , the foreign tax credit was not and never was , a method superior to exemption.”
Having considered the above arguments, Vogel then goes on to consider whether the law of the European Community (now European Union) requires a certain method to be used in treaties between EU Member States. As long as direct taxes are not harmonised within the European Union, Member States are free to choose their own system and rates of direct taxation ( to the extent they do not grant non-residents exceptionally low rates of tax or other favourable circumstances which might constitute an illicit subsidy). Residents of member states are entitled to exploit the differences resulting from this diversity of tax systems and striving for capital-export neutrality would, therefore, interfere with their freedom to do so. Vogel points out that establishing that there is interference or restriction of market activities does not necessarily mean that there has been a violation of the EU Treaty.
In the end Vogel concluded that , even though the credit method might in theory violate EU law, there was little chance that that the ECJ would in the near future declare the credit method a violation of the rights of EU citizens. However, he then concludes the article;
“.. it is very well possible that the conflict between the credit method and the EC’s market freedoms will one day lead to a verdict of the Court against the credit method to avoid double taxation among the EU Member states”
[i] Which Method Should the European Community Adopt for the Avoidance of Double Taxation? Prof Dr Klaus Vogel – IBFD Bulletin – Tax Treaty Monitor
