Relief from international double taxation.

International double taxation represents the imposition of comparable income taxes by two or more
sovereign countries on the same income items on the same taxpayer for the same tax period.
Bilateral tax treaties often provide solutions to this problem. Most are based on one of three models-the United States Model Income Tax Convention of September 20, 1996 (the U.S. Model), the
United Nations Model Double Taxation Convention Between Developed and Developing Countries
(the U.N. Model) or the Organization for Economic Cooperation and Development (OECD) Model Tax
Convention on Income.
Acceptable international practice grants countries a primary right to tax income with a source in
that, country. Put simply, the source country's right has priority over the taxpayer's country of
residence/citizenship. The taxpayer's "home" country would then provide relief if its taxing
jurisdiction (based on residence or citizenship) overlaps the source jurisdiction's right. No
international consensus dictates the appropriate relief method; countries commonly use three--the
deduction method, the exemption method and the credit method. Countries can use one method or a
combination to provide relief from international double taxation.
Deduction Method
The deduction method (such as the U.S., under Sec. 164(a)(3)) allows residents/citizens to deduct
foreign taxes paid in computing their taxable worldwide income. This treats the foreign taxes paid as
a current expense; it is the least effective means of providing relief. Residents paying and deducting
foreign taxes on foreign-source income are taxed at a higher combined rate than on domestic-source
income. The deduction method creates an obvious bias in favor of domestic investing, and is not tax
neutral in allocating resources between countries.
Exemption Method
Under the exemption method, a taxpayer's home country will tax its residents/citizens only on their
domestic-source income. The country of residence exempts the taxpayer's foreign-source income
from domestic taxation, leaving it to be taxed by the source country.
Many countries employ variations of this method due to different tax structures worldwide. For
example, the exemption on income derived by resident companies through foreign affiliates or
branches located in tax-haven countries is often limited. Only if the foreign-source income is subject
to a tax by the foreign country will an exemption be available.
The "exemption with progression" is another alternative to a pure foreign-income exemption, under
which foreign-source income is accounted for in determining the tax rate applicable to the
taxpayer's other taxable income, creating a tax-averaging mechanism.
Although the OECD and the U.N. Models sanction the exemption method (Article 23A of both
treaties), that method would not conform to a tax policy's objectives of fairness and economic
efficiency if foreign taxes are lower than domestic taxes. As a general rule, resident taxpayers with
exempt foreign-source income receive more favorable tax treatment than those with only domesticsource income. Thus, the current exemption system encourages resident taxpayers to invest abroad
in countries with lower tax rates (especially tax havens) and divert domestic-source income to those
countries.

To avoid this inequity, some countries have adopted a partial exemption system, under which a
foreign-source exemption is provided only on income derived from
http://www.linkedin.com/pub/wayne-lippman/14/204/452 countries committed to imposing a tax
structure comparable to that of the resident taxpayer's country. However, this system is effective
only if countries can prevent taxpayers from (1) improperly treating income earned in tax-haven
countries as derived from exempt countries and (2) artificially shifting deductions from exempt
countries to income earned in a tax-haven country.
In the U.S., under Sec. 911, a qualified individual can elect to exclude foreign-earned income and
housing costs from his or her gross income for the year, to the extent of the applicable yearly limit
($80,000 for years after 2001). However, the individual must earn the foreign-earned income during
a period for which he or she qualifies for an election. In general, the exclusion extends to a U.S.
citizen or resident who is present in a foreign country for at least 330 days during a 12-month
period.
Credit Method
Under the credit method, any foreign taxes paid by a resident taxpayer on foreign-source income
serve to reduce domestic taxes payable by the foreign tax amount. In general, countries using the
credit method would not refund taxes if their taxpayers pay foreign taxes at a rate higher than the
domestic rate (OECD Model, Article 23B).To boot, a taxpayer cannot even offset the excess foreign
tax imposed against his or her domestic income taxes.
In general, the foreign tax credit's (FTC's) dollar-for-dollar tax offset is far more beneficial than a
deduction.
Example: U.S. citizen/resident A receives $100 from investing in a foreign country with a 30% tax
rate. As A's U.S. tax rate on worldwide income is 35%, a deduction for the foreign country's tax will
reduce double taxation, but not eliminate it. If A takes the deduction for foreign taxes paid, his U.S.
income tax would be $54.50 (0.35 x ($100-$30), plus $30 in foreign tax).As a result, choosing a
foreign tax deduction still leaves a tax burden substantially higher than the $35 in tax that would be
paid had A earned the entire $100 (35% x $100) in the U.S. On the other hand, if A chose to use an
FTC, the U.S. liability would be reduced from $35 to $5, with the $30 paid to the foreign country
credited against A's U.S. tax.
As a general rule, a taxpayer's total tax on foreign-source income is the greater of the (1) pre-credit
U.S. tax on the income or (2) foreign tax. This is due to Sec. 904(a), which limits the FTC to the precredit U.S. tax on the taxpayer's foreign-source income. In other words, the available FTC is the
lesser of the foreign tax paid or the pre-credit U.S. tax on the foreign income.
In the example, under Sec. 904(a), $30 is the maximum FTC available (the lesser of the foreign tax
paid ($30) or the pre-credit U.S. tax on the foreign income ($35)). Thus, the total tax equals the
greater of the $35 pre-credit U.S. tax or the $30 foreign tax. (The $35 comprises $30 in foreign tax,
plus $5 in U.S. tax after the FTC.) However, if the foreign country imposed a 40% tax (or $40) on the
$100 foreign-source income, the maximum credit A could receive on a U.S. tax return would be only
$35 (the lesser of the 35% tax the U.S. would impose, rather than the $40 (40%) foreign tax). The
total tax would be the greater of the $35 pre-credit U.S. tax or the $40 foreign tax (comprised
entirely of the $40 foreign tax paid, inasmuch as the FTC would eliminate any Wayne Lippman U.S.
tax on the foreign income).
Two other types of FTCs are available to U.S. taxpayers and other "credit" countries. The U.S.

treatment of direct and indirect FTCs is comparable to other treaty countries. The direct FTC is
available to U.S. citizens, residents and nonresident aliens; the deemed paid or "indirect" FTC
extends only to U.S. domestic corporations that paid foreign taxes indirectly through a 10%-owned
foreign corporation (Sec. 902(a)).
Conclusion

In addition to other limits on FTC use, availability rules defray opportunistic, tax-motivated behavior.
These rules isolate income into "separate baskets" frequently subject to income taxes at either
extremely high or low foreign tax rates, thereby limiting a taxpayer's ability to manipulate the credit
limit by averaging rates. Although "separate income limits" and "income baskets" are beyond the
scope of this item, their mind-numbing complexity often baffle the brightest of international tax
experts. In short, the separate-baskets concept exists to prevent taxpayers from arranging their
affairs to maximize the FTC at the expense of U.S. tax on U.S.-source income.
The OECD and the U.N. models only authorize the credit and exemption methods, not the deduction
method. Considering tax policy, the credit method is recognized as the best method for eliminating
international double taxation.
While the U.S. employs both the deduction and exemption methods, the impact of double taxation is
often mitigated with an FTC.
FROM THOMAS M. BRINKER, JR., J.D., M.S., CPA, ASSOCIATE PROFESSOR OF ACCOUNTING,
ARCADIA UNIVERSITY, GLENSIDE, PA, AND W. RICHARD SHERMAN, J.D., LL.M., CPA,
ASSOCIATE PROFESSOR OF ACCOUNTING, ST. JOSEPH'S UNIVERSITY, PHILADELPHIA, PA
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