Double Tax Agreements – How Do They Work?

Double Tax Agreements – How Do They Work?
Double tax agreements (DTAs), also referred to as double tax treaties, are agreements which relate to tax matters between two countries. DTAs have two objectives: namely, avoidance of double tax and prevention of tax avoidance/evasion.

The UK is party to over 100 such agreements (e.g. with Australia, Belgium, Canada, USA) which deal with income tax and capital gains tax and 10 agreements which deal with inheritance tax (e.g. with India, Italy, Netherlands and USA). 

Income tax/capital gains tax DTAs

The typical DTA contains a number of provisions (normally around 30) referred to as ‘Articles’. Such Articles typically deal with the tax treatment of employment income, pensions, property income, interest income, dividend income, capital gains and business profits. In essence the primary right to tax is allocated to one country or the other.

Example 1 - John avoids Spanish tax on his pension 

John Smith has worked all his life in the UK. He decides to retire to Spain and his UK private pension is paid to him in Spain by his former UK employer.

In the absence of a DTA between the UK and Spain, the UK would levy income tax as the pension arises in the UK and Spain would levy its income tax as John is resident there.

Under the DTA the right to tax John’s pension is granted to Spain (hence the UK loses the right to tax it).

Example 2 - Tom avoids tax when working in Switzerland

Tom Brown works in the UK for a UK employer. He is sent to work for a short period in Switzerland by his employer. 

Both the UK and Switzerland have the right to levy their income tax on the salary attributable to the duties performed in Switzerland. 

However, under the UK/Switzerland DTA, if Tom works in Switzerland for 183 days or less in the tax year then Switzerland is precluded from taxing his employment income. 

DTA: avoidance/evasion

To try and prevent tax avoidance/evasion, information may be exchanged automatically between countries.

Example 3 – Trap: Bank interest international avoidance

Mary, an individual resident in the UK, opens a bank account in, say, the Isle of Man. She does not declare the interest earned on the account in her UK tax return. 

However, she is caught out because under the DTA the Isle of Man tax authorities have provided information to the UK which details UK residents who have bank deposits with banks in the Isle of Man. 

Inheritance tax DTAs

The objectives of the inheritance tax DTAs are the same as those applicable to the income tax and capital gains tax DTAs i.e. avoid double tax and prevent tax avoidance/evasion. The general approach adopted is to give primary taxing rights to the country where an individual is domiciled (a concept different from residence), i.e. broadly where the individual intends to reside/live in the long term.

Example 4 - Mary mitigates her UK inheritance tax charge

Mary Manchester is domiciled in the UK. She dies owning various UK assets (e.g. bank accounts; shares in UK companies; and a UK house); a house in Florida; and a bank account in Amsterdam.

Under the UK/USA and the UK/Netherlands DTAs the UK will have the right to levy inheritance tax on Mary’s worldwide estate. The USA will have the right to levy their equivalent inheritance tax on the Florida property only, but the Netherlands will not have any right to levy their equivalent inheritance tax on the bank account in Amsterdam.

The UK will also be under an obligation to grant an offsetting tax credit for any USA tax charge against the UK tax charge on the Florida house.

Practical Tip :

For UK residents entitled to income arising in a country other than the UK (or a capital gain on a disposal of assets located overseas; or on a death owning assets located overseas) then check, first, whether there is a DTA in existence and, if so, how it may reduce or (possibly even avoid) the overall UK and foreign tax charge. 

Malcolm Finney