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Relief of double taxation or not such a relief at all?

Relief of double taxation or not such a relief at all?

Relief of double taxation or not such a relief at all?

In this article, BDO aims to show you the effect of (relief of) double taxation on your disposable income.

Expats living abroad face a number of tax challenges, perhaps the most potent of which is the risk of “double taxation” - i.e. taxation of your income in both the country where the income is earned (source country) and the country in which the person who receives the income is normally based (country of residence). In order to ease this burden, many countries provide relief from double taxation, which is achieved by virtue of the country’s own domestic law or by the closing of bilateral tax treaties. 

Fundamental taxing principles

Most countries have based the right to levy taxes in their domestic law on one of the following principles:

  • Nationality, for instance, the US taxes individuals based on having US nationality
  • Residence, which is based on the principle that people should contribute towards the public services provided by the country where they live
  • Source, which is justified by the view that the country which provides the opportunity to generate income or profits should have the right to tax it

You can see how each country choosing their own taxing principle can lead to overlap. Fortunately, bilateral tax treaties address these instances of double taxation by allocating taxing rights to the contracting states and providing relief from double taxation. Two mechanisms are generally available in bilateral tax treaties, one being the exemption method and the other the credit method. Where the bilateral tax treaty gives priority to the source principle, the resident state must provide relief from double taxation.

Which method applies in your specific situation depends on the applicable tax treaty. In the paragraphs below, we have described both methods illustrated with a (simplified and fictional) calculation example.

Salary split example

Gianni lives in Italy and (partly) works in the Netherlands. He earns an income of 15.000 euros in his home country Italy and 45.000 euros from working in the Netherlands. His worldwide income is therefore 60.000 euros. As a tax resident of Italy, he is taxed for this worldwide income in Italy. He is also taxed in the Netherlands as he derives income from employment in the Netherlands. Without relief from double taxation his net income would only be 16.000 euros, see the table below:

 

Netherlands

Italy

Total

Income

EUR 45.000

EUR 60.000 (worldwide income incl. EUR 15.000 Italian-sourced income)

EUR 60.000

Tax rate

Average rate 40%

Progressive rate:

10% - income up to EUR 10.000

30% - income between EUR 10.000 and 30.000

50% - income exceeding EUR 30.0000

 

Tax amount

EUR 18.000

EUR 26.000

EUR 44.000

Net income

 

 

EUR 16.000

Exemption method (with progression)

The first method of relief to be discussed - the exemption method - entails that a taxpayer’s country of residence must exempt the foreign income from domestic taxation. The country of residence can grant a full exemption, meaning the foreign income is deducted from the worldwide income at once, before calculating the taxes due. In our example this would leave 15.000 euros to be taxed against the progressive Italian tax rate, leading to an amount of 5.000 euros tax due.

Or the country could grant an exemption with progression, meaning the exemption is given against the average rate of each bracket instead of the top rate of a progressive tax system. The tax exemption to be granted by Italy can be calculated as follows: (foreign income / worldwide income) * taxes paid in residence country.

Applying this to our example, (EUR 45.000 / EUR 60.000) * EUR 26.000, Italy must grant an exemption of 19.500 euros, leaving only 6.500 euros as taxes due in Italy.

Credit method

The second method - the credit method - entails that the country of residence grants credit to the taxpayer for any foreign taxes paid. There are two mechanisms; first is the full credit, where the foreign taxes paid are deducted from the taxes to be paid in Italy in full. Applying this to our example, this would lead to 8.000 euros tax being due in Italy (26.000 euros minus the foreign tax of 18.000 euros).

Then there is the ordinary credit method, which also allows a credit for any foreign taxes paid, but not more than the proportion of tax that would be attributable to the foreign income as computed before the deduction is given. The cap on the relief is calculated as follows: (foreign income / worldwide income) * taxes paid in residence country.

Applying this to our example, the maximum credit is (EUR 45.000 / EUR 60.000) * EUR 26.000 = EUR 19.500. As the actual taxes paid in our example (18.000 euros) are less than the maximum credit, the actual taxes paid can be credited in full.

To show you the effect of the different methods of relief we have summarised the above in the below table:

 

Without relief of double taxation

Full exemption

Exemption with progression

Full credit method

Ordinary credit method

Tax relief granted by Italy

0

EUR 21.000

EUR 19.500

EUR 18.000

EUR 18.000

Italian taxes to be paid

EUR 26.000

EUR 5.000

EUR 6.500

EUR 8.000

EUR 8.000

Total tax burden incl. EUR 18.000 Dutch taxes due

EUR 44.000

EUR 23.000

EUR 24.500

EUR 26.000

EUR 26.000

In the example chosen, the effect of the relief method might not be that significant. However, this can become all the more significant when the 30%-ruling is involved…

Salary split and the 30%-ruling

Using the same example of the split salary, but with the 30%-ruling, only 12.600 euros tax is due in the Netherlands. We refer to the table below. As you can see the difference in total tax burden between the exemption method (with progression) and the (ordinary) credit method has increased from 1.500 euros to 6.900 euros, totally wiping out the advantage of having the 30%-ruling.

 

Without relief of double taxation

Full exemption

Exemption with progression

Full credit method

Ordinary credit method

Tax relief granted by Italy

0

EUR 21.000

EUR 19.500

EUR 12.600

EUR 12.600

Italian taxes to be paid

EUR 26.000

EUR 5.000

EUR 6.500

EUR 13.400

EUR 13.400

Total tax burden incl. EUR 12.600 Dutch taxes due

EUR 38.600

EUR 17.600

EUR 19.100

EUR 26.000

EUR 26.000

In short, the method unilaterally chosen by a country or laid down in the applicable tax treaty can have quite an effect on the total taxes due and ultimately your disposable income. Even when you expect to have a tax advantage, such as the 30%-ruling, this can be undone based on the applicable method for relief of double taxation.

Calculate your tax position in advance

Our advice if you, for instance, find yourself on the verge of a secondment or salary split situation, is to always have an advisor calculate your tax position in advance. This will give you better insight into your disposable income and will help you when discussing the terms of your secondment / salary split with your employer.

If you have any more questions about double taxation or a salary split situation, do not hesitate to get in touch with BDO. They are happy to assist! 

Marjolein

Author

Marjolein Boer

Marjolein Boer is working at the Amstelveen office of BDO. After studying international tax law at the University of Amsterdam she specialized in the international income and wage taxation. As...

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