Malta: The Tax Challenges Of The Digital Economy – Article 3
Main principles of Direct Taxation – Double Tax Treaties
In our third article in a series of articles on the tax challenges of the digital economy, we shall be providing you hereunder with a brief overview of the principles of direct taxation, with a focus primarily on the taxation of cross-border income under double tax treaties.
The exercise of tax sovereignty by States may result in more than one State claiming the right to tax the same taxable amount, which may result in double taxation. One State will claim the right to tax based on the fact that the recipient is resident within its territory, while another State may claim the right to tax based on the fact that the income has arisen within its territory. Many states try to avoid double taxation by unilaterally implementing provisions in their domestic legislation, while many other sign bilateral agreements for the avoidance of double taxation.
Model double taxation agreements exist on which countries base their treaties. Such model agreements include those adopted by the OECD, the UN and the US. These model agreements give greatest weight to the origin of the wealth and the residence or domicile of the owner who consumes that wealth. These agreements advocate that tax jurisdiction should be allocated between the State of source and the State of residence depending on the nature of the income.
For some types of income, the State of source or the State of residence will be granted the exclusive right to tax while for other types of income, the State of source is given a primary right to tax while the State of residence is given a secondary right to tax. In the second scenario, the jurisdiction to tax will be shared between the source State and the residence State, where the latter State will be required to grant relief from double taxation.
With respect to business profits, treaty rules provide that the jurisdiction where the PE is located is granted an unlimited right to tax only those profits which are attributable to a PE which the non-resident enterprise might have in that jurisdiction. A certain level of physical presence is required for a PE to exist, however the development of the service industry has led to an additional threshold whereby the performance of services by employees may justify source taxation as soon as the duration of such services exceeds a specific period of time.
Income from immovable property may generally be taxed by the country in which the property is situated, while treaties generally allow the source State to levy a limited withholding tax on gross interests, dividends and royalties.
Two methods are generally available for the residence State to grant relief from double taxation – the exemption method and the credit method. Many States adopt a mixture of both methods, with the exemption method being applied to business profits, while the credit method is generally applied to dividends, interests and royalties.
