Double Taxation for individuals – Don’t get caught in the trap!

Double taxation occurs when an individual receives foreign income and pays tax on this income in the foreign country.  As the country of residence taxes worldwide income, tax has been paid twice on the same income, once in the foreign country and again in the country of residence. In this article we explain how to avoid getting this tax trap.

There are two ways to avoid double taxation:

  1. Exempting foreign income from domestic taxation
  2. Granting a credit for foreign taxes.

1.The Exemption Method

With the exemption method, the foreign country taxes the income according to its own tax rules and rates.  The country of residence does not tax the foreign income.  There are two ways of doing this:

a)      Full Exemption

b)     Exemption with Progression

2. The Credit Method

With the credit method, the country of residence taxes the foreign income but gives a credit for tax paid in the foreign country.

Again, there are two ways in which this is done:

a)      Full Credit

b)     Ordinary Credit

Example

An individual earns £80,000 in his country of residence and the equivalent of £20,000 in a foreign country giving a total worldwide income of £100,000.  In his country of residence the effective tax rate on income of £100,000 is 35% and 30% on income of £80,000.  Considering two scenarios, one being in the foreign country the tax rate applied to the foreign income is 20% (Case 1) and the second being 40% (Case 2).

No relief

If there was no relief given the foreign income would be taxed twice, once in the foreign country and again in the country if residence.

 

 

Case 1

 

 

Case 2

 

 

Income

Tax Rate

Tax

Income

Tax Rate

Tax

 

£

 

£

£

 

£

Country of Residence

100,000

35%

35,000

100,000

35%

35,000

Country of Source

20,000

20%

4,000

20,000

40%

8,000

Total

39,000

43,000

 

The Exemption Methods


a) Full Exemption

The country of residence does not tax the foreign income.  The tax relief in the country of residence is £11,000 (£35,000-£24,000) in both cases.

 

 

Case 1

 

 

Case 2

 

 

Income

Tax Rate

Tax

Income

Tax Rate

Tax

 

£

 

£

£

 

£

Country of Residence

80,000

30%

24,000

80,000

30%

24,000

Country of Source

20,000

20%

4,000

20,000

40%

8,000

Total

28,000

32,000

b) Exemption with Progression

The country of residence takes into account the foreign income to see what rate of tax to use however it does not tax the foreign income.  The tax relief in the country of residence is £7,000 (£35,000-£28,000) in both cases.

 

 

Case 1

 

 

Case 2

 

 

Income

Tax Rate

Tax

Income

Tax Rate

Tax

 

£

 

£

£

 

£

Country of Residence

80,000

35%

28,000

80,000

35%

28,000

Country of Source

20,000

20%

4,000

20,000

40%

8,000

Total

32,000

36,000


The Credit Methods


a) Full Credit

The country of residence taxes the worldwide income with a full deduction for the foreign tax paid.  The tax relief in the country of residence is £4,000 and £8,000, respectively.

 

 

Case 1

 

 

Case 2

 

 

Income

Tax Rate

Tax

Income

Tax Rate

Tax

 

£

 

£

£

 

£

Country of Residence

100,000

35%

35,000

100,000

35%

35,000

Double Tax Relief

20,000

20%

(4,000)

20,000

40%

(8,000)

Total tax in Residence Country

31,000

27,000

Country of Source

20,000

20%

4,000

20,000

40%

8,000

Total

35,000

35,000

b) Ordinary Credit

The country of residence taxes the worldwide income with a deduction for the foreign tax paid, however if the tax rate in the foreign country is higher that the tax rate in the country of residence then this deduction is restricted to the residence country’s tax rate on the foreign income.  The tax relief in the country of residence is £4,000 and £7,000, respectively.

 

 

Case 1

 

 

Case 2

 

 

Income

Tax Rate

Tax

Income

Tax Rate

Tax

 

£

 

£

£

 

£

Country of Residence

100,000

35%

35,000

100,000

35%

35,000

Double Tax Relief

20,000

20%

(4,000)

20,000

35%

(7,000)

Total tax in Residence Country

31,000

28,000

Country of Source

20,000

20%

4,000

20,000

40%

8,000

Total

35,000

36,000


Conclusion

Of the two exemption methods, the full exemption method is usually the most advantageous as this taxes the income from the country of residence at a lower rate and offsets the exemption against the highest tax rate.  The exemption with progression method offsets the exemption against the average tax rate on the income in the country of residence.  This means that if the country of residence has steep tax rates, the full exemption method becomes more and more beneficial.

Of the two credit methods, the full credit method is the most beneficial as the total tax paid is equal to the tax that would have been paid had the foreign income arisen in the country of residence.  However, most countries using the credit method use the ordinary credit method, therefore limiting the tax credit given.

 

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