Defining Tax Treaty

Also called a Double Tax Agreement (DTA), a tax treaty is known as a bilateral, meaning two-party, an agreement that is made between two nations to solve issues that involve double taxation of active and passive Income of citizens.

Generally, income tax treaties comprehend the tax amount that a nation is free to apply to the wealth, estate, Capital, and income of taxpayers. One of the essential factors of a tax treaty is the policy on withholding Taxes as it comprehends how much tax will be levied on any Earned Income (through dividends and interests) from securities that non-resident owns.

Understanding How Tax Treaty Works

When a business or a person invests abroad, the problems of which nation is going to tax the Earnings come into the picture. Both the residence and the source countries might then create a tax treaty to agree on which nation should be taxing the investment income to avert the same income from being taxed twice.

While the source country, often known as capital-importing country, is the one that hosts inward investment; the residence country, generally referred to as the capital-exporting country, is where the investor resides.

To prevent taxing twice, tax treaties might follow one of these two different models:

* The Organization for Economic Co-Operation and Development (OECD) Model

This one is a group that includes 37 nations with an objective to promote world economic and trade situations. However, this model is more advantageous for capital-exporting nations than capital-importing ones.

It needs the source country to give up certain or all of the tax on specific income categories earned by the residents of the other nation in the treaty. Also, both the nations can only get benefit from this agreement type of the flow of investment and trade between them is almost equal and if the residence nation taxes income that is exempted by the source nation.

* The United Nations (UN) Model Convention

This one is formally known as the United Nations Model Double Taxation Convention. This agreement type is majorly done between developed or developing nations. A treaty that follows the model of UN provides reasonable taxing rights to abroad nations.

Generally, this reasonably taxing scheme offers advantages to developing nations that are on the receiving end of inward investment. It also offers increased taxing authority to source country over the business income of non-residents.