ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT

RESTRICTED
Paris, 12th September, 1975
CFA/WP1(75)5
Scale 6
Or.Eng./Fr.

WORKING PARTY No 1 ON DOUBLE TAXATION
OF THE COMMITTEE ON FISCAL AFFAIRS

SECOND REPORT OF WORKING GROUP No 15
(Switzerland — Ireland — Japan — Netherlands)

QUESTIONS CONNECTED WITH THE METHODS
FOR ELIMINATION OF DOUBLE TAXATION

Introduction

• 1. Working Group No. 15 was re-established in 1973 to study problems connected with the methods for elimination of double taxation (Doc. DAF/CFA/WP1/73.3 of 22nd February, 1973).
• 2. The first Report of Working Group No. 15 (Doc. CFA/WP1(74)2 of 28th February, 1974) was based on the Analyses of bilateral Conventions (Doc. FC(70)1 of 4th June, 1970) and on the List of Outstanding Points (Doc. TFD/FC/218 of 21st July, 1967). It also took into account a list of problems submitted by the Delegate for Austria and the discussions held at the 5th and 7th meeting of the Working Party (Doc. DAF/CFA/WP1/72.9 of 28th July, 1972 and DAF/CFA/WP1/73.5 of 11th April, 1973). This Report was discussed at the 15th meeting of the Working Party held from 4th to 7th March, 1975. An Addendum to the first Report (Doc. CFA/WP1(74)2 of 18th March, 1975) on “Double residence” was discussed at the 16th meeting of the Working Party held from 13th to 16th May, 1975.
• 3. At the discussions of the Working Party at the 15th and 16th meetings, several points were left open which are dealt with in the first part of this Report. The second part contains the proposals of the Working Group for changes in the text of the Articles, and the third part the Commentary on these Articles.

Note: This report does not necessarily reflect the views of the Japanese member of the Working Group who has not commented on the draft of this report.

17.996 - 2 - CFA/WP1(75)5

Part I: Open Points

• 4. When discussing the first Report within the Working Party, the Working Group was charged with the study of several problems. In addition, the Working Group itself raised a problem (Double residence) which was submitted to the delegations before the meeting in May 1975 (Doc. CFA/WP1(74)2 of 18th March, 1975). Since this problem is of great importance, it will be treated at the beginning of this Report, followed by the remaining problems in the order in which they are mentioned in the Summary of discussions at the 15th meeting of the Working Party (Doc. DAF/CFA/WP1/75.8 of 26th March, 1975).

A. “Double residence”

• 5. Each of two Contracting States may subject, under its internal law, the same person to unlimited tax liability, either as a resident of such State, or exceptionally as a national thereof. The Draft Convention aims at avoiding the situation that such person continues to be subjected in both States to tax on his total worldwide income and capital: Under Article 4 of the Convention the person will be considered, for the application of the Convention as a resident of State A only. The intention is that the other Contracting State B should be precluded from taxing income or capital for which the Convention gives the right to tax to the State of residence (with the special exceptions provided for in par. 2 of Art. 10 and 11). The question was raised whether such aim is really achieved under the existing version of the Draft Convention, since some provisions contain no reference to the State of residence (see Art. 6 par. 1, 13 par. 1, 17 par. 1, 22 par. 1 and 2 and old Art. 19 par. 1). By stating for example that income from immovable property situated in a State may be taxed in such State (Art. 6 par. 1), the other State is not expressly precluded from taxing a person who under its internal law is subjected to unlimited tax liability but for the purposes of Article 4 of the Convention is not a resident of such State. Although the Conventions based on the 1963 Draft Convention seem to have been generally interpreted according to the intention rather than to the wording, the Working Party found it advisible to have this point made clear in the revised Convention. The discussions held at the 16th meeting of the Working Party (Doc. DAF/CFA/WP1/75.11 of 10 July 1975) showed two possible solutions.
• 6. One solution would be to state in Article 21 or 23A or 23B quite generally that the income derived or capital owned by a resident of a Contracting State shall be exempt from tax in the other Contracting - 3 - CFA/WP1(75)5 State, except where another Article of the Convention expressly provides for taxation of such capital or income in the State which is not the State of residence. The same goal could be achieved by inserting in paragraph 1 of Article 4 after “For the purposes of this Convention” the words: “and the internal law of the Contracting States”.
• 7. Another solution would be to amend Articles 6, 13, 17 and 22 in such a way that they apply to a resident of a Contracting State (State R) deriving income from, or owning capital in, the other Contracting State. Income derived (or capital owned) by a resident of State R from (in) State R or a third State would then fall automatically under Article 21. This solution would necessitate the following changes in the wording of the said Articles:

“Article 6 paragraph 1

• 1. Income derived by a resident of a Contracting State from immovable property situated in the other Contracting State may be taxed in that other State.

Article 13 paragraph 1

• 1. Gains derived by a resident of a Contracting State from the alienation of immovable property, as defined in paragraph 2 of Article 6, situated in the other Contracting State may be taxed in that other State.

Article 17 paragraph 1

• 1. Notwithstanding the provisions of Articles 14 and 15, income derived by a resident of a Contracting State as entertainer, such as theatre, motion picture, radio or television artiste, or musician or athlete, from his personal activities as such exercised in the other Contracting State, may be taxed in that other State.

Article 22 paragraphs 1 and 2

• 1. Capital represented by immovable property, as defined in paragraph 2 of Article 6, owned by a resident of a Contracting State and situated in the other Contracting State may be taxed in that other State.
• 2. Capital represented by movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or by movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing professional services may be taxed in that other State.”

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D. Reservation of progression

• 11. In its first Report the Working Group has examined the relationship between Article 23 A (and Article 23B) and Articles 8 and 19 and proposed solutions under the exemption as well as the credit method (cf. paragraphs 32 and 36 of the Report).
• 12. For countries following the exemption method, the unrestricted application of the progressive rate of tax could be secured by substituting at the end of paragraph 1 of Article 23A the words “if the Convention did not apply” for “if the exempted income or capital had not been so exempted”. Where both Contracting States apply the exemption method, the same goal could be achieved by substituting in Articles 8 and 19 “may be taxed” for “shall be taxable only”.
• 13. States applying the credit method, however, would have to add a specific provision on the lines of the second half of paragraph 1 of Article 23A. The Delegate for Sweden has drawn the attention of the Working Party to the following text which appeared in one of the Conventions concluded by Sweden:
  • “Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, shall be taxable only in the other Contracting State, the first-mentioned Contracting State may include the income or capital in the taxable base, but shall allow as a deduction from the tax on the income or capital that part of the tax on income or capital, respectively, which is appropriate, as the case may be, to the income derived from or the capital owned in that other Contracting State.”
• 14. However, all these amendments settle the question for the State of residence only. The problem may be of some importance also for the State of source, especially if that State would, but for the Convention, subject the taxpayer under its internal law to unlimited liability to tax. When discussing the first Report of the Working Group (par. 16, 17, 30 to 32), the Working Party held that the State of source is free to apply its national legislation concerning progressive rates of tax. Although at the beginning the views were different regarding the necessity for an express provision in the Convention, the Working Party finally decided to have a clear provision for all cases inserted in Articles 23A and 23B. Parts II and III are drafted accordingly. In Article 23A the end of paragraph 1 is deleted and in both Articles a new paragraph 3 is added. The Commentaries relating thereto are found in paragraphs 40A to 40C and 53 to 55.

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E. Treatment of losses

• 15. The Draft Convention contains no rules in respect of the treatment of losses. Therefore, the following problems are unsolved:
• 16. The fact that the residence State shall, under Article 23A, exempt from tax income falling under Articles 6 or 7 and arising from the other Contracting State may lead to the conclusion that the first-mentioned State must not take into account a loss attributable to immovable property or a permanent establishment when calculating the taxable basis. This seems to be logical, especially in cases where the other State (E or S) allows the carry over of such a loss; otherwise, such a loss would be taken into account twice. However, the residence State may allow such a loss as a deduction from taxable income; in such a case it should be free to restrict the exemption when profits are made subsequently in the other State. In this respect, the Delegate for Belgium has submitted the following provision which is generally inserted in the method Article of the Conventions concluded by Belgium:
  • “When, in accordance with Belgian law, losses of an enterprise carried on by a resident of Belgium which are attributable to a permanent establishment situated in .... (other State) have been effectively deducted from the profits of that enterprise for its taxation in Belgium, the exemption provided in subparagraph ... shall not apply in Belgium to the profits of other taxable periods attributable to that permanent establishment to the extent that those profits have also been exempted from tax in .... (other State) by reason of compensation for the said losses.”
• 16A. The Belgian provision as mentioned here gives no exemption in case the profits of the permanent establishment in the other Contracting State are in fact not taxed by reason of a compensation for losses which are attributable to that permanent establishment. Therefore in the Belgian scheme the exemption is made dependent of possible rules for the compensation of losses in the other Contracting State. It is also conceivable to formulate provisions in such a way that for the determination of the amount of profits derived from the other Contracting State for which exemption is given, losses incurred in that State which led to a reduction of the taxable income in the residence State are taken into account in following years during a certain period (say 6 years).
  
  Hence, in that case the exemption is not dependent of the fiscal regime of the other Contracting State. - 6a - CFA/WP1(75)5 Rules like that taken from the Netherlands legislation would roughly read as follows:
  • “1. If in any year the foreign gross income is negative, this income shall be set off against positive foreign gross income of one or more of the six following years, beginning with the earliest year.
  • 2. If, and to the extent that, in any year the foreign gross income, — calculated, after application of paragraph 1 — exceeds the taxable income, it shall be carried forward to one or more of the six following years, beginning with the earliest year, in such a way, that for the purpose of the calculation of the exemption (tax reduction), a corresponding part of the total gross income not consisting of foreign gross income shall be deemed to be foreign gross income.”
  It may be recalled that the Netherlands use the alternative method mentioned in par. 37 of the Commentary which means that the tax calculated on the total income is reduced by such part of the tax as bears the same proportion to the tax calculated, as the part of the income which is included in the total income and may be taxed in the other Contracting State according to articles ... of the Model Convention bears to that total income.
• 17. Further problems arise in a case where losses are incurred in the other Contracting State for which, in the opinion of the Working Group, it is difficult to find satisfactory solutions. In the first place there is the application of progressive rates. Due to the said losses, the total income determined for tax rate purposes will be lower than the income derived from domestic sources. By applying the principle of the reservation of the progression also in cases of losses incurred in the other State, the domestic income could only be taxed at the rate for the (lower) total income. As regards the tax rate applicable to a permanent establishment, see par. 37 of the new Commentary on Article 24, par. 3.
• 18. Another problem concerns set off of losses in a case in which a resident of a Contracting State derives income from sources in the other Contracting State but also incurs losses therein. The question arises whether this other State is obliged to set off the losses (e.g. from a permanent establishment) against the income derived from sources within this State (e.g. dividends, interest or directors’ fees). Moreover, the situation of the residence State under Article 23A or 23B has to be determined in such a case. This problem is mentioned in quite a general way in paragraph 32 of the existing Commentaries. Belgium deals with this problem by inserting in its Conventions the following provision: - 7 - CFA/WP1(75)5
  • “The exemption provided in paragraph .. of this Article shall not be allowed by a Contracting State in respect of income which may be taxed in the other Contracting State to the extent that this income has not been charged in that other Contracting State because of the set-off of losses also deducted, in respect of any accounting period, from income taxable in the first-mentioned Contracting State.”
• 18A. Also for this case an alternative wording were possible which would make the exemption independent from the fiscal regime in the other Contracting State. That aim could be reached at for example by adopting the alternative formulation of Article 23A mentioned in par. 37 of the Commentary (see also Article 26, par. 2(b) of the Convention between the Netherlands and the United Kingdom and par. 16 above).
• 19. A further problem may arise where income is derived from the other Contracting State (e.g. through a permanent establishment) but a loss is incurred in a third State (e.g. from immovable property which does not form part of the business property of the permanent establishment situated in the other Contracting State). It is the opinion of the Working Group that the other State is not obliged to take into account such a loss. Therefore, it is up to the State of residence to grant relief for this loss and, furthermore, for the tax on the income from the other Contracting State.
• 20. The second part of paragraph 43 of the existing Commentaries deals with the amount of credit to be granted where the domestic losses are lower than the income derived from abroad.
• 21. It seems to the Working Group very difficult to find satisfactory solutions for the above-mentioned problems. Since it does not have at its disposal sufficient experience in this field, definite proposals cannot be submitted for the time being. Moreover, it has to be taken into account that possible solutions also depend on the internal law of a Contracting State and that problems as mentioned in paragraphs 18 and 19 above may be involved which do not concern only the State of residence. Besides, it has to be recalled that in case of permanent establishments the method according to which profits are attributed (directly or by apportionment, Art. 7 par. 1 or 4) may be of importance.
• 22. Under these circumstances no proposals are made in respect of paragraph 38 of the Commentaries. On the other hand, the Working Group proposes to enlarge slightly paragraph 43 of the Commentaries.

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F. Tax exemption thresholds

• 23. When discussing the first Report at the 15th meeting of the Working Party, the Delegate for Austria held that the Commentary should deal not only with how to apply progressive rates but also with tax exemption thresholds which directly affected the amounts taxable. The following example illustrates the problem:

  a) Total income	20’000
  b) Tax exempt foreign income	15’000
  c) Taxable income	5’000
  d) Tax is levied in the residence State when taxable income exceeds	9’700

• 24. According to internal law this amount (d) may constitute an absolute limitation, i.e. no tax is due if taxable income is lower. However, it may provide for another solution according to which the tax exempt limitation is part of the schedule of tax rates; in such a case, the principle of progression may be applied which has as a consequence that an amount beeing lower than (d) can be taxed at the rate applicable to 20’000 (a). It may happen that the internal law provides for different solutions depending on whether income or capital taxes are involved. Since a Double Tax Convention does not seek to harmonise the internal law of the Contracting States but to avoid international juridical double taxation, the Working Group considers it preferable to leave the solution of this problem to the internal legislation of the Contracting States and to handle cases of excessive tax burden on the basis of the mutual agreement procedure.

G. Dividends received from subsidiaries

• 25. It is recalled that the Working Party decided to postpone discussions of these questions until it has considered the forthcoming report by Working Group No 23 on the taxation of dividends paid by one company to another (cf. Summary of discussions at the 15th meeting, Doc. DAF/CFA/WP1/75.8 of 26th March, 1975, par. 46 to 48).

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PART II

Articles 23A and 23B

Article 23A
Exemption method

• 1. Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall, subject to the provisions of paragraphs 2 and 3, exempt such income or capital from tax.
• 2. Where a resident of a Contracting State derives income which, in accordance with the provisions of Articles 10 and 11, may be taxed in the other Contracting State, the first-mentioned State shall allow as a deduction from the tax on the income of that person an amount equal to the tax paid in that other Contracting State. Such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is appropriate to the income derived from that other Contracting State.
• 3. Where in accordance with the provisions of the Convention income derived or capital owned by a person is exempt from tax in a Contracting State, such Contracting State may nevertheless, in calculating tax on the remaining income or capital of such person, apply the rate of tax which would have been applicable if the exempted income or capital had not been so exempted.

Notes of the Working Group:

Paragraph 1: without last part of the sentence;

Paragraph 3: new.

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Article 23B
Credit method

• 1. Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall allow:
  • a) as a deduction from the tax on the income of that person, an amount equal to the income tax paid in that other Contracting State;
  • b) as a deduction from the tax on the capital of that person, an amount equal to the capital tax paid in that other Contracting State.
• 2. The deduction in either case shall not, however, exceed that part of the income tax or capital tax, respectively, as computed before the deduction is given, which is appropriate, as the case may be, to the income or the capital which may be taxed in the other Contracting State.
• 3. Where in accordance with the provisions of the Convention income derived or capital owned by a person is exempt from tax in a Contracting State, such Contracting State may nevertheless, in calculating tax on the remaining income or capital of such person, apply the rate of tax which would have been applicable if the exempted income or capital had not been so exempted.

Note of the Working Group:

Paragraph 3: new.

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PART III

$$$Commentary on Articles 23A and 23B
concerning the methods for avoidance of double taxation

(Remarks of the Working Group concerning the presentation of the Report:

• — Contrary to the rule usually adopted, lines alongside the text of the Draft Commentary indicate that those parts are already in the existing version of the Commentary.
• — The paragraphs in the Commentary will be renumbered when the revised text has been discussed by the Working Party.)

I. General observations

A. The scope of the Article

• 1. The Articles deal with the so-called juridical double taxation, where the sa$$$ income or capital is taxable in the hands of the same person $$$by more than one State.
• 2. This case has to be distinguished especially from the so-called economic double taxation, i.e. a taxation of the same income or capital in the hands of two different persons both chargeable to tax. If two States wish to solve problems of economic double taxation, they must do so in bilateral negotiations.
• 3. International juridical double taxation may arise in three cases:
  • a) Where each of the two Contracting States subjects the same person to tax on his worldwide income or capital (concurrent full liability to tax, “double residence”, see par. 4 below);
  • b) Where each of the two Contracting States subject the same person, not being a resident of either Contracting State within the meaning of Article 4 of the Convention, to tax on income derived from or capital owned in a Contracting State; this may result in the case where a non-resident person has a permanent establishment or fixed - 12 - CFA/WP1(75)5 base in one Contracting State (E)* through which he derives income from or owns capital in the other Contracting State (S) (concurrent limited tax liability, see par. 4A below);
  • c) Where a person is a resident of one of the Contracting States (R) within the meaning of Article 4 of the Convention and derives income from or owns capital in the other Contracting State (S or E and both States impose tax on that income or capital (see par. 5 below).
• 4. The conflict in case a (double residence) is dealt with in Article 4 on fiscal domicile. That Article defines the term “resident of a Contracting State” by referring to the liability to tax of a person under internal law by reason of his domicile, residence, place of management or any other criterion of a similar nature (Art. 4 par. 1) and by listing special criteria for the case of double residence, which give preference to one Contracting State as State of residence (R) within the meaning of the Convention (Art. 4 par. 2 and 3). By virtue of Article 4 of the Convention, case a is reduced to case c (except on the very rare occasion when tax liability in both Contracting States is based on nationality only and not on one of the criteria listed in Art. 4 par. 1; in such circumstances case b above would apply).
• 4A. The conflict in case b of paragraph 3 is outside the scope of the Convention, as this is confined, by Article 1 on the personal scope of the Convention, to persons who are residents of one or both of the Contracting States. It can, however, be settled by applying the mutual agreement procedure (see also par. 7B hereafter).
• 5. The conflict in case c of paragraph 3 may be solved by a renunciation of the right to tax either by the State of source or situation (S or E or the State of residence (R). To achieve this, in a number of Articles (Art. 6 – 22) of the Convention the right to tax is allocated expressly to one of the Contracting States.
• 6. For many items of income or capital an exclusive right to tax is given to one of the Contracting States. The relevant Article then states that the income or capital in question “shall be taxable only” in one of the Contracting States (See Art. 7 par. 1

• * Throughout the Commentary the letter “R” stands for the State of residence within the meaning of the Convention, “S” for the State of source or situation, and “E” for the State where a permanent establishment or a fixed base is situated.

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• 1st sentence, Art. 8 par. 1 and 2, Art. 12 par. 1, Art. 13 par. 3, Art. 14 par. 1 1st sentence, Art. 15 par. 1 1st sentence and par. 2, Art. 18, Art. 21 par. 1 and Art. 22 par. 3 and 4). Such State is normally the State of which the taxpayer is a resident (State R). Under four Articles (Art. 8 par. 1 and 2, Art. 13 par. 2 2nd sentence, Art. 19 par. 1(a) and 2(a) and Art. 22 par. 3) it may be the other Contracting State (S) of which the taxpayer is not a resident. The words “shall be taxable only” in one Contracting State preclude the other Contracting State from taxing (by reason of exemption), and no double taxation arises here.
• 7. For other items of income or capital, the attribution of the right to tax is not exclusive. The relevant Article then states that the income or capital in question “may be taxed” in the Contracting State (S or E) of which the taxpayer is not a resident.* In such a case the State of residence (R) must give relief so to avoid the double taxation. Such relief is provided for in Article 23A or Article 23B, as the case may be.
• 7A. Articles 23A and 23B are drafted on the basis that a resident of State R derives income from or owns capital in the other Contracting State E or S (not being the State of residence under the Convention). They do not, therefore, deal with income (such as income from immovable property, dividends, interest, royalties), derived by a resident of Contracting State R through a permanent establishment or fixed base which the resident of State R has in the other Contracting State E, from Contracting State R or from a third State.
• 7B. Where a resident of the Contracting State R derives income from sources in the same State R through a permanent establishment or a fixed base which he has in Contracting State E State E may tax such income (except income from immovable property situated in State R**) if it is attributable to the said permanent establishment or fixed base (art. 21 par. 2). In this instance too, State R must give relief under Article 23A or 23B for income attributable to the permanent

• * Note: Attention is drawn to the fact that in some cases under the OECD Draft Double Taxation Convention of 1963 (Art. 6 par. 1, Art. 13 par. 1, Art. 17, Art. 19 par. 1 and Art. 22 par. 1 and 2) the State to which the right to tax income or capital is given could be State R. To make it clear that in such cases the other Contracting State, which under the Convention is neither State R nor State S, is prevented from taxing, the wording of Articles 6, 13, 17 and 22 requires to be amended accordingly.
• ** Remark of the Working Group: this is subject to the amendment of Article 21 paragraph 2 as proposed in paragraph 9 of Part I.

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• establishment or fixed base situated in State E notwithstanding the fact that the income in question originally arises in State R (cf. par. 5 of the Commentary on Art. 21). There is, therefore, no need for a special provision for credit to be given by State E for taxes of State R. However, where the Contracting States agree to give to State R as the State of source of dividends or interest a limited right to tax within the limits fixed in paragraph 2 of Article 10 or 11, then the two States should also agree upon a credit to be given by State E for the tax reserved to State R on the lines of paragraph 2 of Article 23A or of Article 23B.
• 7C. As regards income from a third State, the Contracting State E where the permanent establishment or fixed base is situated may tax such income (except income from immovable property situated in the third State *) if it is attributable to such permanent establishment or fixed base (Art. 21 par. 2). Contracting State R must give relief under Article 23A or 23B in respect of income attributable to the permanent establishment or fixed base in State E. But no relief is provided for in the Convention to be given by Contracting State E for taxes levied in the third State where the income arises; except that under Article 24 paragraph 3 of the Convention any relief provided for in the internal legislation of State E (excluded any double taxation convention) for residents of State E is also to be granted to a permanent establishment in State E of an enterprise of Contracting State R (see par. 47 to 51 of the Commentary on Art. 24). Cases in which more than two States are involved (triangular cases) raise many problems in which not only the Convention between the States R and E but also between States R and/or E with State S may come into play. It could be argued that a provision in a Convention between State R and State E obliging State E to give credit or exemption for income derived from a third State leads to a more favorable treatment of the permanent establishment than is granted by State E to its own residents, and that the effect of the concurrent application of internal law and of one or more Conventions may even result in double or multiple relief. It is, therefore, left to Contracting States to settle the question bilaterally either generally in a Convention to be concluded between them or accidentally by way of a mutual agreement procedure (Art. 25).

• * Remark of the Working Group: this is subject to the amendment of Article 21 paragraph 2 as proposed in paragraph 9 of Part I.

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B. Description of Methods for Avoidance of Double Taxation

• 8. In the existing Conventions two leading principles are followed for the avoidance of double taxation by the State of which the taxpayer is a resident. For purposes of simplicity only income tax is referred to in what follows; but the principles apply equally to capital tax.

1. The exemption method

• 9. Under the exemption method, the State of residence R does not tax the income which, according to the Convention, may be taxed in the other Contracting State E or S (nor, of course, also income which is taxable only in State E or S; cf. par. 6 above).
• 10. The exemption method is found in two different forms:
  • a) The income which may be taxed in the other Contracting State is left entirely out of account by State R for the purposes of its tax. In this case, State R is not entitled to take the income $$$se exempted into consideration when determining the rate of tax to be imposed on the rest of the income. This method is called “full exemption”.
  • b) The income which may be taxed in the other Contracting State is left out by State R, but State R retains the right to take that income into consideration when determining the rate of tax to be imposed on the rest of the income. This method is called “exemption with progression”.
• 11. (deleted)

2. The credit method

• 12. Under the credit method, the State of residence R calculates its tax on the basis of the taxpayer’s total income including the income from the other Contracting State E or S which, according to the Convention, may be taxed in such other Contracting State (but not including income which is taxable only in State S; cf. par. 6 above). It then allows a deduction from its own tax for tax paid in the other Contracting State. - 16 - CFA/WP1(75)5
• 13. The credit method is found in different forms:
  • a) State R may allow the deduction of the total amount of tax paid in the other State on income which may be taxed in that State. This method is called “full credit”.
  • b) The deduction given by State R may be restricted so that the deduction does not exceed that part of its own tax which is appropriate to the income which may be taxed in the other State. This method is called “ordinary credit”.
  • c) Further variations of the credit system are possible, e.g. where State R limits the deduction to an amount not exceeding the tax which it would itself have imposed on that income if the taxpayer had no other income.
• 14. Fundamentally the difference between the exemption system and the credit system is that the exemption system looks at income, the credit system at tax on income.

C. The functions and effects of the methods

• 15. An example in figures will facilitate the explanation of the effects of the various methods. Suppose the total income to be 100 000, 80 000 being derived from one State (State of residence R) and 20 000 derived from the other State (State of source S). Assume that in State R the rate of tax on income of 100 000 is 35 per cent and on an income of 80 000 is 30 per cent. Assume further that in State S the rate of tax is either 20 per cent (case (i)) or 40 per cent (case (ii)), so that the tax payable therein on 20 000 is 4000 (i) or 8000 (ii), respectively.
• 16. If the taxpayer’s total income of 100 000 arises in State R, his tax would be 35 000. If he had an income of the same amount derived in the manner set out above, and if no relief is provided for in the internal law of State R and noConvention exists between State R and State S, then the total amount of tax would be, in case (i): 35 000 plus 4000 = 39 000, and in case (ii): 35 000 plus 8000 = 43 000.

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1. Exemption methods

• 17. Under an exemption method State R limits its taxation to that part of the total income which, in accordance with the various Articles of the Convention, it has a right to tax, i.e. 80 000.
  • a. Full exemption:
    
    State R imposes tax on 80 000 at the rate of tax applicable to 80 000, i.e. at 30 per cent.

    	case (i)	case (ii)
    Tax in State R, 30 p.c. of 80 000	24 000	24 000
    plus tax in State S	4 000	8 000
    Total taxes	28 000	32 000
    Relief by State R	11 000	11 000

  • b. Exemption with progression:
    
    State R imposes tax on 80 000 at the rate applicable to total income wherever it arises (100 000), i.e. at 35 per cent.

    	case (i)	case (ii)
    Tax in State R, 35 p.c. of 80 000	28 000	28 000
    plus tax in State S	4 000	8 000
    Total taxes	32 000	36 000
    Relief by State R	7 000	7 000

• 18. In both cases, the level of tax in State S has no influence on the amount of tax given up by State R. If the tax on the income from State S is lower in State S than the relief to be given by State R (cases a(i), a(ii) and b(i)), then the taxpayer will fare better than if his total income were derived solely from State R.
• 19. The example shows also that the relief given where State R applies the full exemption method may be higher than the tax levied in State S, even if the rates of tax in State S are higher than those in State R. This is due to the fact that under the full exemption method not only the tax of State R on the income from State S is surrendered (35 p.c. of 20 000 = 7000; as under the exemption with progression), but that also the tax on remaining income (80 000) is reduced by an amount corresponding to the difference in rates at the two income levels in State R (35 less 30 = 5 p.c. applied to 80 000 = 4000).

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2. Credit methods

• 20. Under the credit methods State R retains its right to tax the total income of the taxpayer, but against the tax so imposed it allows a certain deduction.
  • a. Full credit
    
    State R would compute tax on total income of 100 000 at the rate of 35 per cent and would allow the deduction of the tax due in State S on the income from S.

    	case (i)	case (ii)
    Tax in State R, 35 p.c. of 100 000	35 000	35 000
    less tax in State S	−  4 000	−  8 000
    Tax due	31 000	27 000
    Total taxes	35 000	35 000
    Relief by State R	4 000	8 000

  • b. Ordinary credit
    
    State R would compute tax on total income of 100 000 at the rate of 35 per cent and would allow the deduction of the tax due in State S on the income from S, but in no case would it allow more than the * in State R attributable to the income from S (maximum deduction). The maximum deduction would be 35 per cent of 20 000 = 7 000.

    case (i)	case (ii)
    Tax in State R, 35 p.c. of 100 000	35 000	35 000
    less tax in State S maximum deduction	−  4 000	−  7 000
    Tax due	31 000	28 000
    Total taxes	35 000	36 000
    Relief by State R	4 000	7 000

• 21. (deleted)
• 22. A characteristic of the credit methods compared with the exemption methods is that State R is never obliged to allow a deduction of more than the tax paid in State S.
• 23. Where the tax in State S is lower than the tax of State R appropriate to the income from State S (maximum deduction), the taxpayer will always have to pay the same amount of taxes as he would have had to pay if he were taxed only in State R, i.e. as if his total income were derived solely from State R.

• * proportion of tax

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• 23A. The same result is achieved, even if the tax in State S is higher than the maximum deduction, if State R applies the full credit, at least as long as tax on other income is as high or higher than the amount of the tax of State S which exceeds the maximum deduction.
• 24. Where the tax in State S is higher and where the credit is limited to the maximum deduction (ordinary credit), the taxpayer will not get a deduction for the whole of the tax paid in State S. In such event the result would be less favourable to the taxpayer than if his whole income arose in State R. In fact, the ordinary credit method would have the same effect as the exemption with progression method.
• 25. to 28. (deleted)

D. The methods proposed in the Articles

• 29. In the Conventions concluded between OECD Member countries both methods have been adopted. Some States have a preference for one method, some for the other. Theoretically a single system could be held to be more desirable, but, on account of the preferences referred to, each State has been left free to make its own choice.
• 30. On the other hand it has been found important to limit inside each main method the number of methods to be employed. In view of this limitation, the Articles have been drafted so that Member countries are left free to choose between two methods:
  • — the exemption method with progression (Article 23A), and
  • — the ordinary credit method (Article 23B).
• 30A. If two Contracting States both adopt the same method, it will be sufficient if the relevant Article is inserted in the Convention. On the other hand, if the two Contracting States adopt different methods, both Articles may be amalgated in one and the name of the State must be inserted in each appropriate part of the Article, according to the method adopted by that State.
• 30B. The two Articles are drafted in a general way and do not give detailed rules on how the exemption or credit is to be computed, this being left to the domestic law and practice applicable. Contracting States which find it necessary to settle any problem in the Convention itself are left free to do so in bilateral negotiations. - 20 - CFA/WP1(75)5
• 31. (deleted)

II. Comments on Article 23A (Exemption)

Paragraph 1

A. The obligation of the State of residence to give exemption

• 32. In the Article it is laid down that the State of residence shall exempt from tax income and capital, which in accordance with the Convention “may be taxed” in the other State.
• 32A. The State of residence must accordingly give exemption whether or not the right to tax is in effect exercised by the other Contracting State (the State of source). This method is regarded as the most practical one since it relieves the State of residence from undertaking investigations of the actual taxation position in the other State.
• 33. Occasionally, negotiating States may find it reasonable in certain circumstances to make an exception to the absolute obligation on the State of residence to give exemption. Such may be the case, in order to avoid non-taxation, where the internal legislation of the State of source does not effectively levy a tax, e.g. where it does not impose capital tax at all, or does not impose a tax on specific items of income or capital, or does not actually impose tax owing to special circumstances such as the set-off of losses, a mistake or the statutory time limit having expired. To avoid non-taxation of ** of income, Contracting States may agree to amend the relevant Article itself (See par. 4 of the Commentary on Art. 15 and par. 5 of the Commentary on Art. 17; for the reverse case, relief in the State of source subjected to actual taxation in the State of residence, see Commentaries on Art. 10, par. 19, Art. 11 par. 18, Art. 12 par. 12, Art. 13 par. 21 * and Art. 21 par. 3 *). Another case for an exception may be, where in order to achieve a certain reciprocity, one of the States adopts the exemption method and the other the credit method.

• * Remark of the Working Group: Reference in such Commentaries to paragraphs 32 and 33 of the Commentaries on Article 23A have to be adapted.
• ** specific items

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• 33A. A quite general exception to the rule laid down in paragraph 1 of the Article is stated in paragraph 2 relating to income which in accordance with the Convention may be subjected in the State of source to a limited tax (cf. par. 39 hereafter).
• 34 – 36 (Chapter B, deleted; see par. 40A to 40C hereafter).

B. Alternative formulation of the Article

• 37. An effect of the exemption system as it is drafted in the Article is that the taxable income or capital in the State of residence is reduced by the amount which the State of residence exempts. If in a particular State the amount of income as determined for income tax purposes is used as a measure for other purposes, e.g. social benefits, the application of the exemption system in the form proposed may have the effect that such benefits may be given to persons who ought not to receive them. To avoid such consequences, the Article may be altered so that the income in question is included in the taxable income in the State of residence. The State of residence must in such cases give up that part of the total tax appropriate to the income concerned. This procedure would give the same result as the Article in the form proposed. States can be left free to make such modifications in the drafting of the Article. If a State wants to draft the Article as indicated above, paragraph 1 may be drafted as follows:
  • “Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, is taxable only or may be taxed in the other Contracting State, the first-mentioned State shall, subject to the provisions of paragraph 2, allow as a deduction from the income tax or capital tax that part of the income tax or capital tax, respectively, which is appropriate, as the case may be, to the income derived from or the capital owned in that other Contracting State.”

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C. Miscellaneous Problems

• 37A. Article 23A contains the principle that the State of residence has to give exemption, but does not give detailed rules on how the exemption has to be implemented. This is consistent with the general pattern of the Draft Convention. Articles 6 to 22 too lay down rules attributing the right to tax in respect of the various types of income or capital without dealing, as a rule (see, however, Art. 7 par. 3 and 24), with the determination of taxable income or capital, deductions, rate of tax etc. Experience has shown that many problems may arise. This is especially true with respect to Article 23A. Some of them are dealt with in the following paragraphs. In the absence of a specific provision in the Convention, the internal law of each Contracting State is applicable. Some Conventions contain an express reference to the internal law. However, often reference to internal law would not help since the exemption method is not known in such internal law. In such cases Contracting States should establish rules for the application of Article 23A, if necessary after having consulted with the competent authority of the other Contracting State (Art. 25 par. 3).

1. Amount to be exempted

• 37B. The amount of income to be exempted from tax by the State of residence is the amount which but for the Convention would be subjected to domestic income tax according to the national law governing such tax. It may, therefore, differ from the amount of income subjected to tax by the State of source according to its domestic law.
• 37C. Normally, the basis for the calculation of income tax is the total net income, i.e. gross income less allowable deductions. Therefore, it is the gross income derived from the State of source less any allowable deductions (specified or proportional) connected with such income which is to be exempted.
• 37D. Problems arise from the fact that most countries provide in their tax law for additional deductions from total income or specific items of income to arrive at the income subject to income tax. An example in figures may illustrate the problem:

  a) domestic income (gross less cost)	100
  b) income from the other State (gross less cost)	100
  c) total income	200

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  d) deductions for expenses allowed under the law of the State of residence, but not connected with any of the income under a) or b), such as insurance premiums, contributions to welfare institutions	−  20
  e) “net” income	180
  f) personal and family allowances	−  30
  g) income subject to tax	150

  The question is, what amount should be exempted from tax, e.g.
  • — 100 (line b), leaving a taxable amount of 50;
  • — 90 (half of line e, according to the ratio between line b and line c), leaving 60 (line f being fully deducted from domestic income);
  • — 75 (half of line g, according to the ration between line b and line c), leaving 75;
  or any other amount.
• 37E. A comparison of the law and practice of the OECD Member countries shows that the amount to be exempted varies considerably from country to country. The solution adopted by a State depends upon the policy followed by such State and the structure of the tax. It may be the intention of a State that its residents always enjoy the full benefit of their personal and family allowances and other deductions. In other countries these tax free amounts are apportioned. In many countries personal or family allowances form part of the progressive scale, are granted as a deduction from tax, or are even unknown $$$—the family status being taken into account by separate tax scales.
• 37F. In view of the wide variety of social policy objectives and fiscal techniques in the different countries regarding the determination of tax, especially deductions, allowances and similar benefits, it is preferable not to propose an express and uniform solution in the Draft Convention, but to leave each country free to apply its own legislation and technique. Contracting States which prefer to have special problems solved in the Convention are, of course, free to do so in bilateral negotiations. Finally, attention is drawn to the fact that the problem is also of importance for countries applying the credit method (see par. 43 hereafter).

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2. Treatment of losses

• 38. (To be redrafted at a later date in the light of the outcome of the discussion on Part I Chapter E)

3. Taxation of the rest of income.

• 38A. Apart from the application of progressive tax rates which is now dealt with in paragraph 3 of the Article (see par. 40A to 40C hereafter), some problems may arise from specific provisions of the tax law. Thus, e.g. some tax laws provide that taxation starts only if a minimum amount of taxable income is reached or exceeded (tax exempt threshold). Total income before application of the Convention may clearly exceed such tax free threshold; but, by virtue of the exemption resulting from the application of the Convention which leads to a deduction of the tax exempt income from total taxable income, the remaining taxable income may be reduced to an amount below the threshold. For the reasons mentioned in paragraph 37F above, no uniform solution can be proposed. It may be noted, however, that the problem would not arise, if the alternative formulation of paragraph 1 of Article 23A (as set out in par. 37 above) is adopted.
• 38B. Many countries have introduced special systems for taxing corporate income (see Chapter III of the Commentary on Article 10). In countries applying a split rate corporation tax (par. 41 of the said Commentary), the problem may arise whether the exempted income has to be deducted from undistributed income (where the normal rate of tax applies) or from distributed income (which benefits from a reduced rate) or whether an average rate of tax has to be applied to the profits which remain taxable. Where, under the law of a country applying the split rate corporation tax, a supplementary tax (“Nachsteuer”) is levied in the hands of a parent company on dividends which it received from a domestic subsidiary company but which it does not redistribute (on the grounds that such supplementary tax is a compensation for the benefit of a lower tax rate granted to the subsidiary on the distributions), the problem arises, whether such supplementary tax may be charged where the subsidiary pays its dividends out of tax exempt income. Finally, a similar problem may arise in connection with taxes (“précompte”, Advance Corporation Tax) which are levied on distributed profits of a corporation in order to cover the “tax credit” (“avoir fiscal”) attributable to the sharesholders (see par. 45 of the Commentary on Article 10). The question is whether such special taxes connected with the distribution of profits are covered by Article 23A and, accordingly, could not be levied insofar as distributions are made out of profits exempt from tax. - 25 - CFA/WP1(75)5
• 38C. Here too, the solution depends upon the policy of the State which operates such special systems. The point is also of great importance in other fields (e.g. taxation of dividends, Art. 10, and non-discrimination, Art. 24 par. 3, and Commentaries relating thereto). It must, therefore, be left to Contracting States to settle the question by bilateral negotiations.

Paragraph 2

• 39. In Articles 10 and 11 the right to tax dividends and interest is divided between the State of residence and the State of source. Such is also the case with respect to royalties, as regards Greece, Luxembourg, Portugal and Spain (See Chapter III of the Commentary on Article 12). As a consequence double taxation in these cases cannot be expected to be avoided by the application of the exemption method since this method secures that the State of residence gives up fully its right to tax the income concerned, but the State of residence is left free to apply the exemption method if it wants to do so. For the State of residence the application of the credit method would normally seem to give a satisfactory solution. Consequently, the paragraph is drafted in accordance with the ordinary credit method. The commentary on Article 23B hereafter applies mutatis mutantur to paragraph 2 of Article 23A. (Rest deleted)
• 40. In the cases referred to in the previous paragraph certain maximum percentages are laid down for tax reserved to the State of source. In such cases the rate of tax in the State of residence will very often be higher than the rate in the State of source. Consequently, a limitation of the deduction in accordance with the ordinary credit method would have only a limited significance. If in such cases the Contracting States find it preferable to use the full credit method they can do so by deleting the second sentence of the paragraph.

Paragraph 3

• 40A. The OECD Draft Convention of 1963, in harmony with most Conventions concluded between Member countries following the exemption method, reserved expressly the progression for the State of residence. According to Article 23A paragraph 1, the State of residence retains the right to take the amount of exempted income or capital into consideration when determining the rate of tax to be imposed on the rest of the income or capital. The Commentary on Article 23A - 26 - CFA/WP1(75)5 as drafted in 1963 raised the question whether the State of source may also apply a progressive tax scale (par. 35 and 36). It stated that the said Article does not prejudice the application by the State of source of the provisions of its internal legislation concerning the progression. The two Contracting States were left free, however, to clarify the point in bilateral negotiations.
• 40B. Further consideration in the Committee on Fiscal Affairs led to the conclusion that the problem of progression has a broader importance and that it may also arise for income or capital which by direct application of Articles 8, 13, 19 or 22, respectively, are exempt from tax in the State of residence (cf. par. 6 above). It was therefore found advisable to amend Article 23A in such a way as to eliminate any doubt and to cover all cases of exempted income or capital, i.e. the ones resulting for the State of residence from the application of all Articles (not only Article 23A) and for the State of source.
• 40C. Paragraph 3 is based on the underlying idea that the determination of the tax on income and capital which, in accordance with the Convention may be taxed in a Contracting State, is regulated by the internal law and practice of that State unless otherwise provided for in the Convention. The implementation of Article 23A of the Draft Convention shall not prejudice the interpretation of existing conventions in which the 1963 version was adopted.

III. Comments on Article 23B (Credit)

Paragraphs 1 and 2

A. Methods

• 41. Article 23B which embodies the credit provision, follows the ordinary credit method: The State of residence allows, as a deduction from its own tax on the income or capital of its resident, an amount equal to the tax paid in the other State on the income derived from, or capital owned in, that other State, but the deduction is restricted to the appropriate proportion of its own tax. - 27 - CFA/WP1(75)5
• 42. The ordinary credit method is intended to apply also for a Contracting State which follows the exemption method but has to give credit, under Article 23A paragraph 2, for the tax levied at limited rates in the other Contracting State on dividends and interest (cf. par. 39 above). The possibility of a certain modification which is referred to under paragraphs 39 and 40 above (full credit) could, of course, also be of interest for dividends and interest paid to a resident of a Contracting State which adopted the ordinary credit method.
• 42A. It is to be noted that Article 23B applies in a Contracting State only to items of income or capital which, in accordance with the Convention, “may be taxed” in the other Contracting State. Items of income or capital which, according to Articles 8, 13, 19 and 22 are “taxable only” in the other Contracting State, are from the outset exempt from tax in the State of residence (see par. 6 above), and the Commentary on Article 23A applies to such exempted income and capital. As regards progression see paragraph 3 of the Article (and par. 53 to 55 hereafter).
• 42B. Article 23B contains the principle of credit, but does not give detailed rules on how the credit has to be computed. This is consistent with the general pattern of the Draft Convention. Experience has shown that many problems may arise. Some of them are dealt with in the following paragraphs. In many States extensive rules on tax credit already exist in their internal laws. A number of Conventions, therefore, contain a reference to the internal law of the Contracting States and further provide that such internal rules shall not affect the principle laid down in Article 23B. Often reference to internal law would not help since the credit system is not known under the internal *
  
  In such cases Contracting States should establish rules for the application of Article 23B, if necessary after having consulted with the competent authority of the other Contracting State (Art. 25 par. 3).
• 42C. The amount of foreign tax for which a credit has to be allowed is the tax actually paid to the other Contracting State. Problems may arise, e.g. where such tax is not calculated on the income of the same year for which it is levied, but on the income of a preceding year or on the average income of two or more preceding years. Other problems may arise in connection with different determinations of the income or in connection with changes in the currency rates (devaluation or revaluation). However, such problems may scarcely be solved by an express provision in a double taxation Convention.

• * law of the State concerned.

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• 43. According to the Article, the deduction which the State of residence R is to allow, shall not exceed that part of the income tax which is appropriate to the income derived from the State of source S or E (so called “maximum deduction”). Such maximum deduction may be computed either by apportioning the total tax on total income according to the ratio between the income for which credit is to be given and the total income, or by applying the tax rate for total income to the income qualifying for credit. In fact, in cases where the tax in State E or S equals or exceeds the appropriate tax of State R, the credit method will have the same effect as the exemption method with progression. Also under the credit method similar problems as regards the amount of income, tax rate etc. may arise as are mentioned in the Commentary on the exemption method (see especially par. 37B to 37D and 38). For the reasons mentioned in paragraphs 37E and 37F above, in the Commentary on the exemption method, it is preferable, also for the credit method, not to propose an express and uniform solution in the Draft Convention, but to leave each country free to apply its own legislation and technique. This is also true for some further problems.
• 43A. If a resident of State R derives income of different kinds from the State S, and the latter State, according to its tax law imposes tax on only one of these items, the maximum deduction which State R is to allow will normally be that part of its tax which is appropriate only to that item of income which is taxed in State S. However other solutions are possible, especially in view of the following broader problem: The fact that credit has to be given, e.g. for several items of income on which tax at different rates is levied in State S, or for income from several States, with or without Conventions, raises the question whether the maximum deduction and/or the credit has to be calculated separately for each item of income, or for each country, or for all foreign income qualifying for credit under internal law and under Conventions. Under a system of an “overall credit” all foreign income is aggregated and the total of foreign taxes is credited against the domestic tax appropriate to the total foreign income.
• 43B. * Further problems may arise in case of losses. A resident of State R, deriving income from another State E or S, may have a loss in State R, or in the other Contracting State E or S or in a third State. For purposes of the tax credit, in general a loss in a given State will be set off against other income from the same State. Whether a loss suffered outside the State R (e.g. in a permanent

• * Note of the Working Group: Subject to the results of the discussion of Part I Chapter E.

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• establishment) may be deducted from other income (whether derived from State R or abroad) depends from the internal law of State R, and here similar problems may arise as mentioned in the Commentary on Article 23A (par. 38 above). When the total income is derived from abroad and no income but a loss not exceeding the income from abroad arises in State R, then the total tax charged in State R will be appropriate to the income from the State of source, and the maximum deduction which State R is to allow will consequently be the tax charged in State R. Other variations are possible.
• 43C. The aforementioned problems depend very much on internal law and practice, and the solution must therefore be left to each Contracting State. In this context it may be noted that some States are very liberal in applying the credit method. Some States are also considering or have already adopted the possibility of carrying forward unused tax credits so as to avoid any possible double taxation. Contracting States are, of course, free in bilateral negociations to amend the Article to cover any of the problems mentioned before.
• 44. (New text to be proposed by Italy)

B. Remarks concerning tax on capital

• 45. and 46. (old texts)

C. The relation in special cases between the taxation in the State of source and the ordinary credit method

• 47.–51. (old texts; add reference to the Report of 1965 on fiscal measures to encourage private investments in developing countries)

D. Special credit with respect to dividends

• 52. *

• * Note of the Working Group: Special treatment of dividends from subsidiaries, such as credit for underlying tax, affiliation privilege, to be considered in connection with the report of Working Group No 23 on corporate dividends.

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Paragraph 3

• 53. The OECD Draft Convention of 1963, in harmony with most conventions concluded between OECD Member countries following the credit method, did not mention expressly the right of the Contracting States to apply progressive rates for taxes on income or capital in a case where by virtue of the provisions of the Convention part of such income or capital is exempt from tax in such State. Article 23B of the 1963 Draft is based on the idea that a Contracting State applying the credit method is allowed to subject the total income of a resident taxpayer to tax. It was further assumed that the Convention does not prejudice the application by the State of source of the provisions of its internal legislation concerning the progression (see par. 35 and 36 of the Commentary on Art. 23A).
• 54. For the reasons mentioned in paragraph 40B above, the Committee on Fiscal Affairs found it advisible to amend also Article 23B so as to eliminate any doubt and to cover all cases, namely the State of residence with regard to income or capital exempt by other provisions of the Convention (such as Articles 8, 13, 19 or 22) and the State of source.
• 55. Paragraph 3 is based on the principle that the determination of the tax on income and capital which in accordance with the Convention may be taxed in a Contracting State is regulated by the internal law and practice of such State unless otherwise expressed by the Convention. The implementation of Article 23B of the Draft Convention shall not prejudice the interpretation of existing Conventions based on the 1963 version.