Taxation across borders

The issue surrounding what and how much a taxpayer should be paying in the UK is a frequent topic of debate, but it becomes even more complex when said taxpayer starts to operate in more than one jurisdiction.

Taxation is a subject which can divide opinion among taxpayers for any number of reasons; everyone has their own view on, amongst other things, (i) what should be taxed, (ii) when it should be taxed i.e., on what 'event', and (iii) how much the tax should be. The same too can be said of countries or, to use the correct terminology, 'states': they will each have their own approach to taxation within their own jurisdiction. That all sounds non-controversial but what happens when taxpayers start to operate in more than one jurisdiction?

Several states, including the UK, have over the years agreed how tax will be levied in those situations and committed that agreement to a treaty, specifically to a Double Tax Treaty (DTT). In a world where individual taxpayers move between jurisdictions and may well need to engage with more than one tax system, the role of DTTs should not be underestimated.

What do DTTs do?

The general perception of the role of DTTs is to guard against anyone from being 'double taxed'. On first principles that sounds about right but the technically correct way of describing the role of a DTT is to determine which state has 'primary' taxing rights when the same income / gain is taxable by both states. That does not mean however that, under every DTT, the other contracting state cannot apply its own taxing rights – that is still possible and very likely.

What do DTTs cover?

As one would expect, DTTs cover taxes. In very broad terms, most DTTs will narrate:

1. specifically, what taxes in each jurisdiction will be governed by its terms;
2. how someone will be determined to be resident in each jurisdiction, and so subject to tax in each jurisdiction;
3. provisions for what happens where something is found to be taxable in both jurisdictions;
4. the various kinds of income and gains and how (and if) they will fall to be taxed under the DTT e.g. dividends, business profits, interest, royalties, pensions and annuities etc; and
5. how credit or relief is to be given where tax is paid in one state but also falls due in another state by reference to the same income / gain.

Anyone looking to make use of or advise a client on a DTT should check its terms thoroughly to understand how the parties to the treaty have agreed to tax the relevant item of income / gains.

 How would this work for a UK taxpayer?

The UK's approach to taxation for both income and Capital Gains Tax (CGT) purposes is relatively simple: a UK resident taxpayer (under the Statutory Residence Test) will be subject to UK income tax on their worldwide income, and UK CGT on any gains they enjoy. The exposure of a taxpayer's estate to UK Inheritance Tax will, as at the time of writing, be dependent on their domicile – IHT is outside the scope of this article but is commented on here.  

For the sake of argument, assume that there is a UK resident taxpayer, Mr Jones, (a dual UK-USA citizen) that happens to have interest bearing bank accounts and investments (rental properties) in each of the UK and the USA. Those two states happen to have agreed a DTT (available here) which makes clear that:

• for interest purposes, under Article 11 of the Treaty, interest arising in one state that is owned by a resident of another state will be taxable only in that other state; and
• the taxation of rental income is governed by Article 6 of the Treaty. It stipulates that income arising to a resident of one state, from the letting of property in another state, will be taxable in the other state.

Applying those rules to our taxpayer would lead to the following result:

Mr Jones' having connections to both the UK (residence and citizenship) and the USA (citizenship) does complicate matters. The USA is one of the few states that obliges people to report on their tax position on their worldwide income / gains based on their being a US citizen – their being non-US resident will not release them from the US tax rules, and that is reflected in the Treaty (Article 1(4)) and confirmed by the Inland Revenue Service (here).

Is there ever really double taxation?

It is possible that certain income / gains streams may fall to be taxed in both jurisdictions e.g., for dividends, under the Article 10 of the Treaty, tax may be due in both (1) the state where the company paying the dividend is based, and (2) the state where the recipient of the dividends is resident. That exposes the same asset to each jurisdiction's tax system i.e., subjecting it to 'double taxation'. However, that is inequitable and the Treaty recognises that by limiting the tax that can be applied by the state that lacks the primary taxing rights. Furthermore, under Article 24 of the Treaty, credit can be given for tax on income paid / gains enjoyed in one state, that also happens to be taxable in another state. 

So what does this mean for Mr Jones?

In practice, Mr Jones' situation would, broadly, be as follows using the Treaty:

• the UK will subject the interest on the UK and US bank accounts, and the UK rental income to UK tax rates;
• the US will tax the US rental income under its domestic rules;
• Mr Jones will need to report on his income streams in both the UK and USA, and as part of that exercise, he will engage the Treaty.

In situations like Mr Jones', the UK has a number of allowances which may, depending on the level of income / gains, mitigate any UK tax liability.  Advice would need to be taken on whether or not similar allowances are available in the US.

How can DTTs be relied upon?

It may be an obvious point but it is one worth making: DTTs are not 'shields' against tax, nor can they be engaged automatically simply because an individual, by virtue of their residence and / or the locations of the income / gain, falls to be taxed in two states that happen to have agreed a DTT. Every jurisdiction will have its own domestic taxing criteria for each source of income / gain. That will also have a mechanism to make use of a DTT, and an individual looking to take advantage of those provisions will need to engage them. For example, to engage the terms of a DTT that the UK is party to, an individual will normally need to report that when submitting their UK tax return under the Self-Assessment system. Following the example above through, if Mr Jones was looking to use the Treaty, he will likely need to carry out similar reporting in both the UK and the USA. But take heart, reporting twice does not mean taxing the same asset, to the same extent, in both jurisdictions.   

What is the key message?

Individuals with multiple income / gain streams both within and outside of the UK tend to be familiar with the existence of DTTs, but can encounter difficulties in engaging with them:

• DTTs can be challenging to interpret;
• the practicalities of using DTTs effectively requires collaboration between advisors across jurisdictions; and
• every DTT and situation will be different and the terms of the relevant DTT will need to be considered carefully.

It is suggested that when dealing with clients that both operate and acquire assets across borders, they are supported by advisors who are able to help them navigate the tax regimes(s) effectively.

Written by Kevin Winters and Laura Brown at Brodies