How do double taxation agreements work?

1 June 2021

A double taxation agreement is designed to do exactly what it says – prevent double taxation.

It is a treaty between two countries which sets out who gets the main right to charge tax on particular types of income and capital gains.

The other country to the treaty can still potentially charge tax on that income and gains but it would have to allow a credit from the tax that would usually be due for the tax already paid in the other country. Generally this means that you end up paying whichever is the higher of the tax due in the two countries.

Sometimes the agreement does specify that a particular type of income or gains is only taxable in one of the two countries, an example being pension income or a lump sum from a pension scheme in that country. However even then there is usually a part of the agreement that says when the income or gains is not subject to tax in the country with the main taxing rights for example through a claim to the remittance basis, then the other country can still charge tax as there is no double taxation.

US treaties also contain an extra specific carve out known as the savings clause allowing US citizens to be taxed as if the treaty did not exist in most cases. What this means that even if the treaty says the income is only taxable in the UK on a UK resident, it is also taxable in the US but the US would have to give credit for the UK tax due on the same amount. In that way double taxation is still avoided.

In the more unusual circumstances where an individual is considered resident for tax purposes in both countries then before the treaty can even be considered you will need to determine where the person is resident for this purpose. This is done using a four part test set out in the agreement and you go through the four tests in order, stopping when one of the tests is met. The tests include where you have a home, where you main social, family professional and economic ties are (known as the centre of vital interests), where you physically spend more of your time and which country you are a national of.

Double taxation agreements are very useful to avoid being taxed twice on the same income in two places but can be difficult to understand and need to be applied correctly to get the right outcome.

The UK in particular are looking more and more closely and claims to foreign tax credits to ensure they are allowable under the terms of the various double tax agreements they have entered into.