The Problem

A double taxation problem arises when a taxpayer who has a personal relationship with one country (home country) derives income from sources within another country (host country). The host country usually will assert jurisdiction on the basis of its economic relationship with the taxpayer.

The home country may assert jurisdiction over the income on the basis of its personal relationship with the taxpayer. The countries involved must decide whether and how to adjust their tax systems so as to avoid international double taxation.

The Traditional Solution

Traditionally, it has been up to the home country to solve the double taxation problems of its citizens and residents. To accomplish this, the home country forfeits part or all of its’ jurisdictional claim over the foreign-source income of its citizens under a territorial system or a credit system.

Territorial System

Under a territorial system, the home country taxes citizens and residents only on income derived from sources within its own borders. These citizens and residents are allowed to exclude from taxation all income derived from foreign sources. For example, the home country would tax a citizen’s wages that were earned domestically. However, it would exempt from tax any wages earned abroad.

This leaves only the host country to tax the citizen’s foreign source income. Under a territorial system, the foreign income of a citizen or resident is taxed only once at the host country’s rate.

Credit System

Under a credit system, the home country taxes the foreign income of its citizens and residents. However, it allows a credit for any foreign taxes paid on that income. In other words, the home country asserts secondary jurisdiction over the foreign income of its citizens and residents. The net result is that foreign income is taxed only once at the higher of the host country’s rate or the home country’s rate.

Example # 1: Host country tax rate is lower than home country rate

ABC Corp. has taxable income of $ 100, all of which is derived from foreign sources. Assume that the home country tax rate is 35% and the foreign tax rate is 25%.

• Scenario # 1 – No mechanism for mitigating double taxation

If the home country provides no mechanism for mitigating international double taxation, the total tax on ABC’s $ 100 of foreign-source income is $ 60 [$ 35 home country tax + $ 25 host country tax], computed as follows:

Home Country Tax Return

1. Taxable income: $ 100
2. Tax rate: 35%
3. Tax: $ 35

Foreign Tax Return

1. Taxable income: $ 100
2. Tax rate: 25%
3. Tax: $ 25

• Scenario # 2 – Territorial System

Under a territorial system, the total tax on ABC’s foreign-source income is $ 25 [$ 0 home country tax + $ 25 foreign tax], computed as follows:

Home country tax return

1. Taxable income: $ 0
2. Tax rate: 35%
3. Tax: $ 0

Foreign tax return

1. Taxable income: $ 100
2. Tax rate: 25%
3. Tax: $ 25

• Scenario # 3 – Credit system

Under a credit system, the total tax on ABC’s foreign source income is $ 35 [$ 25 host country tax + $ 10 home country tax], computed as follows:

Foreign tax return

1. Taxable income: $ 100
2. Tax rate: 25%
3. Tax: $ 25

Home country tax return

1. Taxable income: $ 100
2. Tax rate: 35%
3. Pre-credit tax: $ 35
4. Foreign tax credit: ($ 25) (Taxpayer gets a credit for the taxes paid to the foreign government)
5. Tax: $ 10

• The Takeaway From This Example

Under a credit system, the taxpayer pays not only the host country tax, but also any home country tax in excess of the lower host country tax.

A credit system and a territorial system both solve ABC’s double taxation problem, but they do so in different ways.  A territorial system eliminates the $ 35 home country tax on ABC’s foreign source income, resulting in taxation once at the lower foreign rate.  In contrast, a credit system eliminates the $ 25 foreign tax on ABC’s foreign source income, resulting in taxation once at the higher home country rate.

Example # 2: Host country tax rate is higher than home country rate

When the host country tax rate is higher than the home country rate, territorial and credit systems produce equivalent results. Assume the same facts as above, except that the foreign tax rate is now 40%.

• Scenario # 1 – Territorial System

Under a territorial system, foreign source income is taxed once at the higher foreign rate. Therefore, the total tax on ABC’s foreign-source income is $ 40 [$ 0 home country tax + $ 40 foreign tax], computed as follows:

Home country tax return

1. Taxable income: $ 0
2. Tax rate: 35%
3. Tax: $

Foreign tax return

1. Taxable income: $ 100
2. Tax rate: 40%
3. Tax: $ 40

• Scenario # 2 – Credit system

Under a credit system, the total tax on ABC’s foreign source income is also $ 40 [$ 0 home country tax + $ 40 foreign tax], computed as follows

Foreign tax return

1. Taxable income: $ 100
2. Tax rate: 40%
3. Tax: $ 40

Home country tax return

1. Taxable income: $ 100
2. Tax rate: 35%
3. Pre-credit tax: $ 35
4. Foreign tax credit: ($ 35)
5. Tax: $ 0

A credit system results in taxation once at the higher foreign rate because the foreign tax credit completely offsets the pre-credit home country tax on the foreign source income.

• The Takeaway From This Example

No home country tax is collected on the high tax foreign source income under either system.