3.3.4.1 Introduction

Art. 23 A and 23 B OECD MTC are aimed at preventing juridical double taxation by the state of residence.1 The Commentary on art. 23 A and 23 B OECD MTC outlines three situations in which international juridical double taxation may occur:2

The first form of international juridical double taxation is in principle solved by the application of the tiebreaker provision as contained in art. 4 OECD MTC.4 The second form is partly solved by the distribution of taxing rights as prescribed in Chapters III and IV of the OECD MTC.5 In this context, the provisions of art. 23 A and 23 B are also relevant. The third form falls outside the scope of the OECD MTC, as the Convention applies only to persons who are residents of one or both of the Contracting States.6 Any resulting double taxation can be solved via a MAP.7

Art. 23 A and 23 B OECD MTC are particularly relevant to resolve the second form of international juridical double taxation: a resident of a Contracting State that receives income from the other state that is taxed by both states. The articles elaborate on the methods for the elimination of double taxation: the exemption method and the credit method. Contracting States may choose between the application of the methods, and application of one method is supplemented by elements of the other.8 No ‘standard’ method has been prescribed, as it was not possible to reach agreement on this point9 due to the differences in principles underlying the methods. The exemption method is based on the idea that the state in which the income arises has more right to tax the income. The exempting state must therefore ‘give away’ part of its taxing rights. The credit method ‘pushes up’ the tax burden to the level prevailing in the residence state (if that level is higher).10

Under the exemption method the state of residence does not tax income that may be taxed in the source state or permanent establishment state under the treaty. As such, the foreign profit may be exempt or there may be an exemption with progression. In the latter case, the elements of income that may be taxed abroad are not taxed in the residence state but are taken into consideration to determine the tax to be imposed on the rest of the income.11 The exemption method is part of a system that aims to achieve CIN. The idea behind CIN is that there should be an equal treatment in the foreign market, i.e., that a subsidiary should be able to compete in the foreign market on equal terms with local companies. Thus, the subsidiary must be subject only to local tax, and an exemption method must be applied in the residence state.

When the credit method is applied, the foreign income is first fully included in the taxable object. The tax levied abroad is then deducted from the tax on the worldwide income. If the tax levied abroad can be fully offset against the tax on the worldwide income, this is called a full credit. A limited credit – the ordinary credit – is granted when the foreign tax may be offset up to the proportionate tax in the state of residence that is attributable to the foreign income.12 Application of the credit method corresponds to a system based on CEN. In such a system, there must be an equal treatment in the home market. Companies investing abroad should pay the same tax as companies investing exclusively in the home country, so taxation should not influence the decision where to invest. This can be achieved by taxing the company for its worldwide income and granting a tax credit for the taxes paid abroad. Under this system, worldwide income is taxed at the home state’s tax rate. A country that applies such a system tends to adversely affect the international competitive position of its own enterprises.13

Whether the exemption method or the credit method produces a more favourable outcome for a taxpayer depends on the facts and circumstances of each particular case. The two provisions for the elimination of double taxation included in the OECD MTC are intended to provide guidance. The details of how the tax exemption or credit is to be calculated must be determined at the national level.14

Since art. 23 A and 23 B OECD MTC provide the mechanisms to prevent juridical double taxation, these provisions are aimed at realizing one of the objectives of the OECD MTC. Application of the exemption method can lead to double non-taxation since the provision does not include a subject-to-tax requirement.15 Double non-taxation occurs if the source state is granted taxing rights in respect of a certain item of income but does not tax this item of income under national law, while the state of residence applies the exemption method. This means that the provision essentially facilitates tax avoidance.

The Commentary on art. 23 A and 23 B OECD MTC only discusses the existence of group companies in the section on the taxation of dividends from substantial holdings by a company.16 The current art. 23 A and 23 B do not prevent economic double taxation in group situations. No agreement could be reached at the OECD level on how to eliminate double taxation in such situations. Since the OECD MTC aims at the elimination of juridical double taxation, this outcome is not contrary to the objectives of the OECD MTC. However, the more overarching objective of the OECD MTC is to promote cross-border activities. From that point of view, it can be stated that it would be logical to provide for the prevention of economic double taxation in tax treaties. This subject will be discussed in more detail in chapter 6.