Tax Treaties: What They Are and How They Work

Definition

A tax treaty (also called a double tax agreement, or DTA) is a bilateral agreement between two countries that allocates taxing rights to prevent the same income from being taxed twice. Treaties typically cover income, capital, estate, and wealth taxation and set rules for cross-border investment and trade.

Key takeaways

• Tax treaties reduce or eliminate double taxation by allocating taxing rights between the source country (where income arises) and the residence country (where the taxpayer resides).
• Treaties commonly address withholding taxes on dividends, interest, and royalties, and provide rules for business profits, employment income, and other categories.
• Two main treaty models exist: the OECD Model (generally favors capital-exporting countries) and the UN Model (gives more taxing rights to capital-importing/developing countries).
• Some jurisdictions (notably tax havens) may not enter into treaties. In some cases, domestic rules or subnational authorities may not recognize treaty benefits.

How tax treaties work

When a resident of one country earns income in another, both the source and residence countries might claim tax on that income. A treaty resolves these conflicts by:
* Allocating primary taxing rights (for example, certain business profits or employment income may be taxed in the source country).
* Requiring the residence country to provide relief for tax paid abroad (commonly via exemption or foreign tax credit).
* Limiting withholding tax rates on cross-border payments like dividends, interest, and royalties.

Source vs. residence country
* Source country: where the income originates (capital-importing country).
* Residence country: where the taxpayer resides or is domiciled (capital-exporting country).

Treaty models: OECD vs. UN

Two widely used templates guide treaty negotiation:

OECD Model
* Originates from the Organization for Economic Co-operation and Development.
* Tends to favor capital-exporting (residence) countries by restricting the source country’s taxing rights on certain income types.
* Common among developed countries and used where trade and investment flows are relatively balanced.

UN Model
* Designed to address relationships between developed and developing countries.
* Grants broader taxing rights to the source country, supporting capital-importing nations that receive inward investment.
* Draws heavily from the OECD Model but shifts some allocation in favor of the source country.

Withholding taxes

Withholding tax provisions are among the most important treaty elements because they directly affect the tax withheld on cross-border payments. Typical features:
* Treaty-specified maximum rates for withholding on dividends, interest, and royalties (e.g., a treaty might cap dividend withholding at 10%).
* Procedures for claim and documentation (tax residency certificates, forms) to obtain reduced treaty rates.
* If no treaty exists, normal domestic withholding rates of the source country generally apply.

Practical notes

• Treaty relief is commonly obtained by filing tax forms in the source country or claiming a foreign tax credit in the residence country.
• Some jurisdictions or subnational tax authorities may not honor treaty provisions; taxpayers should verify local practice.
• Treaties usually include anti-abuse rules to prevent treaty-shopping and ensure benefits are used by eligible residents.

Saving clause

Many treaties include a “saving clause” that preserves a country’s right to tax its own residents as if the treaty had not come into effect. This prevents residents from using treaty provisions to escape taxation on domestic-source income.

Reciprocity

Tax treaties are reciprocal: they apply to residents of both contracting countries and set mutual obligations and benefits.

Tax havens and treaties

Tax havens—jurisdictions with low or no corporate taxes—often have fewer or no tax treaties. The absence of treaties can affect withholding taxes and the availability of treaty-based relief for investors.

Conclusion

Tax treaties are key tools for facilitating international trade and investment by clarifying which country may tax cross-border income and by reducing double taxation. Their specific benefits and rules vary by treaty, so taxpayers should consult the relevant treaty text and local tax guidance or seek professional advice when engaging in cross-border transactions.