A Double Taxation Agreement (DTA) is a bilateral international treaty signed between two States, whereby they determine the way in which the income obtained in the second signatory country by the citizens of the first country is subject to the tax system of the second country and vice versa, i.e. how the income obtained in the first signatory country by the citizens of the second country is subject to taxation in the tax system of the first signatory country.
Not all countries have signed DTAs (although most of them have), which can generate a significant disadvantage for taxpayers residing in one country who obtain income from another country with which they have not signed a DTA, given that in such cases the income could be subject to taxation in both countries.
Based on the assumption that a tax resident in a given country must report in his personal income tax return all the income he has received during the year, including income from other countries on which he may have had to pay tax abroad, the DTA is the legal instrument that makes it possible to regulate the mechanisms to prevent the same source of income from being taxed twice.
In any Double Taxation Agreement we can distinguish:
- A definition of the concept of tax resident in a country.
- An explanation of the income that will be subject to the agreement.
- A specification of the country where the income is to be taxed. In DTAs, it is possible that the same income may be subject to taxation in both countries.
A mechanism to correct double taxation, so that the same source of income is not taxed in both countries (double taxation method).
We must start from the fact that a “Spanish” taxpayer must report in his personal income tax return all the income he has obtained worldwide, whether or not he has paid tax abroad, and that all Double Taxation Conventions are not the same.
In general terms, and depending on the configuration of the DTA, double taxation can be corrected in two ways:
- By declaring the foreign source of income as income in the personal income tax return, and once the calculation of the tax payable has been made, deduct the tax payment made abroad.
- Declaring the source of foreign income as income in the personal income tax return (for information purposes) but not paying tax on this income because it is considered to be “exempt’‘ from taxation, although it counts for other purposes.
In our professional experience we have been able to observe that there is the possibility of an income not being taxed in either of the 2 countries (country of residence of the taxpayer, and country of origin of the income), when the applicable mechanism to avoid double taxation is to declare an income exempt, a circumstance that we are going to explain with the following example:
Article 25.3 of a Double Taxation Agreement signed by Spain with a European Union country that we will call “country x” states:
When a resident in Spain obtains income or possesses assets which, in accordance with the provisions of this Agreement, may be subject to taxation in country x, Spain, except for the provisions of number 4, will exempt this income or assets from tax, but in order to calculate the tax corresponding to the remaining income or assets of this resident it may apply the same tax rate that would apply if the aforementioned income or assets had not been exempted.
In a “country x” its tax law states that both residents and non-residents are not taxed on capital gains from the sale of real estate, even though we are talking about a type of income that could have been taxable in that country, as it is in most European countries.
This means that if a tax resident in Spain sells a real estate property located in country x, having obtained a capital gain, this profit will not be taxed in that country because its internal tax regulations so provide, and neither will it pay tax in Spain according to the provisions of article 25.3 of the Double Taxation Agreement. (Binding Tax Query)
From Netlex advisors in Marbella, our recommendation, when applying a Double Taxation Agreement, is to carefully analyse the article referring to the method for eliminating double taxation, and in case of any doubt, consult an expert tax advisor who can clarify any doubts you may have.