credit versus exemption

Part V - Credit versus Exemption

Credit versus Exemption under Domestic Tax Law and Treaties

Author

Guglielmo Maisto

1. Defining credit and exemption methods

Several OECD Member countries have recently revisited their rules on taxation of foreign income and considered

changes to their current method of relief from international double taxation, i.e. either credit or exemption, to seek

simplicity, increase state revenues and support foreign business and investment activities. This paper reviews

this debate and focuses on the impact of credit or exemption systems in the presence of treaties and questions

the extent to which the OECD Model creates an equal balance between the two systems.

Most treatises, essays or articles on income taxation of foreign profits that compare credit and exemption

systems point in several directions: economic neutrality (capital import neutrality (CIN) versus capital export

neutrality (CEN)), compatibility with constitutional principles, WTO compliance, EU law compatibility and, finally,

income tax treaties. Often, the assumption is that there is one credit method only and one single exemption

method, and that tax systems belonging to one family (either credit or exemption) have precisely the same

features. This traditional distinction is, however, not accurate. Several countries do not apply one relief method

only with regard to all foreign-source income. Thus, one should first define credit and exemption and direct the

debate from there.

Taxation of foreign-controlled companies does not in principle fall under the scope of the distinction between

credit or exemption methods but its interaction with the subject matter is self-evident. An “ordinary credit country”

that grants a tax deferral with regard to income derived by foreign companies belonging to its own residents and

exempts that income from tax when paid out to those residents arguably deviates from the credit approach. An

exemption country that does not grant a tax deferral with regard to income derived by foreign companies which

are controlled by its own residents and does not exempt that income from tax when attributed to those residents

arguably deviates from the exemption approach.

1.1. Classification of credit systems

Firstly, one should mention those credit countries that unilaterally provide for the direct credit only and do not

apply CFC rules, so that foreign business income is subject to income taxes only when attributable to a foreign

permanent establishment of a resident taxpayer. One such country is Greece.

Secondly, credit countries exist that unilaterally provide for the direct credit only but do apply CFC rules, so that

foreign subsidiaries´ income (either the entire income or passive income only) is also taxable under certain

circumstances in the hands of the resident shareholder (e.g. Germany, Hungary, Iceland, Italy, Mexico and

Portugal).

Thirdly, some credit countries unilaterally provide for both the direct credit as well as the indirect credit for taxes

paid by first- (or more) tier subsidiaries (I would not draw a distinction here between countries having or not

having CFC rules, since to the best of my knowledge all countries providing for the indirect tax credit also apply

CFC rules). Examples of such countries are Canada (with regard to subsidiaries that are established in a non-

treaty country), the United States and the United Kingdom.

The three categories of credit countries can be depicted as follows:

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Countries falling in principle under any of the above categories may provide exceptions the magnitude of which

may conceptually call for or suggest the segregation of such systems in another separate category. Such

exceptions may derive either from domestic law rules and/or from the double taxation conventions of such

countries. Domestic law exceptions to the credit method may regard certain items of income other than business

income (e.g. foreign employment income, foreign dividends, etc.), [1] other taxes (e.g. exemption, rather than

credit, is granted with respect to foreign business income when taxes other than income taxes are concerned,

such as, for example, regional and local taxes; this is the case, e.g. for IRAP in Italy), as well as some rollover

reliefs. Exceptions to the credit method may also derive from the double taxation conventions of a credit country.

Some countries, for instance, frequently adopt the exemption method in their treaties, although they provide for

the credit method under domestic law. [2] Examples of such countries are Germany and Hungary.

With particular regard to Germany, the use of the exemption method in tax treaties seems to have historical

reasons. The exemption basically was the only method initially used in the first double taxation conventions

between the various German states, and the idea behind seems to have been to just divide the source of

taxation between states. From time to time in Germany there are debates about the “proper” method. Recently,

the new government has stated (in its coalition agreement) to carry on using the exemption method.

Interestingly, however, in late 2006 a rule (Sec. 50d, Para. 9, of the Income Tax Act) was enacted overriding

treaty-based exemption of foreign-source income where foreign-source income is not taxed by the source

country or taxed under a treaty-reduced withholding tax due to the application of a tax treaty by the foreign

source country.

For ease of reference, this paper refers to credit systems as one unified category of system under which relief

from double taxation is generally granted by means of credit, but these “nuances” will be pointed out through the

discussion, as the case may be, if so relevant.

1.2. Classification of exemption countries

The above comments regarding credit countries and their classification also hold true for exemption countries.

Only a few countries apply full exemption on all foreign-source income with no conditions. One example is

Uruguay, due to the adoption of a territorial principle in its income tax system. [3] In this respect, the Commentary

on Art. 4 of the OECD Model, at point 8.3, recognizes that residents of such countries are not intended to be

excluded from the scope of tax treaties only because they are not subject to worldwide income taxation; thus,

they are entitled to treaty benefits (including the relief from double taxation as set forth in the relevant treaty). [4]

Some exemption countries set forth exceptions to the exemption method and unilaterally switch to other relief

methods in particular circumstances (e.g. Austria and the Netherlands unilaterally switch to a credit method in

some cases) or with regard to particular items of income (e.g. France unilaterally grants a deduction from the

taxable base with regard to items of foreign income other than business income). If conditions to benefit from the



exemption are particularly stringent, the exemption system may in fact be turned into a credit system, at least for

a robust portion of foreign-source income.

Some exemption countries also have CFC rules, although they generally provide safe harbours for foreign

business income derived through subsidiaries (e.g. France) in order not to discriminate against indirect

investments vis-à-vis direct investments.

The three categories of exemption countries can be depicted as follows:

For the purposes of this paper, countries which unilaterally grant a credit with respect to foreign business income

(e.g. Italy, the United States, the United Kingdom) will be regarded as credit countries. Countries which

unilaterally exempt foreign business income (e.g. France and the Netherlands) will be regarded as exemption

countries, irrespective of the fact that they grant a credit (or a deduction) with respect to other items of income.

Taxation of controlled foreign companies will be taken into account for purposes of this paper, although it does

not affect the distinction between credit and exemption.

2. International tax policy aspects of credit and exemption

2.1. Credit and exemption in the light of the different approaches to neutrality of tax systems

Traditionally, methods of relief from international double taxation have been considered in the light of those

different approaches to neutrality of tax systems with regard to foreign direct investment income which have

been drawn by economists. As far as credit and exemption methods are concerned, CEN and CIN are

customarily taken into account. [5]

When CEN is chosen, a tax system should be designed to be neutral regarding resident investor preference for

investment at home or abroad: foreign income should be taxed at the home country tax rate so as not to distort a

corporation´s choice between investing at home or abroad. In other words, the return on capital should be taxed

at the same total rate regardless of the location in which it is earned. When CIN is chosen, a tax system should

be designed to be neutral regarding resident investor preference to invest in a given country compared to

residents of that country and different countries: Foreign income should be taxed only at the local rate so that

resident investors can compete with their foreign rivals. In other words, the return on capital should be taxed at

the source country´s tax rate regardless of the residence of investors.

It is generally maintained by scholars that fulfilling both the above neutrality standards with a single method of

relief from international double taxation is impossible, unless all countries adopt identical effective tax rates. [6]

Thus, they maintain that a tax system pursuing CEN should relieve international double taxation by means of the

(full) credit method; whereas a tax system pursuing CIN should relieve international double taxation by means of

the exemption method (or territorial taxation), but CIN would actually be satisfied only if source countries do not

practice tax discrimination between domestic and foreign investors operating in their jurisdictions.

Economists have been developing further approaches to neutrality during the last decade. These approaches

are known as “capital ownership neutrality” (CON) and “national ownership neutrality” (NON). [7] The debate on

the exact content of such concepts is ongoing. In general terms, CON can be achieved when tax systems make

it unachievable to increase output by trading capital ownership among resident investors of different countries.

Hence, CON can be achieved through the adoption by all countries of either the (full) credit method or the

exemption method (territorial taxation). Conversely, NON can be achieved when a tax system encourages

nationals to make foreign investments the after-foreign-tax return of which is higher than the after-tax return on

alternative domestic investments, if one assumes that inbound investments made by foreign investors will be a

substitute for any domestic investment not made by national investors and therefore compensate for the loss in

terms of national tax revenue. [8] Thus, NON could be achieved by means of the exemption method (territorial

taxation).



In summary:

- CEN can be achieved through the (full) credit method or through the adoption by all countries of the exemption method (territorial taxation) and identical effective tax rates;

- CIN can be achieved through the exemption method (territorial taxation), to the extent source countries do not

practice tax discrimination between domestic and foreign investors operating in their jurisdictions;

- CON can be achieved through the adoption by all countries of either the (full) credit method or the exemption method (territorial taxation); and

- NON could be achieved through the exemption method (territorial taxation).

It is worth noting, however, that countries will consider many other factors beyond neutrality in designing their tax

systems, including competitiveness and prevention of double non-taxation with particular regard to certain items

of income. This emerges clearly from recent studies performed worldwide on the taxation of foreign direct

investment income, as well as from the tax treaty policy of some countries. [9] With regard to these recent

studies, it is interesting to note that only Canada and the United States have taken into account CON together

with CEN and CIN in performing the analysis. NON was never taken into account.

2.2. Credit and exemption in recent studies and legislative proposals worldwide

Credit and exemption have recently been analysed in the context of several studies relating to the development

of the tax system. The Office of Tax Policy of the US Department of the Treasury issued a study in 2007, [10]

where the appropriateness of the credit method was scrutinized. According to the US Department of the

Treasury:

the foreign tax credit rules are complicated and include several significant limitations. (…) This foreign

tax credit limitation, however, does allow active income subject to high foreign taxes (usually active

earnings of foreign subsidiaries distributed to U.S. parent corporations as dividends) to be mixed with

active income subject to low foreign taxes (usually royalties or interest)” (…) known as “cross crediting”.

[Because of this] current U.S. law may be more favorable to many U.S. corporate taxpayers than a

predominantly territorial system.

The proposal by the US Department of the Treasury is thus to move to a “basic” dividend exemption system,

which is described as a system under which:

dividends paid by foreign subsidiaries of U.S. corporations would not be subject to U.S. tax, nor would

foreign active business income earned directly by foreign branches of U.S. corporations. Gains from the

sale of assets that generate exempt income, and gains from sales of foreign corporation shares

generating exempt dividends, would also not be subject to tax while losses from the sale of such assets

or stock would likewise be disallowed.

According to the US Department of the Treasury, such a system:

would remove the tax disincentive to the repatriation of foreign earnings [and] reduce some of the

complexity related to the current system with respect to foreign tax credits, primarily because dividends

would no longer give rise to foreign tax credits. Furthermore, it would likely increase corporate income

tax revenues, since the above-mentioned phenomenon known as “cross crediting” will not occur

anymore.

The HM Treasury of the United Kingdom also issued a study on foreign-source income in 2007, [11] which only

focuses on the method of relief from international economic double taxation, i.e. on the taxation of dividends. The

UK study starts with the following consideration:

The current system of taxing foreign dividends and relieving double taxation through crediting foreign

tax produces only a modest amount of direct tax yield [and] as a system of relieving double taxation,

the credit system is inevitably less straightforward for large and medium business than dividend

exemption.

Given the above, the HM Treasury seeks views on a move to a regime in which foreign dividends paid to large

and medium UK-based businesses would be exempt from UK tax, coupled with amendments to the CFC

legislation. The proposal is (i) to replace the CFC legislation with a CC regime (controlled companies) targeted

both at UK and foreign-controlled companies, under which the UK parent would be taxed on passive income of

controlled companies when it arises and (ii) to exempt from tax dividends received by UK large- and medium-

sized parents from the profits of foreign companies in those cases where the new CC rules apply to those foreign

companies and the UK parents hold a participation holding (defined as a shareholding of 10% or more).

In short, the outcome is that active income derived through foreign companies controlled by UK parents is

definitively exempt from tax in the United Kingdom, whereas passive income derived through controlled foreign

companies is subject to tax in the United Kingdom in the hands of the UK parent, as if it were directly derived by

such UK parent. The tax treatment of foreign permanent establishments, however, was voluntarily ignored:



Although there are clear links between the taxation of foreign dividends and of the overseas branches

of UK companies, considering foreign permanent establishments now would raise a large number of

additional issues, which would divert focus from the present discussion: so depending on the outcome,

the Government considers it would be more appropriate to return to this question at a later date.

The Advisory Panel on Canada´s System of International Taxation also published a study in 2008, [12] where the

following recommendations – among others – were proposed: (i) exempt from tax all foreign active business

income earned by foreign affiliates (i.e. companies subject to CFC legislation), whereas passive income of

foreign affiliates would continue to be taxed in Canada; in this connection, exempt from tax all dividends from

foreign affiliates; and (ii) exempt from tax capital gains and losses realized on the disposition of shares of a

foreign affiliate where the shares derive all or substantially all of their value from active business assets.

Such modifications were proposed by the Advisory Panel for the following reasons: simplicity; revenue-neutrality;

and facilitating the repatriation of foreign profits, as well as consistency with the tax policies (or policy direction)

of most other industrialized nations. [13] As in the case of the UK study, the tax treatment of foreign permanent

establishments was also voluntarily ignored by the Canadian Advisory Panel:

Conceptually, there is no reason to tax foreign-source active business income earned through a foreign

branch of a Canadian company differently than such income earned through a foreign affiliate.

However, exempting a foreign branch´s active business income from Canadian tax would require

complicated rules. (…) The Panel believes that treating the foreign active business income of foreign

branches and foreign affiliates more consistently is a desirable goal, but the practical difficulties

involved currently outweigh the benefit of uniform treatment. For these reasons, the Panel suggests no

fundamental changes to the taxation of foreign branch income at this time.

The trend thus seems unambiguous: move to exemption on dividends from foreign companies and on gains from

the disposal of shares in those companies, as well as restrict the scope of CFC rules to passive income derived

by those companies (i.e. exempt from tax active income derived by those companies). The main focus is

therefore on economic double taxation rather than on methods of relief from juridical double taxation (although

juridical double taxation is taken into account in the US study with regard to foreign active business income

earned directly by foreign branches of US corporations). This trend can be depicted as follows:

Consistency would require that exemption be granted also with respect to active business income earned

through foreign branches. Nonetheless, in most cases (United Kingdom and Canada) it was affirmed that

exempting foreign active business income earned through branches involves many practical difficulties, and thus

it was proposed not to implement such a measure. In the case of the US study, however, the proposal to move to

exemption also covered active business income earned through foreign branches.

3. Constitutional aspects of credit and exemption

Although, according to most scholars, neither an obligation to design tax systems so that double taxation does

not arise [14] nor an obligation to eliminate double taxation when it arises exists within the international legal

order, [15] states generally commit themselves to do so (at least partially) and, to this purpose, adopt one of the

methods illustrated in sections 1., 2. and 3. [16] One could question, however, if, and to what extent, constitutional

principles play a role in so far as the elimination of international double taxation and the methods generally

adopted to achieve that aim (particularly credit and exemption) are concerned.

3.1. Constitutional principles that may be significant with regard to credit and exemption

The constitutional principles that may be of significance are mainly the equality principle and the ability-to-pay

principle. [17] Further constitutional principles, when set forth in the constitution of the relevant country, may also

play a role, such as – when we look at the Italian situation – the promotion of private economic activity and free

competition, [18] or the promotion of market development. [19]



With regard to the equality and ability-to-pay principles, some believe that horizontal and vertical equity are

essentially applications of those principles. Many slightly different definitions of horizontal and vertical equity can

be found but the aim of this paper is not to define those concepts. In general terms, horizontal equity is the

principle that equals should be treated equally and vertical equity is the principle that unequals should be treated

unequally.

Hence, the principle of horizontal equity demands that similar persons face similar tax burdens. The principle of

vertical equity instead demands that the greater the taxpayer´s means as measured by income, the greater the

share of the overall income tax burden the taxpayer should bear; it basically provides grounds to the principle of

progressivity of taxation.

3.2. Whether constitutional principles require a state to give relief from international double taxation and/or imply a preference for credit or for exemption

Arguments might be found to maintain that the equality and ability-to-pay principles require a state to give relief

from international double taxation, even though arguments may be found to instead maintain that a state is not

required to do so in obedience to those principles because of further constitutional principles to be considered

together with equality and ability to pay. [20] A conclusion on this topic largely depends on the constitution of the

relevant state.

When a state provides relief from international double taxation, constitutional issues may also arise with regard

to the compliance of the specific method adopted by that state with the above-mentioned constitutional

principles. As far as the credit method is concerned, it appears that such a method is in general compliant with

those principles, since it guarantees that taxpayers deriving foreign-source income are subject to taxation in their

state of residence in proportion to their actual available income, irrespective of the fact that it is “sourced” within

the territory or abroad. [21] In effect, supporters of the credit system argue that it tends to give horizontal equity,

since two taxpayers resident in the same country will pay the same tax on their worldwide income. [22]

Compliancy issues, however, can arise when the credit is in fact not granted due to (business) losses incurred in

the state of residence and no remedies are set forth in the relevant rules. In such circumstances, resident

taxpayers suffering domestic (business) losses and deriving foreign income would be treated less favourably

than resident taxpayers suffering domestic (business) losses and deriving domestic income.

With regard to the exemption method, issues of compatibility with the mentioned constitutional principles could

instead arise. The exemption method could lead to an infringement of the equality and ability-to-pay principles, at

least where the state of source does not levy any tax on a certain item of income produced in its territory. The

resident taxpayer would not be subject to tax on that foreign-source item of income (which certainly constitutes

expression of his ability to pay taxes) either in the state of source or in the state of residence, and this could be

regarded as a more favourable treatment of resident taxpayers deriving income abroad as compared with

resident taxpayers deriving income only in the state of residence. In any event, it appears that the principle of

vertical equity requires at least that exemption with progression is adopted.

On the other hand, the exemption method could lead to an infringement of the equality and ability-to-pay

principles where foreign (business) losses are suffered by a resident person. If the exemption method were also

applied to losses, the taxpayer would not be allowed to deduct the losses realized abroad from its domestic

income and would therefore be subject to tax in the state of residence on unrealized income, being taxed less

favourably than resident taxpayers suffering domestic (business) losses. Note, however, that the German

Federal Financial Court (Bundesfinanzhof) recently held that the denial of foreign losses deduction does not

infringe the principle of equality encompassed in Art. 3(1) of the German Constitution. Unfortunately, the grounds

of this conclusion do not clearly emerge from the text of the decision. [23] In any case, some countries have

remedied a possible exposure of illegality by permitting foreign losses to be offset against domestic source

income, subject to a recapture mechanism when foreign profits are earned in future years. [24]

With respect to (business) losses incurred in the state of residence, the exemption method may also lead to an

infringement of constitutional principles when its application prevents domestic losses to be carried forward and

offset against domestic income in subsequent years. In this respect, the Court of First Instance of Brussels

(Tribunal de Première Instance de Bruxelles) on 26 October 2007 held such a rule to be contrary to the

constitutional principle of equality (non-discrimination) set forth in Art. 10 of the Belgian Constitution. [25]

4. History of tax treaties with regard to credit and exemption

When tax treaties were first concluded by Continental European countries at the end of the 18th century, it was

usual for contracting states to allocate taxing rights to one state only and exempt income sourced in the other

state. Until World War II, the exemption method might actually be regarded as the mainly applied method in tax

treaties signed between European countries. [26] Nonetheless, in the draft conventions prepared by the League

of Nations in the late 1920s, both the credit and the exemption method were already proposed.



A specific study of methods of relief from double taxation was first carried out by the OEEC Working Party No. 15

(hereinafter the “WP”), composed of delegates for Denmark and Ireland. In the WP´s Preliminary Report of 2

March 1959, it was concluded that “for the avoidance of double taxation it should be sufficient if the lower of the

two taxes were given up” and it was claimed that, from a theoretical standpoint, the ordinary credit “seems to be

in accordance with the conclusion”: the taxpayer actually obtains relief for an amount which is the lower of the

two income taxes paid in the state of residence and in the state of source. [27] As far as the exemption (with

progression) method was concerned, it was instead claimed that “This principle does not fit in with the conclusion

referred to, because it disregards the tax paid in the State of source.”

A dissenting opinion was given by the Netherlands delegation in a note dated 14 March 1959. Admittedly, the

underlying approach was to “characterise the three main methods for avoiding double taxation considering them

from the point of view of their more or less favourable results for the resident taxpayer with foreign income”.

Accordingly, full exemption was considered to be more favourable, exemption with progression was considered

to be intermediary and ordinary credit to be the less favourable method; interestingly, the Netherlands delegation

also pointed out that

It may be asked whether the method of ordinary credit does not discriminate against foreign income for

if such income is taxed abroad at a lower rate than in the State of residence this advantage is not

granted; if, on the contrary, the foreign tax rate is higher, the heavier burden is left intact.

The Netherlands delegation concluded that:

For use in relation between O.E.E.C. States the Netherlands Delegation prefers the intermediary

method [i.e. exemption with progression] which, in its opinion, fits in best with the allocation of the

various categories of income to one of the States or to the other.

Afterwards (12th Session held on 17-20 March 1959), the various delegations expressed their preferences which

are as follows:

- the delegates for Italy, Greece, Portugal, Turkey and the United Kingdom were in favour of the credit method;

- the delegates for Austria, Belgium, Denmark, France, Germany, Norway, Spain and Switzerland were in favour of the exemption with progression method, although some of them (Belgium and Switzerland) held that

the credit method could give better results in the case of dividends and interest where the right to tax was apportioned between the country of residence and the country of source; and

- the delegates for Sweden were in favour of neither of the two.

Furthermore, the delegates for Germany, Luxembourg and the United Kingdom regarded it as desirable to agree

upon only one method (although they recognized the difficulty to do so), whereas the delegates for Austria,

Sweden and Switzerland maintained that states should have been left free.

Following this discussion, in its “Memorandum relating to preliminary report on methods for avoidance of double

taxation of income” of 15 May 1959, the WP released three draft articles. The draft articles were targeted to

different cases, namely (A) the two states both apply the credit method under domestic law, (B) the two states

both apply the exemption method under domestic law, and (C) one state applies the credit and the other state

the exemption method under domestic law.

The two states both apply the credit method under domestic law (Draft A):

1. The laws of each Contracting State shall continue to govern the taxation of income arising in that

State and of income derived by residents of that State from the other Contracting State, except where

express provision to the contrary is made in this Convention.

2. Where a resident of one of the Contracting States derives income from sources in the other

Contracting State and that income is subject to tax imposés in that other Contracting State, the

Contracting State in which the person is resident shall allow as a deduction from its own tax an amount

equal to the tax paid in the other Contracting State: provided that such deduction shall not exceed that

part of the total tax (as computed before the deduction is given) which bears the same proportion to the

said total tax as the income which is taxable […] in the other Contracting State bears to the total

income.

3. For the purposes of this Article the Contracting State in which the taxpayer is resident shall deem the

taxpayer to have paid the amount by which the taxes of the other Contracting State have been reduced

under the provisions of ………..(1)

Note: (1) Here insert reference(s) to the tax law(s) of the other Contracting State under which the tax

incentive(s) is/are granted [cf. the Report of 2nd March, 1959, FC/WP15(59) 1 Part I, under no. 10, B,

II, b (ii)]. [28]

The two states both apply the exemption method under domestic law (Draft B):



1. Income shall be subject to tax imposé only in that Contracting State of which the taxpayer is a

resident, except where a provision to the contrary effect is contained in any Article in this Convention.


Contracting State and that income, in accordance with this Convention, may be taxed imposable in that

other Contracting State, the Convention State in which the person is resident shall, subject to

paragraph (3) of this Article, exempt such income from tax but may, in calculating its tax, apply the rate

of tax which would have been applicable if such income had not been so exempted.


Contracting State which is taxable imposable in that other contracting State in accordance with Articles

…….(1), the Contracting State in which the person is resident shall not be obliged to exempt such

income from tax but shall allow as a deduction from its own tax thereon an amount equal to the tax

paid, in accordance with the said Articles, in the other Contracting State.

Note: (1) Here insert references to the Articles in accordance with which the other Contracting State

imposés tax, but limited to a certain low percentage of the income [cf. the Report of 2nd March, 1959,

FC/WP15(59)1 Part I , under No. 10, B, I.]. [29]

One state applies the credit method and the other state the exemption method under domestic law:

I. The State which applies the credit method

1. The laws of each Contracting State shall continue to govern the taxation of income arising in that

State and of income derived by residents of that state from the other Contracting State, except where

express provision to the contrary is made in this Convention.

2. Where a resident of state x derives income from sources in state y and that income is subject to tax

imposés in State y, State x shall allow as a deduction from its own tax an amount equal to the tax paid

in State y: provided that such deduction shall not exceed that part of the total tax (as computed before

the deduction is given) which bears the same proportion to the said total tax as the income which is

taxable imposable in state y bears to the total income.

3. For the purpose of this Article State x shall deem the taxpayer to have paid the amount by which the

taxes of State y have been reduced under the provisions of……(1)

II. The State which applies the exemption method

1. If a taxpayer is a resident of State x income shall be subject to tax imposés only in that State, except

where a provision to the contrary effect is contained in any Article in this Convention.

2. Where a resident of State x derives income from sources in state y and that income, in accordance

with this Convention, may be taxed imposable in state y, State x shall, subject to II paragraph (3) of this

Article, exempt such income from tax but may in calculating its tax, apply the rate of tax which would

have been applicable if such income had not been so exempted.

3. Where a resident of state x derives income from sources in state y which is taxable imposable in

state y in accordance with Articles……..(2), State x shall not be obliged to exempt such income from

tax but shall allow as a deduction from its own tax an amount equal to the tax paid, in accordance with

the said Articles, in state y.

Note: (1) Here insert reference(s) to the tax law(s) of state y under which the tax incentive(s) is/are

granted [cf. the Report of 2nd March, 1959, FC/WP15 (59)1 Part I, under No. 10, B, II, b (ii)].

(2) Here insert references to the Articles in accordance with which State y imposés tax, but limited to a

certain low percentage of the income [cf. the Report of 2nd March, 1959, FC/WP15 (59)1 Part I, under

No. 10, B, I]. [30]

Interesting aspects of these three draft articles are the following:

- the choice for the ordinary credit and the inclusion of a tax sparing provision in the draft article on credit [Draft

A and Draft C(I)]; no tax sparing provision can be found, however, in the current OECD Model Convention;

- the choice for exemption with progression and the inclusion of a switch-over clause to credit for certain items of income, which, however, were not listed, in the draft article on exemption [Draft B and Draft C(II)]; the current OECD Model Convention is basically in line with this draft, although the items of income covered by a switch-over clause to credit are expressly mentioned (dividends and interest); interestingly, however, the

rationale for the application of a switch-over clause to credit with regard to such items of income in the OECD Model Convention (as explained in the Commentary on Arts. 23A and 23B, at Paras. 47 et seq.) seems to be

similar to that found in the above draft article on the exemption method (see the footnotes to the draft article, according to which a switch-over to credit should have been applied to items of income which may be taxed in the State of source “… but limited to a certain low percentage of the income.”);

- the doubt concerning the use of the term “may be taxed” when the exemption method is involved; according to the relevant explanatory remarks (see note 28), the use of the term “may be taxed” implies that the state of residence must give exemption irrespective of the fact whether the state of source makes use of the right to

tax which it has under the convention, or not; if this were not considered to be desirable, the term “may be



taxed” would have replaced by the term “is subject to tax”; by the way, this corroborates the soundness of the

statement found at Para. 34 of the Commentary on Arts. 23A and 23B of the OECD Model, according to which “The State of residence must accordingly exempt income and capital which may be taxed by the other State in

accordance with the Convention whether or not the right to tax is in effect exercised by that other State”; and

- the suggestion, coming from Draft C, that in case one state applies the credit and the other state the exemption method under domestic law, each state should keep applying its own method when concluding a double tax treaty; this seems to be in line with the approach currently found in the OECD Model Convention (but see below the following section 6. for further considerations on the approach found in the OECD Model).

At the end of the work by the WP, two draft articles were proposed. [31] Consistently, in the Fourth Report of the

Fiscal Committee submitted on 19 June 1961, two draft articles were indeed put forward: Art. XXIII (exemption

with progression plus switch-over clause regarding dividends and interest) and Art. XXIV (ordinary credit). The

following interesting observations can be found in the remarks on the articles:

- it was confirmed that in case one state applies the credit method and the other state the exemption method under domestic law, each state should continue applying its own method when concluding a double tax treaty

(“if the two Contracting States adopt different methods, the name of the State must be inserted each in the appropriate Article, according to the method adopted by that State”, see point 30); this, as already mentioned,

seems to be in line with the approach currently found in the OECD Model Convention; however, it was affirmed that “exceptionally some negotiating States may find it reasonable in certain circumstances to deviate

from the provision concerning the absolute obligation of the State of residence to give exemption. Such may be the case where one of the States adopts the credit method and the other State the exemption method” (see point 33);

- since the term “may be taxed” (rather than “is subject to tax”) was chosen with regard to the exemption method, it was explained that such a choice was made so that “the State of residence must accordingly give exemption whether or not the income or capital in question is actually taxed in the State of source. (…) It is

regarded as the most practical method since it relieves the State of residence from undertaking onerous and time-consuming investigations of the actual taxation position in the State of source”. The statement found at

Para. 34 of the Commentary on Arts. 23A and 23B of the OECD Model is consistent with this remark. However, it was also maintained that “exceptionally some negotiating States may find it reasonable in certain circumstances to deviate from the provision concerning the absolute obligation of the State of residence to give exemption. (…) It may also be the case that the internal legislation of the State of source does not enable

the fiscal authorities of that State to make use of a right to tax conferred on it by the Convention – e.g. where it does not impose capital tax” (see points 32 and 33);

- the grounds for the switch-over clause from exemption to credit with regard to dividends and interest were

found in the circumstance that “the right to tax dividends and interest is divided between the State of residence and the State of source. (…) double taxation in these cases cannot be expected to be avoided by the

application of the exemption method since this method secures that the State of residence gives up its right to tax the income concerned, but the State of residence is left free to apply the exemption method if it wants to do so” (see point 39); The rationale for the switch-over clause to credit found in Art. 23A of the current OECD

Model Convention, as explained in the Commentary on Arts. 23A and 23B, at Paras. 47 et seq., is consistent with this remark;

- a special remark on the relationship between the exemption method and foreign losses. [32] According to that

remark “Where the State of residence allows as a deduction from the income it assesses the amount of a loss incurred in the other State, there should be no objection if, when profits are made subsequently in the other

State, the amount of the exemption for the later years is restricted appropriately. States are left free in this respect and, if it is found necessary for clarification, can refer to such a restriction in the Article.” (see point

38); current Para. 48 of the Commentary on Arts. 23A and 23B of the OECD Model is consistent with this remark.

5. Further studies carried out at the OECD level with regard to credit and exemption

No special attention was paid to the methods of relief from double taxation by international organizations [33] until

the OECD Reports on Harmful Tax Competition [34] and Tax Sparing Credit [35] were submitted in 1998.

In the Report on Harmful Tax Competition, the OECD advocated that tax exemption regimes (such as

participation exemption and other systems exempting foreign-source income) should be restricted so that foreign

income benefiting from tax practices deemed as constituting harmful tax competition do not qualify for the

exemption; otherwise, the exemption method may imply double non-taxation. In this respect, it was considered

that the credit method may work as an “anti-abuse” method against harmful tax competition practices. [36]

On the basis of the restrictions that already existed in the legislation of some countries, the OECD suggested the

following possible “minimum” restrictions to the exemption: [37] (a) the income deriving from a country or territory

that is included in a list of tax havens or from listed harmful preferential tax regimes should not benefit from the

exemption; (b) the foreign-source income that clearly could be attributed to specific practices that are eligible as

harmful preferential tax regimes should not benefit from the exemption; and (c) the income which is not subject to

a minimum rate of foreign tax or to a minimum amount of foreign taxes actually paid abroad should not benefit

from the exemption. In this regard, one can claim that these suggestions have in fact strengthened the remark

contained in the above-mentioned 1961 Report of the OEEC Fiscal Committee, i.e. that states may deviate from



the principle, incidental to the term “may be taxed”, that the exemption must be granted whether or not the

income or capital in question is actually taxed in the state of source. The OEEC in effect admitted that the state

of residence deviated from the exemption method only “exceptionally … [one such cases being when] the

internal legislation of the State of source does not enable the fiscal authorities of that State to make use of a right

to tax conferred on it by the Convention – e.g. where it does not impose capital tax”.

In the Report on Tax Sparing Credit, the OECD highlighted that tax sparing provisions offer ample opportunities

for tax planning and tax avoidance, which undermine the tax base of both residence and source country and are

in principle incompatible with the policy behind the credit method, since they make it more favourable, with

respect to taxation, to invest abroad than domestically. In this respect, it was considered that tax sparing

provisions have potentially harmful effects.

The Report on Tax Sparing Credit was also the occasion for the OECD to point out that “the assumption that all

OECD Member countries are major exporters of capital and all non-Member countries are major importers of

capital is increasingly being questioned”. This could be regarded as a statement that there is no preference, at

the OECD level, for the credit method (as the method theoretically preferred by exporters of capital) or for the

exemption method.

6. The OECD Model Convention and its Commentaries

6.1. The OECD Model Convention

In the light of the historical development described above – and notwithstanding the fact that both credit and

exemption have always been included in model conventions – the question may arise whether the OECD Model

Convention (OECD Model) can be regarded as supporting credit or exemption. According to some scholars, from

a historical analysis of the provisions of the OECD Model it appears that the credit method is the more

supported, since it would constitute the balance to the reduction of tax in the state of source. [38] It is worth

noting, however, that several aspects of the historical debate might lead to a more neutral position. [39]

As far as the OECD Model is concerned, it is worth noting that the model article on the exemption method (Art.

23A) includes two switch-over clauses that provide for a switch from exemption to credit in certain

circumstances. Para. 2 of Art. 23A (existing since 1963 in the OECD Model) deals with cases where the taxing

rights are divided between the state of residence and the state of source, such as the cases of dividends and

interest. [40] Para. 4 of Art. 23A (introduced in the OECD Model in 2000) deals with disagreements between the

state of residence and the state of source on the facts of a case or on the interpretation of the provisions of the

convention, that give rise to double non-taxation: the state of residence is not obliged to exempt an item of

income where the other contracting state applies the provisions of the convention to exempt such income or

applies to such income the reduced tax rate provided for in Arts. 10 and 11.

According to the interpretation proposed since 2000 by the Commentary on Arts. 23A and 23B of the OECD

Model, Para. 1 of Art. 23A can also work per se as a switch-over clause in cases of “negative conflicts of

qualification”, i.e. cases where, due to differences in the domestic law between the state of source and the state

of residence, the former applies, with respect to a particular item of income or capital, provisions of the

Convention that are different from those that the state of residence would have applied to the same item of

income or capital, and this would give rise – if the exemption were granted – to double non-taxation. According to

Para. 32.6 of the Commentary, in such cases the state of residence is not required by Para. 1 to exempt the item

of income.

With regard to the credit method, no switch-over clauses that provide for a switch from credit to exemption exist

in Art. 23B of the OECD Model.

6.2. The OECD Commentaries on the Model Convention: When it is appropriate to limit the scope of the exemption?

The current Commentary on Arts. 23A and 23B of the OECD Model acknowledges that both the ordinary credit

method and the exemption method are generally used to relieve juridical double taxation in the conventions

concluded between OECD Member countries, since some countries have a preference for the former and some

for the latter. [41] In the light of this state of affairs, the OECD has decided to leave each Member country free to

make its own choice and has accordingly drafted two model articles. [42]

Nevertheless, both the Model and the Commentaries apparently recognize the need to limit the undesirable

effects stemming from the rigorous application of the exemption method in certain circumstances. The

Commentary on Arts. 23A and 23B in fact acknowledges, at Para. 31, that an exemption country may be

interested in using a combination of the two methods and:

wish to exclude specific items of income from exemption and to apply to such items the credit method.

In such case, paragraph 2 of Article 23 A could be amended to include these items of income.



The most relevant of such circumstances is where a risk of double non-taxation, or very limited taxation, exists.

In those cases, the combination of credit and exemption is suggested in order to counteract the undesirable

result. According to Para. 31 of the Commentary on Arts. 23A and 23B of the OECD Model, the switch from

exemption to credit is, for instance, “necessary”, where dividends, interest (and royalties) are subject to a limited

tax in the state of source.

The same paragraph recognizes that states generally adopting the exemption method may be willing to apply the

credit method to other specific items of income. Subsequently, Para. 31.1 highlights that this could be the case

with reference to items of income that benefit from preferential tax treatments in the state of source by reason of

tax measures that have been introduced in that state after the date of signature of the treaty.

Seemingly, in Para. 35 of the Commentary on Arts. 23A and 23B of the OECD Model it is recognized that,

occasionally, states may find it reasonable to make an exception to the exemption method in order to avoid

double non-taxation. Such may be the case “where no tax on specific items of income or capital is provided

under the domestic laws of the State of source, or tax is not effectively collected owing to special circumstances

such as the set-off of losses, a mistake, or the statutory time limit having expired”. [43] In this respect, it is

interesting to note that the following examples are found in the Commentaries:

- Para. 28.12 of the Commentary on Art. 13 of the OECD Model, according to which, since the domestic laws of some states do not allow them to tax the gains covered by Para. 4 of Art. 13, states that adopt the exemption

method should be careful to ensure that the inclusion of the paragraph does not result in a double exemption of these gains. The OECD suggests that in those cases, these states may wish to exclude these gains from

exemption and apply the credit method thereto.

- Para. 12 of the Commentary on Art. 17 of the OECD Model, according to which, in the cases dealt with in Paras. 1 and 2 of such an article, where the state of residence applies the exemption method it would be

precluded from taxing the income derived from the performance even if the state of source could not tax it under its domestic law. In this situation, the OECD maintains that the credit method should be applied.

- Paras. 16 and 17 of the Commentary on Art. 13 of the OECD Model, which regard currency gains or losses

that, commonly, do not accrue in the state of source but only in the state of residence. According to the Commentary, in this case the question arises as to whether the state of residence must exempt such currency gains or losses. In this respect, however, no clear-cut solution is provided.

A singular case also mentioned in the Commentary, [44] in respect of which the application of the exemption can

lead to unacceptable results for the state of residence, is that where the beneficiary and the payer of passive

income (e.g. dividends or interest) are both residents of the same contracting state and the income is attributed

to a permanent establishment which the beneficiary of the income has in the other contracting state. In such a

case, due to the application of Arts. 7 and 23A, the state of residence would be prevented from taxing the income

notwithstanding the fact that it could if the beneficiary were resident of the other contracting state. In this

situation, the OECD maintains that the states should agree upon the application of the credit method.

6.3. The OECD Commentaries on the Model Convention: When it is appropriate to limit the scope of the credit?

Suggestions to directly limit the credit method cannot be found in the Commentaries. However, cases exist

where the Commentaries suggest using the term “shall be taxable only” rather than the term “may be taxed” to

obtain an exemption effect.

For example, in Para. 27 of the Commentary on Art. 18 of the OECD Model the following is affirmed:

Some States, however, consider pensions paid out under a public pension scheme which is part of their

social security system similar to Government pensions. Such States argue on that basis that the State

of source, i.e. the State from which the pension is paid, should have a right to tax all such pensions.

Many conventions concluded by these States contain provisions to that effect, sometimes including

also other payments made under the social security legislation of the State of source. Contracting

States having that view may agree bilaterally on an additional paragraph to the Article giving the State

of source a right to tax payments made under its social security legislation. A paragraph of that kind

could be drafted along the following lines:

Notwithstanding the provisions of paragraph 1, pensions and other payments made under the social

security legislation of a Contracting State may be taxed in that State.

Where the State of which the recipient of such payments is a resident applies the exemption method

the payments will be taxable only in the State of source while States using the credit method may tax

the payments and give credit for the tax levied in the State of source. Some States using the credit

method as the general method in their conventions may, however, consider that the State of source

should have an exclusive right to tax such payments. Such States should then substitute the words

´shall be taxable only´ for the words ´may be taxed´ in the above draft provision.

In Para. 2 of the Commentary on Art. 19, similar behaviour is also suggested:



In the 1977 Model Convention, paragraph 1 was split into two paragraphs, paragraph 1 concerning

salaries, wages, and other similar remuneration other than a pension and paragraph 2 concerning

pensions, respectively. Unlike the original provision, subparagraph a) of paragraphs 1 and 2 are both

based on the principle that the paying State shall have an exclusive right to tax the payments.

Countries using the credit method as the general method for relieving double taxation in their

conventions are thus, as an exception to that method, obliged to exempt from tax such payments to

their residents as are dealt with under paragraphs 1 and 2. If both Contracting States apply the

exemption method for relieving double taxation, they can continue to use the expression ´may be

taxed´ instead of ´shall be taxable only´. In relation to such countries the effect will of course be the

same irrespective of which of these expressions they use. It is understood that the expression “shall be

taxable only” shall not prevent a Contracting State from taking into account the income exempted under

subparagraph a) of paragraphs 1 and 2 in determining the rate of tax to be imposed on income derived

by its residents from other sources. The principle of giving the exclusive taxing right to the paying State

is contained in so many of the existing conventions between OECD member countries that it can be

said to be already internationally accepted. It is also in conformity with the conception of international

courtesy which is at the basis of the Article and with the provisions of the Vienna Conventions on

Diplomatic and Consular Relations. It should, however, be observed that the Article is not intended to

restrict the operation of any rules originating from international law in the case of diplomatic missions

and consular posts (cf. Article 28) but deals with cases not covered by such rules. [45]

6.4. Conclusion

Both in the Model and in the Commentaries it is acknowledged, more or less explicitly, that a rigorous application

of the exemption method can lead to undesirable effects (i.e. double non-taxation) in certain circumstances, in

respect of which it is preferable (or even “necessary”) that Member countries switch from exemption to credit.

The question therefore is whether this fact could be regarded as an implicit preference for the credit method or

not.

In this respect, it appears that the statements found in the Commentaries on the articles of the OECD Model are

not conclusive to show a preference for either of the methods. [46], [47] One may wonder, however, whether the

OECD should point out which is the method to be preferred, at least with regard to specific items of income.

In this respect, the OECD could use the occasion given by the recent work on the attribution of profits to

permanent establishments, as well as by the international trend confirmed by the recent studies mentioned at

2.2. It was shown that the trend is to move to the exemption method with regard to foreign active business

income. Most countries, however, intend to grant the exemption only with regard to foreign active business

income derived through controlled foreign companies, whereas they are reluctant to grant the exemption with

regard to foreign active business income derived by foreign permanent establishments. Such a reluctance is due

to several practical difficulties which – according to many countries – arise in implementing the exemption with

regard to foreign active business income derived by foreign permanent establishments.

The OECD, however, has recently analysed the topic of attribution of profits to permanent establishments in

depth to seek more clarity in this regard. [48] The developments on the topic could reduce or eliminate most

practical difficulties that, so far, may have suggested not moving to the exemption method with regard to foreign

active business income derived by foreign permanent establishments. The OECD could therefore consider

including the following in the catalogue of issues to be discussed and analysed in depth:

- application of the exemption method with regard to active business income derived through a permanent

establishment in the other contracting state;

- application of the credit method with regard to some passive investment income such as Arts. 10, 11, 12 of the OECD Model income (dividends, interest and royalties).

7. Credit and exemption in tax treaty negotiation

7.1. The tax treaty policy of credit or exemption countries in terms of relief method

In the analysis carried out so far the focus was on whether it is possible to draw a general preference for one of

the above methods of relief, either because of economic arguments, legal constitutional arguments and/or

arguments stemming from the historical development of the OECD Model as well as from the current OECD

Model. The analysis has shown that (i) from an economic perspective, the use of the credit or the exemption

method is linked to a preference for a certain approach to neutrality or for another; (ii) from a constitutional

perspective, the credit method is likely to give rise to fewer issues compared to the exemption method; and (iii)

from a historical perspective and from an analysis of the current OECD Model Convention, there is no express

preference for one or the other method of relief, but with regard to the exemption method there are many more

cases than for the credit method where exceptions to the exemption method are suggested (mainly to avoid

double non-taxation).



One may question, however, whether, irrespective of the existence of such a general preference, countries have

a preference for one of the above methods of relief in tax treaty negotiation. According to the 2003 UN Manual

for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries:

Generally speaking, the method by which a country would give relief from double taxation depended

primarily on its general tax policy and the structure of its tax system.

However, a survey of tax treaties of many countries and, in particular, of methods of relief adopted in tax treaties

compared to those adopted under domestic law shows that this statement is not always true. In some cases, the

fact that a general tax policy is followed can be doubtful and one may question whether it is better to distinguish

domestic policy on international taxation (i.e. the method of relief adopted under domestic law) and tax treaty

policy (i.e. the method of relief adopted under treaty law).

For instance, as already mentioned, some countries that adopt the credit method under domestic law (credit

countries) prefer to make use of the exemption method in their treaties. This is the case for Germany and

Hungary, which have a very consistent treaty policy in this regard. Those countries, however, usually exclude

specific items of income from exemption (generally dividends and interest) and apply to such items the credit

method. Such an approach is in line with that found in the OECD Model where Art. 23A (which provides for the

exemption method) excludes dividends and interest from exemption and applies to them the credit method.

Furthermore, Germany also commonly applies the credit method instead of the exemption method to items of

income other than dividends and interest, such as for example royalties, certain capital gains, directors´ fees,

pensions and/or income derived by artists and sportsmen, and when domestic switch-over clauses applies. [49]

Many credit countries exist, however, whose treaty policy is fully (or mainly) consistent with the choice made

under domestic law, since they adopt the credit method in all or the greater part of their tax treaties. Examples of

such countries are Greece, Ireland, Italy, Sweden, the United Kingdom and the United States.

Some countries whose treaty policy is consistent with the domestic law choice try to maintain this consistency

when they move from an approach to the other. An interesting example is given by Estonia. The credit method

was adopted under both domestic and treaty law (except from the first tax treaties with Latvia and Lithuania), but

when Estonian companies started investing abroad, a choice was made for the exemption method (in order to

make resident companies competitive with respect to other foreign companies investing on the same foreign

markets). The introduction of that different method is, however, thought to be gradual, also to maintain

consistency between domestic law and treaty law methods of relief. The first treaty with exemption was initialled

in 2002 and the gradual introduction of the exemption method into domestic law began in 2004. By now Estonian

domestic law uses both credit and exemption: most Estonian tax treaties still adopt the credit method but several

newly negotiated tax treaties are based on the exemption method. [50]

Exemption countries´ treaty policy is generally more consistent with the domestic law choice than credit

countries´ treaty policy. Belgium and the Netherlands are in effect fairly consistent in this respect: they usually

apply the exemption method in their treaties, but exclude specific items of income from exemption (generally

dividends, interest and royalties) and apply to such items the credit method. Furthermore, the Netherlands

commonly applies the credit method instead of the exemption method also to items of income other than the

above, such as for example certain capital gains, directors´ fees, pensions and/or income derived by artists and

sportsmen. However, examples exist among their treaties of treaties under which the credit is adopted (see e.g.

some of the treaties concluded by the Netherlands before 1980, such as the Netherlands–Switzerland treaty).

The choice for the credit method made in some treaties, however, is not always effective: according to the non-

aggravation principle, tax treaties cannot impose a higher tax burden than under domestic law (this principle is

further explored in the next chapter), thus the domestic law exemption method generally remains applicable

when more favourable to the taxpayer (unless domestic law explicitly provides for a credit method to be applied

when treaties set forth such a method). There is only one exemption country – France – that directly applies the

tax treaty credit method, even though no credit provision exists under its domestic law, and this is likely made

possible because of a general domestic law provision (Art. 209-I CGI) according to which all that is taxable by

France under a tax treaty is subject to tax therein.

The tendency of some countries to deviate from their domestic law method of relief in their tax treaties is an

interesting feature, the grounds for which may be different depending on the case. For example, a certain credit

country may prefer a treaty policy based on the exemption method in order to stimulate other countries to

negotiate tax treaties in order to benefit from investments from the former country: it is self-evident that investors

of the former country find it more convenient to invest in countries in respect of which they can benefit from

exemption rather than credit.

A certain exemption country, on the other hand, may find it more appropriate to agree on the credit method in a

tax treaty with another country, at least with regard to certain items of income, for preventing double non-taxation

(this could be the case when that other country provides for very low taxation) or for reciprocity reasons (this

could be the case when that other country intends to choose the credit method in the treaty).



7.2. Do countries deviate from their tax treaty policy in terms of relief method when negotiating with a country that has an opposite treaty policy?

In fact, an interesting question is whether countries, when negotiating, modulate the preference for the credit or

the exemption method depending on the other country´s preference. The issue is, in other words, whether a

credit country might be interested in moving to exemption when negotiating with an exemption country, or

whether an exemption country might be interested in moving to credit when negotiating with a credit country.

The Commentary on Arts. 23A and 23B, at Para. 30, seems to acknowledge that each country will simply

continue applying its own method:

If two Contracting States both adopt the same method, it will be sufficient to insert the relevant Article in

the convention. On the other hand, if the two Contracting States adopt different methods, both Articles

may be amalgamated in one, and the name of the State must be inserted in each appropriate part of

the Article, according to the method adopted by that State. (emphasis added).

This is basically in line with the conclusion drawn by Lang who maintained that “the other Contracting State

usually accepts that its treaty partner has a preference for a certain method it wants to apply for its own

residents, as long as this State accepts that the Contracting State has a certain policy as far as methods are

concerned as well (…)”. [51]

The tendency of states to stand with their own method irrespective of the other contracting state arises, in fact,

quite clearly from the various treaties. There are, however, exceptions to the general treaty policy of certain

countries, which generally arise when a given country negotiates with a country that has an opposite treaty policy

in terms of relief method and usually regards certain items of income only.

7.2.1. Countries that have a credit treaty policy: Empirical evidence

This is the case, e.g. for the double taxation conventions concluded by Italy, Denmark and Sweden (which have

a credit treaty policy) with Germany (which has an exemption treaty policy). In those conventions, Italy, Denmark

and Sweden adopted the credit method as the general relief method from their side, but they agreed upon the

exemption method with regard to certain “qualified” dividends. Such exceptions may likely be explained by

Germany´s negotiating power vis-à-vis the above countries and by the fact that Germany historically uses the

exemption method to eliminate economic double taxation on dividends.

An interesting case is that of the double taxation convention between Portugal and Austria. Portugal (which has a

credit treaty policy) agreed upon the exemption method, except for dividends, interest and royalties. Austria did

the same. Such an exception may likely be due to the bargaining between Portugal and Austria: Portugal likely

agreed to the exemption to the extent that Austria included a tax sparing credit clause to be applied with regard

to certain to dividends, interest and royalties (which it did). On the other hand, the reason why Austria agreed to

a unilateral tax sparing provision in favour of Portugal likely was a historical one and designed to promote

Austrian investments in Portugal. Nowadays, such provisions would probably no longer be accepted by Austria.

Another interesting case is that of certain double taxation conventions concluded by Sweden (which has a credit

treaty policy) with Cyprus and Greece. Interestingly, Sweden adopted to some extent the exemption method

rather than the credit method, but one should note that Cyprus and Greece both have a credit treaty policy. In the

double taxation convention concluded with Cyprus, Sweden adopted the credit method as the general relief

method but agreed to the exemption method with regard to income arising from business activities; note that

Cyprus adopted the credit method. In the double taxation convention concluded with Greece, Sweden adopted

the exemption method as the general relief method and adopted the credit method only with regard to dividends,

interest and royalties; note that Greece adopted the credit method. Such exceptions may likely be explained by

the purpose of stimulating Swedish investments in Cyprus and Greece.

Similarly, Latvia and Lithuania, which have fairly consistent treaty policies in terms of adoption of the credit

method, agreed upon the exemption method in their double taxation convention. Such an exception may likely be

explained by the purpose of stimulating reciprocal investments.

No such exceptions can be found with regard to other significant countries that have a credit treaty policy, such

as the United States and the United Kingdom.

7.2.2. Countries that have an exemption treaty policy: Empirical evidence

Among countries that have an exemption treaty policy, Austria is an interesting example of a country which in

many cases modulates the treaty relief method by taking into account the other contracting state´s choice.

Although the greater part of the double taxation conventions concluded by Austria either with exemption or credit

countries provide for the exemption method, there are cases where Austria has instead adopted the credit

method; and it did this when negotiating with countries that have a credit treaty policy. In fact, Austria agreed to

the credit method in conventions concluded with, e.g. Finland, Ireland, Italy, Japan, Sweden, the United Kingdom

and the United States. This may be for reciprocity reasons. In relation to states which traditionally used the credit



method Austria was in fact often prepared to follow that method for Austrian residents as well. Issues of double

non-taxation were probably also relevant for that decision. Note, however, that in other conventions concluded by

Austria with countries that have a credit treaty policy (e.g. Denmark, Estonia, Greece, Portugal) Austria

nevertheless agreed to the exemption method.

The reason why Austrian tax treaties are not completely consistent in that regard is likely, on the one hand, to be

the historical development of that treaty network (whenever a method was applied in an earlier treaty this should

normally not be changed in the successor treaty). On the other hand, Austrian negotiators probably always check

the tax treaties of treaty partner states in order to avoid competitive disadvantages for Austria. Therefore,

possibly Austria was prepared to accept the exemption method even if the level of taxation in the other state

would have called for the credit method if that state had concluded tax treaties following the exemption method

with other important EU or OECD states.

Luxembourg (which is a credit country but has an exemption treaty policy) also deviated from its exemption

treaty policy in at least one double taxation convention, i.e. in that concluded with France (which is an exemption

country and has no clear treaty policy in terms of relief method). In that convention, Luxembourg adopted the

credit method; note that France also adopted the credit method. Apparently, these countries could not reach an

agreement upon the exemption method and thus moved to the credit method, although their tax policy would

have theoretically suggested adoption of the exemption method.

As already mentioned, in the Netherlands´ treaties as well some exceptions to the exemption treaty policy can be

found. This is the case, e.g. for some double taxation conventions concluded before 1980, such as the

Netherlands–Switzerland treaty. There is, however, no clear connection with the treaty policy of the other

contracting states, since the Netherlands agreed to the credit method both with countries that have an exemption

treaty policy (e.g. Austria and Germany) and with countries that have a credit treaty policy (e.g. Ireland and

Malta).

No such exceptions can be found with regard to other significant countries that have an exemption treaty policy,

such as Germany (but note that, as already mentioned, Germany commonly applies the credit method in its tax

treaties with regard to dividends, interest, royalties, certain capital gains, directors´ fees, pensions and/or income

derived by artists and sportsmen).

7.3. Recent economic studies with regard to countries´ behaviour in tax treaty negotiation

Recently, at least two economists have tried to establish whether a rule can be found, according to which one

method is preferred over the other in tax treaty negotiation. In a study published by Davies in 2003, [52] the

author discusses the topic “in the context of uniform taxes and simultaneous two-way capital flows that earn

endogenous rates of return”, i.e. in the context of symmetric countries negotiating with each other. According to

the author, “with two-way flows, each country faces the trade-offs of both the capital importer and the capital

exporter. Due to inbound FDI, capital exporters no longer find zero taxation to be a dominant strategy. Because

statutory and effective taxes vary across combinations of relief methods, equilibrium welfare properties will vary

across subgames.”

The basic approach followed by Davies, which is highly significant for understanding his conclusions, is that the

choice of the relief method is made by each government “to maximize its country´s national income. This is done

with the knowledge that tax policies influence capital flows”. On these grounds, he concludes – on the basis of a

mathematical model – that “credits [are] preferred to exemptions when facing either credits or exemptions …

under a treaty which rules out the use of deductions [emphasis added]”. In fact, Davies maintains that an

exemption country should choose credit when facing a credit country: “When facing credits, choosing credits

instead of exemptions increases both world income and the income of the previously exempting country.”

All the above, however, is based on the assumption of symmetric countries, which is hardly verified. With regard

to asymmetric countries, the conclusions of Davies are less straightforward and he acknowledges that “When

countries differ in either their technologies or their endowments [i.e. asymmetric countries] … it is difficult to

narrow the set of possible equilibria, with or without the treaty.”

Another commentator, Dickescheid, published a paper in 2004 on the very same topic. [53] The focus of that

paper is on “two small countries that mutually exchange foreign direct investment while being linked to the world

capital market (…). To introduce tax competition, it is assumed that each country needs revenue from source-

based capital taxes in order to finance public goods.”

The basic approach followed by Dickescheid is that two small countries can try to correct, in bilateral double

taxation treaties, only the fiscal externality due to the incentive to levy taxes on foreigners (tax export) which

inefficiently leads to high taxes. On this ground, the author concludes – on the basis of a mathematical model –

that “revenue demands result in even higher tax rates under the credit method than under the exemption

method.” Thus

Both of the two small countries will choose the exemption method in the subgame perfect equilibrium.

Moreover, it is shown that – given both countries choose nationally optimal tax rates – mutual



application of the exemption method … is the combination of relief methods which yields highest

welfare for each country. This is rigorously proved for symmetric countries and may well carry over to

asymmetric countries as is argued in a non-technical discussion.

Dickescheid acknowledges that his paper arrives at a ranking of relief methods that is reverse to the one found

by Davies in 2003 for the case of large countries.

The above studies both move from the basic assumption that the aim of maximizing the country´s tax revenue is

the driving factor when choosing the method of relief from international double taxation. Interestingly, they draw

different conclusions with regard to large and small countries: Large countries should prefer the credit method

(Davies, 2003), whereas small countries should prefer the exemption method (Dickescheid, 2004). Such

conclusions, drawn on the basis of a mathematical model, are arguably consistent with the way countries

behave. On the one hand, small countries such as, for example, Belgium, Luxembourg and the Netherlands,

have a clear preference for the exemption method. On the other hand, large countries such as, for example,

Canada, Italy, Japan, the United States and the United Kingdom, have a clear preference for the credit method.

Nonetheless, reasons different from maximizing the country´s tax revenue are likely at the basis of the choice by

some large countries, such as, for instance, France and Germany, to adopt the exemption method with regard to

foreign active business income. They are also at the basis of the conclusions drawn in recent studies carried out

in some other countries and mentioned at 2.2.

8. Credit and exemption and the principle of non-aggravation by tax treaties

It is commonly agreed that tax treaties may only limit the content of the domestic tax law of both contracting

states, i.e. that tax treaties may not impose a higher tax burden than under domestic law. [54] One interesting

aspect related to credit and exemption is whether the method of relief from international double taxation set forth

in the relevant tax treaty may worsen the tax burden put on the taxpayer compared to that under domestic law.

This could be the case, for example, where the exemption method is granted under domestic law but the credit

method is set forth in the relevant tax treaty.

The question arises as to whether the exemption set forth under domestic law still applies, since the application

of the tax treaty in the state of residence is not needed, or rather whether the tax treaty may itself provide the

state of residence with the taxing powers to subject the foreign income to tax and then grant a tax credit. With

regard to this aspect, the present writer cannot find any reason why the general principle should be derogated

from when dealing with double taxation relief. The treaty article on double taxation relief, like any other treaty

article, sets forth a limitation to the taxing powers of a contracting state (in particular, of the state of residence)

and it is not understood to give rise to the opposite outcome, i.e. an increase of the taxing powers of a

contracting state.

Another interesting issue regards the possibility to override the relevant tax treaty through recapture

mechanisms, i.e. through mechanisms under which foreign losses may be offset against domestic profits and, in

subsequent years, double taxation relief is not granted up to the amount of those losses (recapture). It is worth

noting that, in effect, through such mechanisms the relevant tax treaty is overridden.

With regard to this issue, the Commentary on Arts. 23A and 23B of the OECD Model reads as follows (Para. 48):

Several States in applying Articles 23A and 23B treat losses incurred in the other State in the same

manner as they treat income arising in that State: as State of residence (State R), they do not allow

deduction of a loss incurred from immovable property or a permanent establishment situated in the

other State (E or S). Provided that this other State allows carry-over of such loss, the taxpayer will not

be at any disadvantage as he is merely prevented from claiming a double deduction of the same loss

namely in State E (or S) and in State R. Other States may, as State of residence R, allow a loss

incurred in State E (or S) as a deduction from the income they assess. In such a case State R should

be free to restrict the exemption under paragraph 1 of Articles 23A and 23B for profits or income which

are made subsequently in the other State E (or S) by deducting from such subsequent profits or income

the amount of earlier losses which the taxpayer can carry over in State E (or S). As the solution

depends primarily on the domestic laws of the Contracting States and as the laws of the OECD

Member countries differ from each other substantially, no solution can be proposed in the Article itself,

it being left to the Contracting States, if they find it necessary, to clarify the above-mentioned question

and other problems connected with losses (cf. paragraph 62 below for the credit method) bilaterally,

either in the Article itself or by way of a mutual agreement procedure (paragraph 3 of Article 25).

In the Commentary, although no clear statement is found, it is affirmed that the state of residence should be free

to restrict the exemption granted under the treaty, i.e. should be free to override the relevant tax treaty when a

recapture mechanism is applied.

Regarding this last statement, one may wonder whether a treaty override actually occurs or, rather, whether

treaty override does not occur when a recapture mechanism is at issue. To answer this question, one should



determine whether the existence of a treaty override should be established by only looking at a situation at a

given moment or, rather, by looking at a situation on an overall basis.

9. WTO aspects of credit and exemption

Direct taxation (in general) and methods to eliminate double taxation (in particular) may have a dramatic impact

on international trade [55] and therefore need also to be analysed in the light of their consistency with the World

Trade Organization (WTO) rules. The importance of international taxation in such a field is reflected in the three

main agreements signed on the occasion of the Uruguay Round in 1993 [i.e. the 1994 update of the General

Agreement on Tariffs and Trade (GATT), the General Agreement on Services (GATS) and the Trade-Related

Aspects of Intellectual Property Rights (TRIPS)], which contain several provisions dealing with direct and indirect

taxes. [56]

With particular reference to the topic of this paper, i.e. the compatibility of methods for the elimination of double

taxation with WTO rules, reference is first made to Art. XVI(4) of the 1994 GATT, which provides that “contracting

parties shall cease to grant either directly or indirectly any form of subsidy on the export of any product other

than a primary product which subsidy results in the sale of such product for export at a price lower than the

comparable price charged for the like product to buyers in the domestic market”. In order to determine which

measures may be included in the definition of “subsidy on the export”, reference must be made to the Agreement

on Subsidies and Countervailing Measures (ASCM), which regulates more in detail the use of subsidies and the

actions Members can take to counter the effects of other Members´ subsidies. In this respect, Art. 3 of the ASCM

provides that “subsidies contingent (…) upon export performance” shall be prohibited, including, in particular,

“the full or partial exemption remission, or deferral specifically related to exports of direct taxes or social welfare

charges paid or payable by industrial or commercial enterprises” [cf. Annex I, Para. (e) of ASCM]. However, the

same Annex I clarifies, at note 59, that “Paragraph (e) is not intended to limit a member from taking measures to

avoid the double taxation of foreign source income earned by its enterprises or the enterprises of another

Member.” [57]

In the light of the above, no doubts seem to arise on the compatibility of the exemption method with WTO rules,

at least based on a literal interpretation of GATT and ASCM. Such a (preliminary) conclusion should not surprise

us, especially if we consider the purpose of the WTO (i.e. the promotion of free trade) and the purpose of both

credit and exemption methods (i.e. the elimination of double taxation). Since double taxation constitutes one of

the major barriers to international trade, the two purposes mentioned above tend to coincide. Thus, the credit

and exemption methods cannot be other than consistent with WTO rules.

What we need to understand now is whether our (primary) conclusion still is valid when we turn to the concrete

application of the methods for the elimination of double taxation by states. As was mentioned in section 1., all

states tend to derogate from the original models by inserting exceptions to the general rules. If the original model

is, in the abstract, compliant with the WTO rules, the domestic variations to the original model may well end

being an infringement of WTO rules. Such a conclusion has been clearly stated in one of the leading cases [58]

on this issue, when the European Commission challenged the US Foreign Sales Corporations (FSC) and

Extraterritorial Income Act (ETI) schemes, maintaining that they constituted a prohibited subsidy under the

ASCM. In the case concerning the ETI, [59] the WTO Appellate body concluded in favour of the incompatibility of

such measure with ASCM provisions concerning prohibited export subsidies, arguing that note 59 could not be

regarded as justifying a measure such as the US ETI scheme. Even if, in principle, the exemption of foreign-

source income is “one of the widely recognized methods of avoiding double taxation” [60] (Para. 146), in order to

be consistent with ASCM provisions, it must be directed only to foreign income (whose double taxation is

intended to avoid): “rather, in some situations, the ETI measure exempts QFTI [i.e. qualifying foreign trade

income] which is foreign-source income; in other situations, the ETI measure exempts QFTI which is not foreign-

source; and, in yet other situations, the measure exempts QFTI which is a combination of both domestic- and

foreign-source income” (Para. 184). Therefore, even if “avoiding double taxation is not an exact science and we

recognize that Members must have a degree of flexibility in tackling double taxation”, however such “flexibility

does not properly extend to allowing Members to adopt allocation rules that systematically result in a tax

exemption for income that has no link with a ´foreign´ State and that would not be regarded as foreign-source

under any of the widely accepted principles of taxation we have reviewed” (Para. 185, emphasis added).

In brief, based on the GATT and ASCM provisions and on the FSC/ETI case (and on previous cases on the

same matter), [61] in order to be consistent with the WTO the foreign-source income exemption may not have as

a consequence that “government revenue that is otherwise due [62] is forgone or not collected” (Art. 1.1(ii)

ASMC), it may apply only to foreign income (any possibility of application to domestic income being excluded)

and, in particular, it shall apply only to foreign income that can, in abstract, be subject to tax in the state of

source.

The following are examples of such domestic law exceptions: (i) In Australia, exemption rules for foreign

employment income derived by Australian residents who are engaged in foreign service for a continuous

period of 91 days or more are provided for under Sec. 23AG of the Income Tax Assessment Act 1936

1.



(and were recently amended effective from 1 July 2009 through the 2009/10 Federal Budget); (ii) In

Germany, based on a decree (Auslandstätigkeitserlass) resident workers who perform specific work in

non-treaty countries sometimes enjoy a unilateral tax exemption (the idea is probably to give an incentive

for working abroad by leaving them the advantage of low taxation in the host state); (iii) in the United

States, exemption rules for foreign employment income derived by US residents are provided for under

Sec. 911(a)(1) of the Internal Revenue Code. Further examples of domestic law exceptions to the credit

method found in credit countries are represented by the exemption of foreign dividends and capital gains

on shares, as found in many European credit countries (usually known as “participation exemption

regime”, found in European credit countries such as e.g. Italy, Finland, Germany, Norway and Sweden).

Countries that instead use the credit method in their tax treaties often make treaty relief subject to

internal law relief rules in their treaty double taxation relief articles. See, on this point, Avery Jones, J., et

al., “Credit and Exemption under Tax Treaties in Cases of Differing Income Characterization”, 36

European Taxation 4 (1996), p. 118 et seq.

One may wonder whether this is one reason why Uruguay has concluded very few tax treaties.

Interestingly, in the Uruguay-Germany convention the definition of “resident” under Art. 4 does not

include the term liable to tax: In effect, for the purposes of that convention “the term ´resident of a

Contracting State´ means any person who has his domicile, residence, place of habitual abode, place of

management or seat in that State.” Nonetheless, in the Uruguay-Hungary convention the definition of

“resident” is similar to that found in the OECD Model and does include the term liable to tax.

A third neutrality approach, known as “national neutrality” (NN), customarily joins CEN and CIN.

However, according to scholars, NN would be satisfied by means of the deduction method (i.e. foreign

taxes are treated as costs of doing business abroad), which is not one of the methods indicated by the

OECD Model. Therefore, NN is not taken into account for the purposes of this paper.

There is agreement that both CIN and CEN can be achieved if all countries adopt territorial taxation with

identical effective tax rates (see e.g. OECD, Taxing Profits in a Global Economy: Domestic and

International Issues (Paris: OECD Publications, 1991), p. 40), but scholars usually maintain that if tax

rates are different, both CIN and CEN cannot be satisfied. Nonetheless, under certain recently proposed

theories, the achievement of both CIN and CEN would be possible through one single method for

relieving international double taxation even though countries adopt different tax rates. For example,

according to Shaheen, F., “International Tax Neutrality: Reconsiderations”, 27 Virginia Tax Review 1

(2007), pp. 203 et seq., both CIN and CEN would be satisfied if all countries adopted territorial taxation

(exemption). According to Knoll, M., Reconsidering International Tax Neutrality, Research Paper No. 09-

16 (Philadelphia: University of Pennsylvania, Inst. for Law & Econ., 2009), available at SSRN:

http://ssrn.com/abstract=1407198, both CIN and CEN would be satisfied if the full credit method was

adopted.

Desai, M.A. and J.R. Hines, “Evaluating International Tax Reform”, 56 National Tax Journal 3 (2003).

It is assumed in practice that the tax burden is the only (or main) factor that determines investment

choices.

See also Hajkova, D., G. Nicoletti, L. Vartia and K.-Y. Yoo, “Taxation and Business Environment as

Drivers of Foreign Direct Investment in OECD Countries”, 43 OECD Economic Studies 2 (2006),

according to which “Most studies, however, do not find significant differences in the elasticity of FDI to

host-country taxation under alternative foreign source income taxation regimes. Thus, the distinction

between credit and exemption countries may not be important in practice”.

Office of Tax Policy, US Department of the Treasury, Approaches to Improve the Competitiveness of the

U.S. Business Tax System for the 21st Century (Washington, D.C.: US Department of the Treasury, 20

December 2007).

HM Treasury and HM Revenue & Customs, Taxation of the Foreign Profits of Companies: a

Discussion Document (London: HM Treasury, June 2007).

Advisory Panel on Canada´s System of International Taxation, Final Report – Enhancing Canada´s

International Tax Advantage (Ottawa: Distribution Centre, Department of Finance Canada, 2008).

According to the Advisory Panel: “A broader exemption system would be simpler, reducing the

compliance burden for Canadian businesses and the administrative burden for the CRA. Broadening the

exemption system would be revenue-neutral for the government, as dividends from foreign affiliates are

rarely taxed under the current regime. A broader exemption system could facilitate repatriation of foreign

profits, generating economic benefits for Canadian businesses and their owners. Our benchmarking

research shows that taxing active business income at its source is consistent with the tax policies (or

policy direction) of most other industrialized nations. As noted in Paras. 3.13 to 3.14, concerns that

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.



formally adopting a broader exemption system would cause a migration of jobs or investment from

Canada are not well supported.”

It is generally agreed among international law scholars that when defining the events that give rise to

taxation states may exercise their sovereign powers without any limitation, except from arbitrary taxation.

This has also been maintained by, e.g. the Italian Constitutional Court, according to which states are free

to determine which events may be subject to tax and which ones are not, with only the limitation of

arbitrary taxation (see Italian Constitutional Court, order 14 June 2002, No. 250). Other (minor) limits to

state sovereignty in the tax field may be found in particular circumstances, such as e.g. under the Vienna

Conventions on Diplomatic Relations and on Consular Relations, which provides for tax immunity of

diplomatic agents and consular officers, and constitutes, as generally agreed, the codification of a rule of

customary law.

Unless it results in taxation of a confiscatory nature which may considered to be in contrast with Art. 1

First Protocol of the European Convention of Human Rights.

As pointed out in section 1., however, not only is states´ practice not uniform in the adoption of such

methods but also states rarely adopt a “pure” version of such methods, since they tend to provide for

several exceptions and derogations from the theoretical models.

In Italy, such principles are provided for by Arts. 3 and 53 of the Italian Constitution, respectively.

According to Art. 3, “All citizens have equal social dignity and are equal before the law, without distinction

of sex, race, language, religion, political opinion, personal and social conditions. It is the duty of the

Republic to remove those obstacles of an economic or social nature which constrain the freedom and

equality of citizens, thereby impeding the full development of the human person and the effective

participation of all workers in the political, economic and social organisation of the country.” According to

Art. 53, “Every person shall contribute to public expenditure in accordance with his/her taxpayer capacity.

The taxation system shall be based on criteria of progression.”

Art. 41 of the Italian Constitution.

Art. 3(2) of the Italian Constitution.

Among Italian scholars, the topic has been recently addressed by Gaffuri, A.M., La tassazione dei redditi

d´impresa prodotti all´estero. Principi generali (Milan: Giuffrè, 2008), p. 383 et seq., and Baggio, R., Il

principio di territorialità ed i limiti alla potestà tributaria (Milan: Giuffrè, 2009), p. 233 et seq., which have

put forth arguments in favour of both conclusions.

Where the tax burden in the state of the source is higher than in the residence state, however, it could be

argued that constitutional principles are violated if the taxpayer is not granted the possibility, for example,

to carry forward the tax credit in excess.

See the UK Inland Revenue, Double Taxation Relief for Companies. A discussion paper (London: Inland

Revenue, 1999).

Cf. German Federal Fiscal Court (Bundesfinanzhof), decision 11 March 2008, I R 116/04. The Court did

not analyse the issue of the compatibility with the ability-to-pay principle.

This is the case, e.g. for Austria, Belgium and the Netherlands, as well as for France from 2009 with

regard to SMEs.

The Brussels Court has de facto extended the reasoning rendered by the European Court of Justice with

respect to losses realized by EU companies having a permanent establishment in another EU Member

State in its decision of 14 December 2000, C-141/99, Algemene Maatschappij voor Investering en

Dienstverlening NV (AMID) [2000] ECR I-11619.

By contrast, in the United Kingdom the credit method was originally introduced in 1894 as relief from

double taxation on estate duties within the British Empire and, in 1916, as a temporary domestic

measure of double taxation relief regarding any “colonial” income tax. In the United States, a provision on

credit for foreign income taxes was introduced in 1918 as a unilateral measure in favour of US citizens.

The full text of the Preliminary Report of 2 March 1959 (OEEC Working Party No. 15 of the Fiscal

Committee, Preliminary Report on Methods for Avoidance of Double Taxation of Income and Capital

(Paris: OEEC, 1959)) can be found at http://www.taxtreatieshistory.org.

The explanatory remarks to Draft A were the following: “The provisions in paragraph (2) are exhaustive

as the state of residence shall allow as a deduction from its own tax an amount equal to the tax paid in

the state of source except where express provision to the contrary is made in the Convention. As a

consequence of this it is not necessary – in special Articles – to confer the right to tax to the state of

source. The adoption at the 12th Session as to the use of the expressions ´shall be taxable only´ and

´may be taxed´ seems to be of no importance for the drafting of the present Article.”

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.

24.

25.

26.

27.

28.



The explanatory remarks to Draft B were the following: “In paragraph (1) it is established as a principle

that the state of residence has the right to tax except where a provision to the contrary effect is contained

in any Article in the Conventions. A provision like paragraph (1) appears in nearly all conventions for the

avoidance of double taxation based on the exemption system, and seems to be necessary in order to

secure that all cases of double taxation that may arise will be solved. At its 12th Session the Fiscal

committee adopted the term ´may be taxed´ in those Articles where the state of source had the right to

tax a certain income. The double taxation, which as a consequence of that term has not been solved in

the special Articles, is avoided by the fact that the state of residence omits to tax that income, e.g.

exempt that income [paragraph (2)]. The use of the term ´may be taxed´ implies that the state of

residence shall give exemption irrespective of the fact whether the state of source makes use of the right

to tax which it has under the convention, or not. If the renunciation of taxation in the state of source the

term ´may be taxed´ must be replaced by the term ´is subject to tax´. This problem, however, has until

now not been decided upon by the Fiscal Committee. If the wording ´is subject to tax´ is chosen by the

Fiscal Committee it is probably necessary to insert in draft B as paragraph (4) a provision corresponding

to paragraph (3) in draft A.”

The explanatory remarks to Draft C were the following: “The provisions of this draft correspond to the

provisions in draft A and B but are framed so that they can be inserted in a Convention where one of the

Contracting States applies the credit system and the other Contracting State the exemption system. For

the understanding of this draft it should be borne in mind that as well in part I as in part II the term ´state

x´ means the state of residence and ´state y´ the state of source.”

See OEEC Working Party No. 15 of the Fiscal Committee, Final Report on Methods for Avoidance of

Double Taxation of Income and Capital (Paris: OEEC, 1961), which can be found at

http://www.taxtreatieshistory.org.

The WP claimed that if the exemption method is applied, possible issues of double utilization or no

utilization of losses could arise.

Note, however, that the International Fiscal Association held its XIII Congress in Madrid in 1959 with

regard to Mesures unilatérales tendant à éviter la double imposition, the content of which can be found in

IFA (ed.) Unilateral measures for the avoidance of double taxation, Cahiers de Droit Fiscal International,

Vol. 40 (Amsterdam: Swets & Zeitlinger N.V., 1970).

OECD, Harmful Tax Competition – An Emerging Global Issue (Paris: OECD Publications, 1998).

OECD, Tax Sparing – A Reconsideration (Paris: OECD Publications, 1998).

This approach to credit was not regarded as innovative and was considered to be in line with certain

domestic legislation that grants exemption as a relief method but limits such a relief to the fulfilment of

certain precise conditions and requirements (so that exemption is limited to genuine situations such as

active business income) [see Para. 104 of the Report on Harmful Tax Competition].

See Para. 105 of the Report on Harmful Tax Competition.

Vann, R., “Liable to Tax” and Company Residence under Tax Treaties, in Maisto (ed.) Residence of

Companies under Tax Treaties and EC law, EC and International Tax Law Series, Vol. 5 (Amsterdam:

IBFD Publications BV, 2009), Ch. 7, p. 259.

This was probably due to the awareness that in some cases certain tax treaty provisions may also serve

purposes other than the avoidance of double taxation. In fact, since the early beginning of the debate on

methods of relief from double taxation, the OEEC Fiscal Committee pointed out that in many

Conventions provisions are made to relieve, in special circumstances, an individual from taxation in the

state of residence. This is the case of certain income earned by students and business apprentices dealt

with in Art. 20 of the OECD Model. The purpose of such a provision would be frustrated if the credit

method were applied in the state of residence. Therefore, in such circumstances the exemption method

seems to be preferable.

The grounds for such a switch-over clause are currently explained at Para. 47 of the Commentary on

Arts. 23A and 23B of the OECD Model: “In Articles 10 and 11 the right to tax dividends and interest is

divided between the State of residence and the State of source. In these cases, the State of residence is

left free not to tax if it wants to do so (cf. e.g. paragraphs 72 to 78 below) and to apply the exemption

method also to the above-mentioned items of income. However, where the State of residence prefers to

make use of its right to tax such items of income, it cannot apply the exemption method to eliminate the

double taxation since it would thus give up fully its right to tax the income concerned. For the State of

residence, the application of the credit method would normally seem to give a satisfactory solution.”

Commentary on Arts. 23A and 23B of the OECD Model, Para. 28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

40.

41.

42.



Introduction to the OECD Model, Paras. 19 and 25; Commentary on Arts. 23A and 23B of the OECD

Model, Paras. 28-29.

A somewhat similar, but reverse, case is that mentioned at Para. 2 of the Commentary on Art. 28 of the

OECD Model, where the OECD recognizes that the simultaneous application of the provisions of a

double taxation convention and of diplomatic and consular privileges conferred by virtue of the general

rules of international law, or under a special international agreement, may, under certain circumstances,

have the result of discharging, in both contracting states, tax that would otherwise have been due. The

OECD cites the example of a diplomatic agent who is accredited by State A to State B and derives

dividends from sources in State A, who is not, owing to international law, subject to tax in State B and

may also, depending upon the provisions of the double taxation convention between the two states, be

entitled as a resident of State B to an exemption from, or a reduction of, the tax imposed on the income

in State A. In order to avoid these kinds of tax reliefs that are not intended, the OECD suggests that the

contracting states may include specific provisions preserving the taxing rights of the state of source

(State A in the above example).

See Para. 5 of the Commentary on Art. 21 and Para. 9 of the Commentary on Arts. 23A and 23B of the

OECD Model.

In general terms, in the Commentary on Arts. 23A and 23B of the OECD Model it is also pointed out that

the switch from exemption to credit may be justified in order to achieve a certain reciprocity where one of

the contracting states adopts the exemption method and the other the credit method. However, this

statement is used as an example and it seems that the reverse case (switch from credit to exemption)

could have been used as well for such a purpose. It therefore appears that nothing in the text and

context of the above statement shows a preference for the credit method in cases where the contracting

states seek to achieve reciprocity.

Such a conclusion is apparently shared by, for example, Lang, M., Tax Treaty Policy, in

Andersson/Eberhartinger/Oxelheim (eds.) National Tax Policy in Europe (Berlin: Springer, 2007), p. 206, who maintains that “a State is relatively free to decide on the method to avoid double taxation in a tax

treaty: The OECD Model Convention offers both, the credit and the exemption method …”.

Similarly, the OECD does not show any preference with regard to the method to be applied (if any) to

relieve economic double taxation on dividends: In Para. 52 of the Commentary on Arts. 23A and 23B of

the OECD Model, the OECD concludes that it appears preferable to leave Member countries free to

choose their own solution to the problem of economic double taxation and indicates that the solutions

most frequently adopted follow either the principle of the indirect foreign tax credit or the principle of

participation exemption.

The “Report on the Attribution of Profits to Permanent Establishments” was issued in 2008 and the first

part of the implementation package of that Report was included in the 2008 update to the OECD Model

Tax Convention. Furthermore, a discussion draft of a new Art. 7 of the OECD Model Tax Convention that

includes the second part of the implementation package of that Report was issued in 2008 and the

revised version of that discussion draft was recently issued in late 2009.

The German practice with regard to the application of domestic switch-over clauses when an exemption

tax treaty is in place is a fairly interesting one. Such a practice follows from a resolution by the Finance

Committee of the Bundesrat issued on 23 May 1991, where the administration was asked to insert in future treaties a provision granting Germany the right to switch-over from the exemption method to the

credit method upon notification to the other treaty country. This was possible since almost all tax treaties

concluded so far by Germany included a reservation in favour of Germany to notify the other contracting

state by way of diplomatic notification of any income to which Germany is intending to apply the credit

method in the future. A similar provision is also included in tax treaties concluded by Germany since that

date. Switch-over clauses are under debate among German international tax scholars and have been the

subject of some criticism, especially with regard to the mechanism of notifications. For details, see

Lüdicke, J., Überlegungen zur deutschen DBA-Politik (Baden Baden: Nomos, 2008), p. 97.

See Pahapill, Estonia´s Tax Treaty Policy, in Lang/Braccioni/Garbarino/ Schönstein (eds.) European Union: Tax Treaties of the Central and Eastern European Countries (Vienna: Linde, 2008), p. 61.

Lang, in Andersson/Eberhartinger/Oxelheim (eds.) National Tax Policy in Europe (2007), p. 207.

Davies, R.B., “The OECD Model Tax Treaty: Tax Competition and Two-Way Capital Flows”, 44

International Economic Review 2 (2003).

Dickescheid, T., “Exemption vs. Credit Method in International Double Taxation Treaties”, 11

International Tax and Public Finance 6 (2004), pp. 721-739.

Most tax scholars agree with such a statement. See, ex multis, Vogel, K., Klaus Vogel On Double Taxation Conventions, 3rd ed. (London/The Hague/Boston: Kluwer, 1997), Introduction MN 26; Fantozzi,

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A. and K. Vogel, Doppia imposizione internazionale, in Digesto delle discipline privatistiche / Sezione commerciale, Vol. V (Turin: Utet, 1989), p. 186 (p. 191); Baker, P., Double Taxation Conventions(London: Sweet & Maxwell Ltd, loose-leaf), Introductory Topics MNs B.02 et seq., which also

provides an analysis of the approaches to the topic by various countries; Van Raad, C., Five

Fundamental Rules in Applying Tax Treaties, in Douclé (ed.) Liber Amicorum Luc Hinnekens (Brussels:

Broylant, 2002), pp. 587 et seq.; Miraulo, A., Doppia imposizione internazionale (Milan: Giuffrè, 1990),

pp. 22, 31 and 59. With specific reference to the relation between treaty and unilateral relief, see Avery

Jones, J., A tale of two Taxes: The Interaction Between Treaty and Unilateral Relief, in

Andersson/Melz/Silfverberg (eds.) Liber amicorum Sven-Olof Lodin (The Hague: Kluwer, 2001), pp. 64-

73; and id., The Interaction between Tax Treaty Provisions and Domestic Law, in Maisto (ed.) Tax Treaties and Domestic Law, EC and International Tax Law Series, Vol. 2 (Amsterdam: IBFD

Publications, BV, 2006), Ch. 6, p. 142. According to some scholars, however, it is doubtful whether a

legal basis exists for such a statement, although in practice double taxation conventions serve as a

limitation on tax liabilities. In this respect, see Lang, M., Einführung in das Recht der Doppelbesteuerungsabkommen (Vienna: Linde, 2002), MN 48; Vitale, M., Doppia imposizione (diritto

internazionale), in Enciclopedia del diritto, Vol. XIII (Milan: Giuffrè, 1964), p. 1010; Gest, G. and G. Tixier,

Droit fiscal international, 2nd ed. (Paris: PUF, 1990), p. 45.

This is particularly evident with respect to states adopting the exemption method with the explicit purpose

of supporting exports.

For a general analysis, see Lang, M., J. Herdin-Winter and I. Hofbauer, WTO and Direct Taxation (The

Hague: Kluwer, 2005); Herdin-Winter J. and I. Hofbauer, The Relevance of WTO Law for Tax Matters(Vienna: Linde, 2006); Presiani, A., “Organizzazione Mondiale del Commercio, disciplina in materia di

sovvenzioni ed imposizione diretta: alcune riflessioni”, Diritto e Pratica Tributaria Internazionale, n. 2

(2007), p. 515; Cappadona, “WTO, GATT, tax treaties and International taxation: the effects of their

interactions and the possibilities of conflict”, Dir. Prat. Trib. Int., n. 2 (2004), p. 457.

Note 59 also makes reference to the necessity to adopt the arm´s-length principle by states for the

taxation of cross-border transactions between related parties. Such a specification may lead one to think

that the compatibility of the exemption method is not absolute but may be subject to the accomplishment

of other conditions by Members.

The WTO Appellate Body dealt with the FSC scheme in the Report of 24 February 2000 and with the ETI

scheme in the Report of 14 January 2002 (both cases were published under the same name “United

States – Tax Treatment For ´Foreign Sales Corporations´ – Recourse To Article 21.5 Of The DSU By

The European Communities (WT/DS108/AB/RW)”).

WTO Appellate Body, Report of 14 January 2002, id.

And, moreover, as the Panel pointed out, “the avoidance of double taxation is not an exact science.

Indeed, the income exempted from taxation in the State of residence of the taxpayer might not be subject

to a corresponding, or any, tax in a ´foreign´ State. Yet, this does not necessarily mean that the measure

is not taken to avoid double taxation of foreign-source income” (Para. 146).

In 1976, the United States brought a case before a WTO Panel against the domestic tax measures

implemented by Belgium, France and the Netherlands concerning the exemption of foreign-source

income under the territoriality principle. Although the Panel characterized such exemptions as prohibited

subsidies (cf. WTO Panel, cases L/442-23S/127, Income tax practices maintained by Belgium; L/442-

23S/114, Income tax practices maintained by France; L/442-23S/137, Income tax practices maintained by the Netherlands), the territoriality principle was then accepted by the GATT Council as may be

inferred from the text of 1994 GATT.

The expression “otherwise due” must be interpreted in the sense that the exemption of foreign-source

income may not be viewed as an exception to the general rule provided under the tax legislation of a

state, but as the general rule systematically applied in all comparable circumstances.

Citation: F. Barthel et al., Tax Treaties: Building Bridges between Law and Economics (M. Lang et al. eds., IBFD 2010), Online Books IBFD (accessed 2 Aug. 2013).

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credit versus exemption

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