What is a tax treaty? A tax treaty, also known as Double Taxation Avoidance Agreement or DTAA, is an agreement between two jurisdiction to avoid a Person/Resident (company or individual) being taxed twice, on the basis that such income should only be taxed in the jurisdiction where the Person is a tax resident in, except for that income generated at the source jurisdiction through a Permanent Establishment.
There are cases when a Person may be considered a tax resident in both countries, so in these cases the tax treaty sets out the rules to determine where the Person would ultimately be a tax resident in, for the treaty’s purposes.
These DTAAs in general cover several taxes all at once, such as royalties, real estate income, capital gains, business income, employment income, etc., but these may vary and the agreement may be just for a specific tax.
What is the benefit of a tax treaty? The benefit could be a full tax exemption, or a lower tax rate.
What is treaty shopping? Treaty shopping is picking a jurisdiction to form an offshore company or to become a resident in merely for the purpose of benefiting from the jurisdiction’s tax treaty network.
So for example, if you will have income from trading in China, you would have to check which jurisdictions China has a tax treaty with, and then send money to this offshore company with no withholding tax or with a lower rate. People mostly pick Hong Kong in this case because Hong Kong has a tax treaty with China, and also Hong Kong has it easier changing exchanging Renminbi
Resident
Something to be careful about:
There is something very important to take into consideration before picking the jurisdiction, and it is the Residence Clause in most tax treaties. Most, if not all, tax treaties in their definition of resident have this sentence: “This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.”
So let’s say you have a company in X country, and this country has a tax treaty with Belize. You cannot just go and open a Belize LLC that is tax exempt and only liable for income derived from Belize as the Belize LLC would not be considered a tax resident in Belize and would not be able to get a Residency Certificate from Belize in order to benefit from the treaty.
The Solution:
That is why Belize (and many other jurisdictions) have another type of company that has a very low tax rate, and in Belize this company is the International Business Company or IBC. These companies are taxed at a progressive tax rate from 1% to 3% rate, but are able to profit from the tax treaty network.
Some other jurisdictions exclude certain territories from some of their tax treaties subscribed. This is the case of Labuan, a Federal Territory of Malaysia, which has a 3% tax rate, but it is excluded from about 2 tax treaties subscribed by Malaysia due its low tax rate
Maintenance price of low tax companies
The price for the yearly maintenance of these can be very high, in comparison to tax exempt companies.
By law, some of these companies, specially those taxed below 10%, are required to have one employee or more, rented office which in the country cannot be a virtual office or address, a minimum of yearly expenditures, etc., otherwise these companies would not be able to get the residency certificate.
So that is the logic of why in a tax haven you would rather pick a low tax entity, instead of a no tax or tax exempt company.
Just a few low tax entities and jurisdictions are the following:
Seychelles Special License Company: 1.5%
Labuan LTD: 3%
Mauritius GBL Company: 3%
Malta LTD: 5%
Barbados: 5.5%
Hungary KFT or OCC: 9%
Ireland LTD: 15.5
and so on…
Nothing in this post should be considered legal, accounting, or financial advice. Please contact your licensed advisor.