Coming to grips with the double-tax treaties

International double-taxation treaties generally apply to a resident of one contracting state who derives income in another contracting state. For the purposes of this article, one state will be Poland. The treaties do not free an individual from taxation in one state altogether on the grounds that he is the resident of another; rather, they are set up to specify where income will be taxed and to ensure that ultimately the individual does not pay tax twice on the same income. The starting point, therefore, is to ascertain "residence." Believe it or not, this is not at all straightforward and it is fairly easy and not uncommon to qualify as a resident of more than one country based on the domestic law of each particular country involved. This is particularly true of countries such as the United States, which looks to citizenship and generally requires all passport holders to remain within the scope of the U.S. tax law at all times. An individual who stays in Poland more than 183 days during a tax year can run the risk of being treated as a resident for Polish tax purposes. The Poland-U.S. treaty, therefore, contains (as do all others) a "tie-break" clause to determine where, for tax purposes, you are actually a resident. I have discussed the criteria for determining residence in a number of earlier articles, so I won't go into great detail on this point. In any event, this is the easy part. By way of reminder, these criteria usually hinge on where you have a permanent home (one you can return to at the drop of a hat rather than a property back home on a long lease to a third party); where your center of vital interests lies (family ties, investments, bank accounts); where your habitual abode is; and, failing all of the above, either based on citizenship or by mutual consent of the two contracting states.

Scary income Now on to more interesting matters. Having ascertained your place of residence, the primary taxing right will go to the state of residence. But it can revert back to the state where the income arises (for example, interest, dividends and employment income) if specific legal provisions are met. If those provisions are not met, it reverts back to the country of residence. In short, tax is levied in the state where the income arises. Then the country of residence may also want to get a slice of the tax cake, but only after the first state has squeezed you once already. This is getting scary. But fear not. The best part is yet to come: Close to the end of most treaties is a section headed "Relief from Double Taxation." This section will likely say one of two things as different countries, traditionally, like to do things differently. One scenario offers relief via the so-called "credit method." Under this scenario, if our roaming employee is taxed in one state on income earned there at, say 20%, the other country will then apply its own appropriate tax rate (say 30%) to the full amount of that same income but will allow the individual to credit against his ultimate tax liability the 20% already paid in relation to that same income in the first state. In short, the individual will pay the same tax amount as if he had stayed at home. The treaty merely determines which state gets which proportion of the total tax amount. Sounds good, but what happens if the tax in the country of residence is only 15% - lower than in the state where the income was earned and which had the primary taxing right? One of two things can happen: Either the home country tax authority says "tough" and takes no tax itself or it can net the 20% already paid against its own 15% liability and carry forward 5% in case the situation is reversed in future years, as in the U.S. This is known as having a surplus foreign tax credit position. Using those credits up is actually not all that easy.

Exemption with progression The second scenario is the so-called "exemption method." This says that if the country where the income was earned (with the primary taxing right) has taxed the income in question, then the other country will not seek any extra tax on that income. As in our earlier example this also works in one of two ways - either the income is ignored completely for the second state's purposes, or it is included in the calculation determining the appropriate rate at which the individual should pay tax on any taxable income. This is known as "exemption with progression." The idea behind this is to ensure that the taxpayer does not use the exemption to fall into a lower tax bracket than he would ordinarily. If you are at all interested in a more in-depth analysis of other matters covered by the double-tax treaties, do let me know.

Anna Szymańska is a tax senior manager in the Warsaw office of Ernst & Young.