In the recent past, world economies have come closer to each other as a result of economic activities. This has made borders seem invisible across the globe economically. Because of liberalization and globalization, there are many transactions happening across many borders covering many nations of the world. This world has become a big global village. There is increased integration between countries. And because of this individuals can earn not only within national borders but there are a lot of opportunities to make money internationally as well.

 

The problem then is with respect to international taxation. Because there is income earned in a foreign country, who will collect the taxes for such an income? The country of residency or the country of source? There is taxation is the resident country (taxation of global tax) and taxation of nonresident income (source based tax). This is the main reason why the dual taxation agreement has come into existence, so that double taxation may be avoided.

 

Technically speaking international taxation merely refers to the international aspects of income tax laws of a particular country. Every country has its own international tax laws. And these tax laws are divided into two dimensions. The first is the taxation of resident individuals on income derived from foreign countries. This is also called taxation of foreign income. The second is the taxation of non-residents from income arising domestically. This is also called taxation of non-resident. So here we can see and understand a resident country taxing an individual from income received from work in another country (resident country), and another country taxing that same individual for income received from their country (source country). This is dual taxation. The resident country taxing the income and the source country also levies taxes on the same income.

 

There is thus a need to come up with an agreement between countries so that dual taxation will be prevented. Thus, the birth of the DTAA or the Dual Taxation Avoidance Agreement.

 

Here is an example to illustrate the exact need for DTAA.

 

Consider a resident of one country (residence) earning 100 units of income from another country (foreign). If the tax rate of the foreign is 40% and the Form 5471 rate of the residence country is 50%, the taxability of the resident without DTAA is as follows:  foreign source income is 100.  Foreign tax is 40% (source based tax) or 40 units. Domestic tax for global income is 50% or 50 units. So the total taxes paid are 90 units. The resident's basic income after tax is 10 units.

 

With this above example we see that double taxation leaves the taxpayer discouraged to continue trade and commerce with another country because a huge portion of his income will just go to the governments of two countries. That is why it is necessary to avoid double taxation because the amount left for the taxpayer will be too low to continue any economic activity.