Elimination of double taxation

A considerable change occurred in the area of elimination of double taxation in the Czech Republic in 2001. The situation up to the end of 2000 may be characterised in the following way:

• the ordinary tax credit method was the basic method of elimination of double taxation under domestic law
• as a complementary method the exemption with progression was used for employment income from abroad
• in a double tax treaty situation the appropriate method under a particular treaty was used
• excessive tax credits could be used as a tax expense in the following taxable year.

What changed in 2001?

• both the credit method as well as the exemption method have been abolished in domestic law
• double taxation may be eliminated only under double tax treaties
• in non-treaty situations only the deduction method is used as a remedy to double taxation.

Let’s look at how particular methods operate in treaty and non-treaty situations.

Deduction method in a non-treaty situation
Business income
The procedure is the same for both individuals and corporations. Tax paid abroad may be used as a taxable expense in the following taxable period. This rule is laid down in Section 24 paragraph 2, (letter ch) of the Income Taxes Act.

Example 1
Company Astra, s.r.o. is a Czech tax resident. Its 2001 accounting profit was 1,580,000 CZK. 520,000 CZK was income from a permanent establishment in Hong Kong, on which tax of the equivalent of 130,000 CZK was paid. The 2002 accounting profit was again 1,580,000 CZK.

Explanation
Hong Kong is a non-treaty country, therefore tax paid in Hong Kong may only be deducted from the total Czech tax base, in the following taxable period. This means that income in 2001 will be double taxed. Double taxation is slightly alleviated in the following year.

Candidates should note that the deduction method is not without problems when applied to individual taxpayers. This is due to certain provisions in domestic law regarding the determination of the tax base for particular types of income. Such provisions do not allow any expenses in connection with income, or allow certain explicitly mentioned expenses, but not particularly this foreign tax. The result is that tax paid abroad in year 1 cannot be used as a tax expense in year 2 when the individual taxpayer has only:

• employment income
• income from investment of capital (e.g. interest, dividends)
• so called ‘other income’ (e.g. gains from alienation of property, occasional activities or leasing, gains from alienation of shares)
• a combination of these three types.

In addition, individuals cannot use foreign tax as an expense if they have business income or income from leasing and letting of movable or immovable property and for tax purposes they do not use actual expenses from their accounting books. Instead, they use percentage expenses allowed by the law (25 per cent of business income, 30 per cent of copyright income, 50 per cent of income from agricultural activities).

Employment income
Example 2: Employment income
Mr Novak is a Czech tax resident. His 2001 income included 150,000 CZK employment income from the Czech Republic and equivalent of 350,000 CZK from employment in Kuwait. Tax withheld in Kuwait was equivalent to 50,000 CZK.

Explanation
Kuwait is a non-treaty country, therefore Kuwait tax may only be deducted from the tax base. In the case of employment income, it is deducted from the income of the current year. Therefore, double taxation is alleviated

In the case of employment income, foreign tax is used as an expense against the income from which it was paid. In the case of business income, the application of the expense is postponed to the following year. The legislator’s reason for this solution was probably that the tax in the foreign country was paid based on the tax return after the end of the current taxable period. Therefore, the taxpayer is made aware of the tax due in the following year. In the case of employment income, the tax is usually withheld during the taxable period. Therefore, the taxpayer is immediately aware of the tax due. Refer to Example 2.

Elimination of double taxation in a treaty situation
Example 3: Exemption Method
Company Astra, s.r.o. is a Czech tax resident. Its 2001 accounting profit was 1,580,000 CZK. From that, the equivalent of 520,000 CZK was income from a permanent establishment in Germany, on which tax equivalent to 130,000 CZK was paid.

Example 4: Exemption method with progression
Mr Novak is a Czech tax resident. His 2001 income included 150,000 CZK of employment income from the Czech Republic and the equivalent to 350,000 CZK from employment in Germany. Tax withheld in Germany was the equivalent of 50,000 CZK.

Example 5: Credit method
Company Astra, s.r.o. is a Czech tax resident. Its 2001 accounting profit was 1,580,000 CZK including equivalent of 520,000 CZK income from a permanent establishment in Slovakia, on which tax equivalent to 130,000 CZK was paid.

Example 6: Credit method
Mr Novak is a Czech tax resident. His 2001 income included 150,000 CZK employment income from the Czech Republic and equivalent to 350,000 CZK from employment in Slovakia. Tax withheld in Slovakia was equivalent of 80,000 CZK.

Note: See my previous note under Example 1. Mr Novak will use this tax expense of 4,230 CZK only if he has business income or income from leasing or letting of movable or immovable property in 2002 and he applies actual expenses from his accounting books.

Loss situations
Example 7: the taxpayer accomplishes domestic profit and foreign loss

Deduction method
Domestic profit and foreign loss are compensated together. Of course, no foreign tax was paid abroad, therefore no expense is used. If the total result is loss, this can be carried forward for seven tax years.

Credit method
Domestic profit and foreign loss are compensated together. Of course, no foreign tax was paid abroad, therefore no tax credit is used. If the total result is loss, this can be carried forward in seven tax years.

Exemption method
Domestic profit and foreign loss may not be compensated together. Foreign loss is completely exempt from taxation and therefore does not influence domestic income.

Example 8: the taxpayer accomplishes domestic loss and foreign profit
Deduction method
Domestic loss and foreign profit are compensated together. Foreign tax paid abroad is used as a tax expense against the income of the following year (business income). If the total result is a loss, this can be carried forward for seven tax years.

A loss of (100,000) can be carried forward. Foreign tax as tax expense in the following year of 40,000.

Credit method
Domestic loss and foreign profit are compensated together. Foreign tax paid abroad is used as tax credit. However, as there is a domestic loss, the credit cannot be used up and remains as excessive credit to the following tax year. In this following year the excessive tax credit is used as a tax expense against business income. If the total result is a loss, this can be carried forward for seven tax years.

Tax loss of (100,000) can be carried forward.

Excessive tax credit of 40,000 can be used as tax expense in the following year.

Exemption method
Domestic loss and foreign profit are not compensated together, because the foreign profit is exempt from taxation. Domestic loss can be carried forward for seven tax years.

Tax loss of (300,000) can be carried forward.

Summary
The article deals with elimination of double taxation in context of the Czech Republic. Recently a quite considerable change has occurred in this sphere, and that is the abolishment of credit method and exemption method under domestic law. These methods may be used now only under Czech double taxation treaties. The domestic law includes only deduction method. This article shows how the particular methods are computed and highlights what problems the taxpayer may encounter.

Lenka Fialková, Tax and Legal Services, PricewaterhouseCoopers.