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TALKING TAX: How to benefit from tax treaties

  • 2007-01-24
  • by Tomas Davidonis
After regaining independence, the Baltic states started to build economic relations with foreign countries. Economic growth led to double taxation, where foreign investors were taxed in the Baltic states and then, afterwards, in the investor's home country. Naturally, such a situation urged the Baltic governments to find a solution. As a result, Lithuania, Latvia and Estonia have started to develop a network of tax treaties. Currently each country has entered into tax treaties with approximately 40 individual countries.

In formulating their tax treaties, the Baltics have relied on the widely accepted OECD model of tax treats, with some exceptions. The main concept of the OECD model treaty could be characterized as follows:- The tax treaty allocates the powers of the government of the taxpayer's resident country and income source in respect to income taxation;- In general, the treaty grants exclusive powers to the country of residence;- The treaty provides that income can be taxed in the country where the income comes from. Such income is usually taxed by withholdings. In regard to income taxed in the source country, the country of residence must abolish the double taxation: either not to tax the income (exemption method) or to reduce its tax by the amount of a tax paid in the country of source (credit method).Having analysed Baltic tax treaties, one could come to certain conclusions. First, the double taxation treaties limit the power of Lithuania, Latvia and Estonia to impose withholding taxes on certain income, which is taxed under domestic law. For instance, most of the treaties applicable in Latvia abolish the application of Latvia's withholding tax of 10 percent on management and consultancy fees. Application of the treaty in Estonia could facilitate the reduction of the Estonian withholding tax on dividends and royalties. In regard to Lithuania, the tax treaty may narrow the application of Lithuania's withholding tax of 10 percent on franchise payments.Furthermore, double taxation treaties may limit taxes on the profits of investors who conduct business activities without a separate corporate establishment. Double tax treaties establish the concept of permanent establishment, and in cases where domestic law establishes a broader definition the treaty must prevail. For example, Lithuanian domestic law says that a construction site is, in all cases, regarded as a permanent establishment. Countries may establish additional tax incentives in relation to tax treaty countries. For instance, Lithuania establishes a more favorable taxation regime for income gained from tax treaty countries by expatriates'.Consequently, tax treaties play an important role in abolition of double taxation in cross-border transactions, and investors should be encouraged to utilize the benefits established by those treaties.Tomas Davidonis is a senior associate at Sorainen Law Offices in Vilnius.