Refund of foreing taxes: tax impact in the country of residence

Posted on Posted in Publications, Tax

Every country in the world retains the right to tax capital gains arisen on the disposal of real estatev or other assets located within its territory. Tax Treaties confirm this tax treatment, at least with regard to real estate. However, other type of assets might have a different treatment (movable property, intangible property…).

Therefore, capital gains arisen on the disposal or sale of real estate may, and usually shall be, taxed twice: once at the county of the source (where the property is located) and again at the tax payer’s home country level. This can lead to double taxation, which is not acceptable, at least when a Tax Treaty exists between the country of the source and the country of residence of the tax payer. Tax treaties oblige the home country to account for this double taxation and eliminate, with certain limits, such excess taxation. Is what is called, foreign tax relief.

There are two methods to deal with double taxation: the exemption system and the imputation system (also called foreign tax credit system). Under the exemption method, the country or residence of the tax payer declares exempt foreign source income. Therefore, the only taxation takes place at the source country level. This is the most effective way to avoid double taxation. On the contrary, under the imputation system, foreign source income is included in the taxable base likewise any other income and taxed accordingly, but then a credit for the tax paid abroad is allowed. Very few countries give a full tax credit, ie, they allow the tax payer to deduct the full amount paid abroad. Most commonly, countries give a limited tax credit, allowing to deduct foreign taxes paid up to the amount payable at home country level on foreign source income.

For instance, if a tax payer gets 1.000 of foreign source income and paid abroad 300, but the tax payable in the country of residence is only 200, the latter would only allow to deduct 200 as foreign tax credit. In this case, there would not be any taxation at home country level:

foreign source income: 1.000

Tax (20 %):                     200

foreign tax credit:         ( 200)

Tax payable:                       0

The global tax paid on foreign source income would be 300,fully  paid in the country of the source

One important corollary of the  foregoing is that when taxes at home country level are higher than in the country of the source, there is always an additional taxation in the country of residence. On the contrary,  when taxes at home country level are lower than in the country of the source, there would not be any  additional taxation in the country of residence (see example).

Then, and going to the point of this post, what happens when a tax payer has originally filed a tax return in his country of residence and applied the foreign tax relief in respect of foreign source income and subsequently he gets the refund (full or partial) of the foreign tax paid. This can happen for many reasons, but the most common is that the foreign tax is declared contrary to the European Treaty or the Constitution.

This happened in 2009, when the European Court of Justice declared that the capital gains tax in Spain was contrary to the European Treaty, because it taxed other european citizens at a flat tax rate of 35 % instead the 15 % tax rate applied to Spanish residents. Many Europeans (at least 500 of our clients) claimed the refund of this 20 points excess taxation to the Spanish authorities.

This is likely to happen again with regard to the Spanish Inheritance Tax, which is currently being examined by the European Court of Justice because it is deemed (at least this is the opinion of the European Commision) to discriminate other European tax payers. In essence what happens is that European tax payers are not entitled to apply the family allowances of the Law, which in practice reduce the tax to nil.

What is the tax impact of these refunds in their home country?

The refund of Spanish Tax paid on the disposal of a property in Spain may had, of course, a tax impact in the home country taxation of the tax payer when the refund was  finally obtained.

The impact of the refund of the Spanish Tax would greatly depend on the manner the capital gain was originally taxed in tax payer’s home country. At home country level, the refund simply implies that the foreign tax paid on the disposal of the property would be reduced (for instance in the case of the Capital Gains Tax (” CGT”) from 35 % to 15 %).

As a general rule, in those countries were double taxation is eliminated under the exemption system (for example, Italy), foreign source income or capital gains are exempt. Therefore, the capital gain obtained on the disposal of the Spanish Property was not taxed at all. In these cases, the refund should not have any tax impact at home country level.

In other countries, like the United Kingdom and Ireland, where the so-called “imputation system” is in force the refund is likely to have some implications. Broadly speaking, the refund will reduce the foreign tax credit applied in the original tax return. As a result of this, a tax liability could arise in case the effective tax paid on the capital gain was higher than 15 %.

The concept “effective tax” means that one should not consider the nominal tax rate applied to the capital gain. On the contrary you should take into account every relief and allowances originally applied to determine the amount chargeable to Capital Gains Tax (CGT). The most important ones are the indexation allowance, the taper relief and the annual exempt amount (EUR 12.500 approximately). There are many other relieves that could reduce, eliminate or defer the chargeable amount to CGT. However, if after application of these tax incentives the effective tax paid on the disposal of the property still exceeded 15 %, the seller may be required to pay the difference to the tax office.

In most cases the tax impact at home country level was likely to be minimal or did not exist at all. However, tax payers with very high revenues and short holding periods (speculative buying) were likely to have a tax impact in the UK.

Other issue which is important with regard to the UK citizens is that if they are  not ordinarily resident in the UK or are domiciled outside the UK  special rules apply. Basically if they do not send the proceeds of the sale to the UK they are not taxed on foreign capital gains.