Elimination of double taxation

by Lenka Fialková
23 Apr 2003

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.

2001 tax return: CZK

Accounting profit 1,580,000
Tax base 1,580,000
Tax rate 31%
Tax payable 489,800

2002 tax return: CZK

Accounting profit 1,580,000
Foreign tax (130,000)
Tax base 1,450,000
Tax rate 31%
Tax payable 449,500

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.

2001 tax return: CZK

Total income from employment 500,000
Tax paid in Kuwait (50,000)
Personal allowance (38,040)
Tax base 411,960
Tax base rounded 411,900
Tax payable
(411,900 - 331,200) x 32%
+ 66,420 92,244

Explanation
base. In the case of employment income, it is deducted from the income of the current year.
Therefore, double taxation is alleviated

immediately in 2001. The rule is based in Section 6 paragraph 13 of the Income Taxes Act.
The reader can see the differences between the solutions when the taxpayer has business
income and when he has employment income.

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.

2001 tax return: CZK

Accounting profit 1,580,000
Tax base 1,580,000
Exempt income (520,000)
Tax base 1,060,000
Tax rate 31%
Tax payable 328,600

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.

2001 tax return: CZK

Total income from employment 500,000
Working computation:
Personal allowance (38,040)
Tax base 461,960
Tax base rounded 461,900
Tax (461,900 - 331,200) x 32% + 66,420 108,244
Tax burden expressed in percentage:
108,244 / 500,000 21.65%
Income exempt (350,000)
Tax base 150,000
Tax rate 21.65%
Tax payable 32,475

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.

2001 tax return: CZK

Accounting profit 1,580,000
Tax base 1,580,000
Tax rate 31%
Tax payable 489,800
Tax credit
Working computation:
(520,000 / 1,580,000) x 489,800 = 161,200
Tax paid abroad:
130,000 is less than tax credit allowed
Tax credit used (130,000)
Tax payable 359,800

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.

2001 tax return: CZK

Total income from employment 500,000
Tax base 500,000
Personal allowance (38,040)
Tax base 461,960
Tax base rounded 461,900
Tax (461,900 - 331,200) x 32% + 66,420 108,244
Tax credit
Working computation:
(350,000 / 500,000) x 108,244 = 75,770
Tax paid abroad:
80,000 is more than tax credit allowed
Tax credit used (75,770)
Tax payable 32,474
Working computation:
excessive credit may be used as a tax expense in the following year:
80,000 - 75,770 = 4,230

Note: See my previous note under Example 1. Mr Novak will use this tax expense of 4,230
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.

CZK
Domestic profit of 200,000
Foreign loss of (300,000)
No tax expense
Total tax base in the Czech Republic (100,000)
Tax payable 0
Loss of (100,000) can be carried forward.

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.

CZK
Domestic profit of 200,000
Foreign loss of (300,000)
Total tax base in the Czech Republic (100,000)
Tax payable 0
No tax credit
Tax loss of (100,000) can be carried forward.

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.

CZK
Domestic profit of 200,000
Foreign loss of (300,000)
Exempt foreign loss 300,000
Total tax base in the Czech Republic 200,000
Tax payable 31 per cent 62,000

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
result is a loss, this can be carried forward for seven tax years.

CZK
Domestic profit of 200,000
Foreign loss of (300,000)
Total tax base in the Czech Republic (100,000)
Tax payable 0

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.

CZK
Domestic loss of (300,000)
Foreign profit of 200,000
Total tax base in the Czech Republic (100,000)
Tax payable 0
Excessive tax credit of 40,000

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.

CZK
Domestic loss of (300,000)
Foreign profit of 200,000
Exempt foreign income (200,000)
Total tax base in the Czech Republic (300,000)
Tax payable 0

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.