Double Taxation Treaties and FDI in Developing Jurisdictions

As globalisation continues to deepen and countries engage in economic activity with each other, double taxation has become an enormous issue for multinational businesses and governments of developing and developed countries alike. “Double taxation” generally refers to the situation in which the same income is taxed in more than one jurisdiction. It can impose fiscal barriers, discourage foreign investment, and interrupt international cross-border trade. Countries around the world manage this issue through bilateral agreements, called Double Taxation Treaties (DTTs), which can promote economic cooperation by identifying and allocating taxing rights between the source country and the residence country while minimising double taxation. Double Tax Treaties (DTTs) are structured in accordance with universally recognised OECD and United Nations models and can eliminate double taxation, prevent tax evasion, and create legal certainty for investors. DTTs are significant instruments for attracting foreign direct investment (FDI) into developing countries like Pakistan and for improving international economic relationships and creating and maintaining an economically competitive environment.

Understanding Double Taxation Treaties (DTTs)

Double Taxation Treaties (DTTs) are international conventions between sovereign states, aimed primarily at avoiding a situation where the same income is taxed in more than one jurisdiction [1]. DTTs are meant to mitigate and address the adverse economic effects of double taxation and assist in global trade by promoting international economic cooperation. DTTs are mutual bilateral arrangements developed by way of negotiation between two states that lay down the principles for preventing the taxation of income and profits obtained from the cross-border transactions of multinational businesses. This means that income should be taxable only in the host country or the source country where this income is derived from. According to the generally accepted norm, the country where the income originates maintains primary taxing rights. When there is no DTT in place, source countries might tax active income (which includes business profits and wages) as well as passive income (dividends, interest, and royalties). This could mean that income would be subject to tax not only in the country where the business or work is carried out, but also again in the residence country of the taxpayer. This brings heavy fiscal burdens for cross-border businesses. This is precisely the reason that international principles emphasise that countries should refine their tax systems in such a way that two or more countries do not tax the same income resulting from cross-border transactions [2]. Double Taxation Treaties are mainly meant to eliminate double taxation, especially for a corporate entity that is residing in one country but derives income from a permanent establishment or branch located in another country. Double Taxation Treaties (DTTs) define a Permanent Establishment (PE) as a fixed place of business that is engaged in active business operations. This definition is really important, as the treaty gives taxing rights to the host country over the revenue generated by permanent establishments within its territory [3]. To avoid income being taxed twice, DTTs lay down a principle that the home country will either provide an exemption for that income or provide tax credits for taxes that have already been paid to the source country. In addition, DTTs also provide guidance on the taxation of passive income such as dividends, interest, and royalties. Under the OECD Model, passive income is largely taxed in the home country. However, the source country retains some taxing rights. The DTTs usually limit withholding tax in the source country, which is usually at 5% for intercompany dividends, 10% for interest, and 0% for royalties, respectively. Apart from the elimination of double taxation, the double taxation treaties also serve as a major instrument to prevent tax evasion. Further, DTTs add another layer of predictability for multinational businesses, as they contain provisions to limit the maximum tax a source country can impose on an international entity. This allows the business entity to have a clearer understanding of tax liabilities that they may face in host countries and assists in mitigating the risk of excessive taxation.

Historical Evolution and the OECD’s Model of DTTs

Double taxation, which is understood as the imposition of tax on the same income in two jurisdictions, has always been one of the serious issues in international taxation. Initiatives to combat double taxation, including bilateral treaties and agreements, date back to the 18th century, and of all these treaties, the 1899 treaty by Austria, Hungary, and Prussia is known as the first modern Double Taxation Treaty. According to the International Bureau of Fiscal Documentation, 65 percent of the existing worldwide stock of DTTs, which is currently at 3,300, was signed within the last 20 years. This might be associated with the increase in the scope and scale of international economic activities. Modern DTTs are mostly based on the models developed by the OECD and the UN, which, in turn, derived a lot from older League of Nations models created between 1927 and 1946. These foundational texts have had a great influence on the creation of modern international tax agreements. The OECD has often emphasised that unsolved problems of double taxation can seriously affect the development of economic relationships between states [4]. The Organisation for Economic Co-operation and Development (OECD) has also acknowledged the damage that double taxation causes to the inflow of foreign direct investment and how it is an obstacle for international economic engagement [5]. In view of this, the OECD produced a model tax convention that was made with the purpose of assisting countries in their bilateral negotiations. The present model is intended to create uniformity and clarity in taxation treatment to prevent situations of double taxation by establishing standardised provisions across all tax treaties. As for the OECD, it first developed the “Model Tax Convention on Income and on Capital” from 1956 to 1961 and officially published it in 1963. The first extensive modification occurred in 1977, and from that time onwards, the model and its commentaries have been updated from time to time. It plays a very important role in the harmonisation of tax definitions, determining taxable bases, clarifying jurisdictional boundaries, and offering procedural mechanisms to resolve cases of double taxation. The model designed by OECD also provides a mechanism for the signatories to share information among tax authorities of the respective countries, which helps a lot in discovering and curbing tax avoidance. DTTs usually follow a standardised title such as “The Convention Between (Country A) and (Country B) for the Avoidance of Double Taxation and for Preventing Fiscal Evasion with Respect to Taxes on Income.” An example could therefore be “Agreement Between the Federal Republic of Germany and the Islamic Republic of Pakistan with Respect to Avoidance of Double Taxation with Respect to Taxes on Income” [6].

Economic Benefits for Developing Countries like Pakistan

Investment is an important driver for economic development in both developed and developing countries. This helps maintain macroeconomic stability, allocate resources more efficiently, create jobs, and increase living standards [7]. DTT contributes to these goals by removing the preventive effects of double taxation, which encourages investment across borders, improves the investor’s confidence, and ensures legal security. In addition, DTT has processes to detect and prevent tax evasion, which improves the overall fiscal regime. Although developing countries, such as Pakistan, may incur some loss in revenue from spending valuable time and resources in negotiating tax treaties, the resulting economic benefits of tax treaties like increased FDI and improved international relations likely outweigh such losses. DTTs tend to favor residence-based taxation over source-based taxation, and developing countries are typically net importers of capital. In other words, they are net recipients of investment and capital inflow from foreign sources rather than investing abroad. Thus, any potential loss of revenue can be justified, as these countries believe they will receive more foreign direct investment in return [8]. Double tax treaties (DTTs) can help reduce financial friction associated with moving corporate income across borders, thereby making investment in foreign markets more attractive to multinational business organisations. As research suggests, DTTs may cause overall foreign direct investment (FDI) to increase by as much as 18% [9]. To increase their attractiveness, countries such as Pakistan sign bilateral investment treaties (BITs) to provide strong indications of legal stability and security for investment. Pakistan’s first BIT was signed with Germany in the year 1959 [10]. Most BITs contain obligations that eliminate any discrimination in the treatment of foreign investors, guarantee just compensation in cases of expropriations, and permit the free movement of capital and profits. BITs frequently include compulsory dispute resolution mechanisms for potential disputes that might arise in the future [11]. By using such international legal instruments, Pakistan attempts to offer the impression of a safe and encouraging climate for investment. Bilateral investment treaties provide assurances to foreign investors that their treatment will be legally equal to domestic businesses. BITs also operate using the “most-favoured-nation” principle, which means if any favourable terms are offered to one investor, then all other foreign investors must be offered the same favourable terms [12]. As a developing, capital-importing country, Pakistan is eager for foreign investment to resolve long-standing economic problems, like trade imbalances and production capacity that remains underutilised [13]. The vast majority of the foreign direct investment (FDI) Pakistan receives originates from economically advanced countries in Europe, North America, the Middle East, and, more recently, China. Studies in the area of International Business have demonstrated that Double tax treaties (DTTs) significantly enhance the flow of FDI into developing countries, as they give investors confidence in the tax system due to more clearly defined rules and structures to enforce them [14]. Currently, bilateral double taxation treaties (DDTs) that were entered into between a developed and a developing country represent more than 2/3 of all global treaties. Since 2003, foreign direct investment (FDI) has become the most important source of external capital for a large number of developing countries, surpassing all other external capital flows, and it looks like it will not change any time soon. Developed countries routinely enter into DTTs with least-developed countries to protect their multinational business entities from unfair taxation, which also creates conditions that are mutually beneficial for the investment.

Double Taxation Treaties (DTTs) not only help in eliminating the instances of double taxation of the same income but also promote Foreign Direct Investment (FDI), which is critical for developing countries such as Pakistan. Through simplifying rules and raising the level of tax certainty, DTTs can provide some level of security and confidence to international investors. As a result, international investors are more inclined to invest their money in countries where they know the tax system is fair and stable. For Pakistan, which needs foreign investment to grow its economy, DTTs are very helpful. They make it easier for businesses to operate across borders without worrying about paying taxes in two places. When DTTs are used alongside other investment agreements, they create a strong foundation for attracting more businesses from around the world. In the future, having well-planned and fair tax treaties will be even more important for countries that want to grow through international investment.

References

[1] Veronika Daurer, ‘Tax Treaties and Developing Countries’ (2014) 42 Intertax 695 <https://doi.org/10.54648/taxi2014062> accessed 11 March 2025.

[2] Michael Lang, Introduction to the Law of Double Taxation Conventions (2013) <http://ci.nii.ac.jp/ncid/BB14485306> accessed 11 March 2025.

[3] Paul L Baker, ‘An Analysis of Double Taxation Treaties and Their Effect on Foreign Direct Investment’ (2014) 21 International Journal of the Economics of Business 341 <https://doi.org/10.1080/13571516.2014.968454> accessed 11 April 2025.

[4] OECD, Model Tax Convention on Income and on Capital: Condensed Version 2010 (OECD Publishing 2010) <https://doi.org/10.1787/mtc_cond-2010-en> accessed 12 April 2025.

[5] ibid

[6] Germany–Pakistan Income Tax Treaty’ (signed 14 June 1994, in force 30 December 1995) <https://download1.fbr.gov.pk/Docs/20181089104537463Germany.pdf> accessed 20 February 2025.

[7] Eric Neumayer and Laura Spess, ‘Do Bilateral Investment Treaties Increase Foreign Direct Investment to Developing Countries?’ (2005) 33 World Development 1567 <https://doi.org/10.1016/j.worlddev.2005.07.001> accessed 12 April 2025.

[8] Eric Neumayer and Laura Spess, ‘Do Bilateral Investment Treaties Increase Foreign Direct Investment to Developing Countries?’ in Karl P Sauvant (ed), Yearbook on International Investment Law and Policy 2009/2010 (Oxford University Press 2009) <https://doi.org/10.1093/acprof:oso/9780195388534.003.0007> accessed 12 April 2025.

[9] Kunka Petkova, Andrzej Stasio and Martin Zagler, ‘On the Relevance of Double Tax Treaties’ (2019) 27 Intl Tax Public Finance 575 <https://doi.org/10.1007/s10797-019-09570-9> accessed 10 February 2025.

[10]  Germany–Pakistan Bilateral Investment Treaty’ (1959) UNCTAD Investment Policy Hub <https://investmentpolicy.unctad.org/international-investment-agreements/treaties/bilateral-investment-treaties/1732/germany—pakistan-bit-1959> accessed 10 February 2025.

[11] UNCTAD, Bilateral Investment Treaties in the Mid-1990s (United Nations 1998).

[12] Allison Christians, ‘Tax Treaties for Investment and Aid to Sub-Saharan Africa: A Case Study’ [2005] SSRN Electronic Journal <https://doi.org/10.2139/ssrn.705541> accessed 12 April 2025.

[13] Shabir J, Khan NA and Khalid M, ‘Tax Policy: A Review of Pakistan’s Tax Treaties and Recommendations for Actions’ <https://file-thesis.pide.org.pk/pdf/ms-management-sciences-2020-jawad-shabir–tax-policy-a-review-of-pakistans-tax-treaties-and-recommendations-for-actions.pdf> accessed 12 April 2025.

[14] Eric Neumayer, ‘Do Double Taxation Treaties Increase Foreign Direct Investment to Developing Countries?’ (2007) 43 The Journal of Development Studies 1501 <https://doi.org/10.1080/00220380701611535> accessed 12 April 2025.