Credit and Exemption Method

With the credit system the state of residence (or state of citizenship) grants a credit of income tax paid in the state of source. Under the exemption system, the source or situs state has the preferential right to tax the income and the residence state exempts the income from taxation. In short, CEN requires that the worldwide or residence principle in combination with the tax credit method is applied. CIN, on the other hand, requires that the source principle in combination with the exemption method is applied.

One great advantage of the tax credit system is that double exemption can never apply if there are no special provisions against it. The residence state may tax always. On the other hand, tax credits take away any relief given by the source state to attract foreign investors.

Under the exemption system, normally the residence state takes into account taxed foreign income but only to compute the tax rate on the income earned in the residence state. This technique is called progressive saving clause. Compared with the income in one state only, the overall tax burden of foreign and domestic income is less because the tax rate is mainly calculated as an average rate and not as a marginal rate.

Between many countries a mixture of the credit and the exemption method in bilateral tax treaties is in force. In general, one can say that income deriving from passive income, like income from royalties, from immovable property, from interests and dividend payments, foreign tax is credited in the resident country. Active income from employment, business profits and personal services are exempted in the resident country. This means that CEN mainly applies to passive income and CIN mainly applies to active income.

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