Double Taxation Treaties: What They Do, and What They Do Not

A founder incorporates a company in the United Kingdom while continuing to live and work in Türkiye. Revenue comes from clients across Europe. At some point the question arrives: where is this income actually taxed, and is it being taxed twice?

The instinct is to reach for the double taxation treaty between the two countries and assume it solves the problem. Treaties are genuinely powerful instruments, but they work in a more specific way than most people expect, and they do not operate automatically.

What a treaty is actually for

A double taxation treaty is an agreement between two states that allocates taxing rights between them. It does not create tax, and it does not remove tax. It decides which state gets to tax which category of income, and in what circumstances the other state must give relief.

Most treaties follow the OECD Model Convention structure. That means the same architecture recurs across hundreds of bilateral agreements: definitions of residence, rules for business profits, separate articles for dividends, interest, royalties, employment income, capital gains, and a mechanism for eliminating double taxation.

The consequence is that the analysis is always the same shape. Identify the type of income. Find the relevant article. Determine which state has the primary right to tax. Then apply the elimination method the treaty specifies.

Residence comes first

Nothing in a treaty works until you establish residence, because the treaty only applies to residents of the contracting states.

For companies, residence usually turns on incorporation, place of effective management, or both, depending on the domestic law of each state. This is where cross-border founders frequently run into difficulty. A company incorporated in the UK is generally UK tax resident — but if the directors take all substantive decisions from Türkiye, the company may also be treated as tax resident in Türkiye under Turkish domestic rules. Two residences, two sets of worldwide taxing claims.

Treaties handle this through tie-breaker provisions. Where a company is resident in both states under domestic law, the treaty determines a single treaty residence, historically by reference to place of effective management and, under more recent treaty practice, sometimes by agreement between the tax authorities.

The practical point: incorporating abroad does not, by itself, move where a business is taxed. Substance — where decisions are made, where people work, where the operation genuinely sits — carries more weight than the certificate of incorporation.

Permanent establishment: the central concept

For business profits, the governing principle is that a company is taxed only in its state of residence, unless it carries on business in the other state through a permanent establishment there.

A permanent establishment is typically a fixed place of business — an office, branch, factory, workshop — or a dependent agent who habitually concludes contracts on the company's behalf. Construction sites usually become a permanent establishment after a threshold period specified in the particular treaty.

Certain activities are generally excluded: storage, display, purchasing, or activities of a preparatory or auxiliary character. But the boundary is narrower than it used to be, and treaty practice has tightened in response to arrangements designed to fragment activity across entities to stay below the threshold.

If a permanent establishment exists, the other state may tax the profits attributable to it. If it does not, that state generally has no claim on the business profits at all. This single determination often decides an entire cross-border tax position.

Withholding taxes on passive income

Dividends, interest and royalties are treated differently. Here the treaty usually permits the source state to tax, but caps the rate.

Domestic withholding rates can be substantial. A treaty may reduce the rate on dividends materially, and often further where the recipient holds a specified minimum shareholding. Interest and royalties are typically capped at their own treaty rates.

Two practical points follow. First, treaty rates are not automatic — the payer or the recipient normally has to claim the benefit, usually by producing a certificate of tax residence and satisfying procedural requirements in the source state. Miss the process and the domestic rate applies, with a refund claim as the only remedy. Second, treaty benefits are increasingly conditioned on the recipient being the beneficial owner of the income and on the arrangement not having treaty benefit as a principal purpose.

The anti-abuse layer

This last point deserves emphasis, because it has changed the landscape.

Modern treaty practice includes provisions designed to deny benefits to arrangements set up primarily to obtain them. Many treaties now contain a principal purpose test, introduced through the multilateral instrument that amended a large number of bilateral treaties simultaneously. The effect is that a structure which is technically within the letter of a treaty can still be denied benefits if obtaining those benefits was one of the principal purposes of the arrangement, and granting them would be contrary to the treaty's object.

Alongside this sit domestic rules — controlled foreign company regimes, transfer pricing requirements, economic substance rules in several jurisdictions — that operate independently of the treaty and can produce a taxing charge regardless of what the treaty says.

The era in which a holding company in a favourable jurisdiction could be inserted purely for treaty access has largely closed. Structures now need commercial rationale and demonstrable substance.

Relief methods

Where both states retain a taxing right, the treaty specifies how double taxation is eliminated. Two methods dominate.

Under the credit method, the residence state taxes the income but allows a credit for tax paid in the source state, usually capped at the residence state's own tax on that income. Under the exemption method, the residence state exempts the foreign income, sometimes taking it into account for rate purposes.

Which method applies depends on the treaty and often on the income type. The difference matters: a credit levels the total burden up to the higher of the two rates, while an exemption can leave the lower source-state rate as the final cost.

Practical guidance

Establish residence before anything else. Where the company is genuinely managed determines a great deal, and it is assessed on facts rather than paperwork.

Assess permanent establishment risk honestly. An employee working from another country, a local agent with authority to conclude contracts, a long-running project — each can create a taxable presence that was never intended.

Handle withholding procedurally. Obtain residence certificates in advance and understand the source state's claim process. Treaty rates that are not claimed correctly are not obtained.

Build substance where you claim residence. Directors who meet where the company is resident, decisions minuted there, real operational presence. Substance is now the pivot on which most cross-border tax positions turn.

Read the specific treaty, not a summary. Treaties differ. Rates, thresholds, permanent establishment periods and anti-abuse provisions vary from one bilateral agreement to the next, and a general rule can be wrong in a particular pairing.

In short

A double taxation treaty is a rulebook for allocating taxing rights, not a shield. It rewards structures with genuine substance and clear analysis, and it offers little to arrangements built solely for the tax outcome. The businesses that benefit are the ones that determine residence, permanent establishment and income characterisation properly at the outset — before the first return is filed rather than after the first assessment arrives.

This article is provided for general information only and does not constitute legal or tax advice. Treaty outcomes depend on the specific bilateral agreement, the domestic law of each state and the facts of the arrangement. For advice on a particular structure, please get in touch.