Double Taxation Treaties: Why Even Properly Structured Models Sometimes Fail

In international tax practice, Double Taxation Treaties are traditionally perceived as tax optimization tools. This logic is deeply rooted among both entrepreneurs and advisers: choose the “right jurisdiction,” apply a reduced withholding tax rate on dividends, rely on a treaty — and the tax burden will be minimized.

In practice, it is precisely this simplification that causes most mistakes.

Treaties were never designed as tax‑reduction mechanisms. Their primary function is the allocation of taxing rights between states. They do not answer the question “how much tax to pay”; they answer the question “where tax should be paid.” When this fundamental principle is ignored, even formally correct structures begin to produce unexpected — and often opposite — results.

This is particularly evident in connection with Portugal, which in recent years has become a key tax residency country for international clients. Historically, the NHR regime allowed the creation of structures with minimal taxation on passive income, including dividends. However, even under NHR, the exemption was not automatic — it was based on the application of the relevant treaty and on the principle that it was sufficient for income to “may be taxed” in the source country.

This distinction is crucial. The ability to tax and actual taxation are not the same. This is why, in many structures involving Cyprus or the UAE — where dividends are either not taxed or taxed minimally — Portugal produces the opposite tax outcome in similar circumstances. Not because the treaty “exempts” the income, but because it allows the residence country to apply an exemption mechanism.

With the introduction of the IFICI regime, the situation has changed not in terms of results, but in terms of approach. IFICI does not include an embedded dividend exemption as NHR did; however, this does not mean automatic taxation either. In practice, everything returns to the basic framework: analysis of the treaty, income qualification, beneficial ownership status, and the applicability of anti‑abuse rules. In certain cases, the outcome may remain the same — even down to a zero rate — but it now requires proper legal substantiation rather than arising by default.
Under IFICI, the exemption of foreign income depends on the qualification of the income and the specific treaty article applied.

It is at this stage that the core problem of most structures becomes apparent: they are designed with the source country in mind, while ignoring the residence country of the beneficiary.

A classic example is the use of a Cypriot company. Cyprus does indeed offer a favorable regime: no withholding tax on dividends and an effective tax rate of 0% under certain conditions. However, for a Portuguese tax resident, this is only half the picture. If the exemption mechanism does not apply, dividends will be taxed in Portugal at 28%. As a result, a “zero‑tax” structure becomes one of the most expensive.

The same logic applies to the UAE. The absence of tax in the source jurisdiction does not mean the absence of taxation in the residence country. Moreover, when the source‑country tax is zero, the foreign tax credit mechanism does not work, and the entire tax burden shifts to Portugal. The only way to avoid this is the correct application of the treaty and the ability to substantiate an exemption — something increasingly challenged in practice through anti‑abuse tools.

The United States presents the opposite problem. Here, the issue is not the absence of tax, but excessive taxation. The standard withholding tax rate is 30%, and although treaties allow reductions, access to treaty benefits is strictly controlled. U.S. practice активно applies beneficial ownership and limitation‑on‑benefits concepts, and structures lacking genuine economic substance quickly lose treaty protection. As a result, the actual tax burden often turns out to be far higher than anticipated at the planning stage.

Poland also deserves special attention, having become one of the most aggressive jurisdictions in applying anti‑abuse rules in recent years. Following the implementation of the MLI, Polish practice has shifted significantly toward analyzing the economic substance of transactions. Formal structures lacking real management and business purpose are increasingly disregarded, and treaty benefits denied. This makes the Ukraine–Poland–Portugal chain one of the riskiest in the absence of sufficient substance.

However, the greatest number of mistakes arises not in passive income, but in active income — primarily employment and entrepreneurial activities.

With respect to salaries, a simplified logic is still widely applied: income is taxed where the employer is located. In practice, this leads to systematic errors, particularly where Ukrainian companies continue paying salaries to employees who actually live and work in Portugal.

Treaties follow a different logic. Article 15 establishes taxation in the country where the work is physically performed. This means that in most such cases Portugal acquires the taxing right, regardless of where the employer is registered or where the payment is made. Ukraine either loses this right or a situation of double taxation arises, requiring subsequent relief through tax credits.

The situation becomes more complex when an employee performs functions beyond ordinary employment. If the individual participates in contract negotiations or acts as a company representative, a permanent establishment may arise. This is no longer a matter of individual taxation, but of business taxation, with significantly more serious consequences.

The situation is even more complex with entrepreneurial activity, particularly involving Ukrainian sole proprietors (FOP). A common assumption is that registration in Ukraine and the use of a simplified tax regime automatically “anchor” income to Ukrainian jurisdiction. From a treaty perspective, this is incorrect.

Once again, the key factor is the place where the activity is actually carried out. If an individual resides in Portugal, makes decisions, provides services, and manages the business from there, that country is regarded as the center of economic activity. In such cases, Portugal acquires taxing rights over the business income regardless of FOP registration in Ukraine.

Ukraine, however, continues to tax the income under its domestic rules, creating a real risk of double taxation. Moreover, credit mechanisms do not always function properly due to differences in income qualification and the specifics of the simplified tax system.

Additional complexity arises from tax authorities’ growing tendency to reclassify income. Depending on the factual circumstances, business income may be treated as employment income, especially where the activity displays features of dependent work. This leads to a reassessment of the applicable treaty provisions and a change in tax consequences.

Taken together, these factors demonstrate that modern double taxation treaties are no longer instruments of “optimization” in the classical sense. They have become tools of control and tax base allocation, where substance prevails over form and economic reality overrides formal structure.

For this reason, simply “choosing the right jurisdiction” is no longer sufficient. It is necessary to design structures, contracts, and personal tax strategies that withstand scrutiny at the level of treaties, domestic law, and anti‑abuse rules simultaneously. Otherwise, even a formally correct model may be fully recharacterized, and the expected tax outcome will not be achieved.

Kateryna Biezhanova

Legal Counsel specializing in international tax matters