Tax treaties entered the U.S. news headlines in July as the Senate approved updates to international tax treaties for the first time in nearly a decade. With an overwhelming vote in the Senate, the treaty protocols with Japan, Luxembourg, Spain and Switzerland signaled a major bipartisan victory for multinational companies in the United States. Other treaties with Chile, Hungary and Poland are also awaiting consideration and approval before the end of the calendar year.
Treaties are essential components to encourage international trade and investment, to promote cooperation among countries in enforcing and administering tax laws, and to facilitate information exchanges. This is particularly important as organizations of all sizes become increasingly more global and develop a more robust international presence.
Whether you are a foreign national, a foreign entity with a U.S. location, or a U.S. company with foreign operations, be aware of the tax treaties in place and how they may better serve you and your business.
What is a tax treaty?
A tax treaty is a bilateral agreement between two countries to resolve issues regarding double taxation of passive and active income.
Treaties also facilitate information exchanges and the reduction or elimination of source country tax for residents investing in international treaty countries. The details of the treaty dictate the amount of tax that a country can apply to a taxpayer’s income, capital, estate, or wealth.
Ultimately, when an individual or business invests in a foreign country, the question arises of which country can tax the investor’s earnings. Here is where the tax treaty comes into play. By entering into an international income tax treaty, the countries determine who taxes the investment income in order to prevent double taxation.
The source country, also known as the capital-importing country, is the one that hosts the incoming investment. On the other side is the residence country, also referred to as the capital-exporting country, which is the resident country of the investor.
To avoid double taxation, countries enter into a tax treaty typically following one of two models:
- Organization for Economic Co-operation and Development (“OECD”) Model
- United Nations (“UN”) Model Convention
What does a U.S. tax treaty entail?
The United States is part of income tax treaties with over 60 foreign countries. Currently, the U.S. treaty network includes most European countries and other major trading partners such as Mexico, Canada, Japan, China, Australia and former Soviet Union countries. Under the determination of these treaties, the residents of foreign countries (not necessarily citizens) may be eligible for taxation at a reduced rate or completely exempt from U.S. income taxes on certain items of income generated from sources in the United States. The rates and exemptions vary between countries and specific items of income.
Keep in mind that some individual states honor the guidelines of U.S. tax treaties and some do not.
Generally, tax treaties reduce the U.S. taxes of international residents as explained by their country’s treaty with the U.S. With certain exceptions, they do not reduce the U.S. taxes of U.S. residents or citizens. Rather the U.S. federal government taxes the U.S. residents or citizens on their worldwide income.
Typically, the terms of the treaty are applicable to both treaty countries. Therefore, a U.S. citizen or resident investing in and receiving income from a foreign treaty country will be taxed by that country. However, per the treaty provisions, the taxpayer may be eligible for specified credits, deductions, exemptions and reduced rates. U.S. citizens residing internationally may also be entitled to particular benefits under the guidelines of the country’s tax treaties with other third countries.
U.S. income tax treaties usually cover various categories of income, such as:
- Business profits
- Passive income, such as dividends, interest, and royalties
- Income earned by teachers, trainees, artists, athletes, etc.
- Gains from the sale of personal property
- Real property income
- Employment income
- Shipping and air transport income
- Income not otherwise expressly mentioned
For more information regarding the types of income that are exempt or subject to a reduced rate under the current U.S. tax treaties, please refer to the Treaty Tables issued by the Internal Revenue Service (IRS).
Likewise, for a list of current U.S. treaties, please refer to IRS Publication 901 U.S. Tax Treaties. You can also access the U.S. Department of the Treasury’s Treaties and Tax Information Exchange Agreements (TEIAs) resource center which offers copies of the formal treaties with other countries upon signature. The IRS offers a similar service HERE.
There are periodic updates to tax treaties, as well as amendments (known as protocols). Therefore, it is important to stay current on the most recent version of the tax treaties affecting you and/or your business.
What is the structure of a U.S. tax treaty?
Generally, tax treaties are organized into articles. The order and names of the articles varies by treaty and some treaties, such as the U.S. treaty with China, does not include article names at all.
Articles describe the required conditions in order to reduce or eliminate U.S. tax on the income of foreign nationals or entities doing business in the United States. Articles also detail how the treaties function. For instance some common titles include “Entry into Force,” “Taxes Covered” and “Residency.” The “Saving Clause” is not a separate article but it is significant to discern when treaty benefits are lost or preserved.
There are also two types of articles that confer benefits:
- Articles based on the primary purpose of the foreign person’s visit to the United States
- Articles based on the character of the payment.
Entry into Force
Entry into Force articles detail the application date of treaty articles with reference to the effective date of the treaty. Articles related to withholding at the source, such as “Dividends,” “Interest” and “Royalties,” typically enter into force on the first day of the second full month following the effective date. All other provisions usually enter into force as of January 1 of the calendar year following ratification.
The Taxes Covered article included in U.S. treaties explains that the treaty applies to federal income taxes. Most treaties explicitly exclude Social Security taxes, and long-standing IRS rulings also declare that tax treaties do not cover Social Security taxes. However, the United States currently has agreements with over 20 countries that may provide exemptions from Social Security and Medicare taxes.
When it comes to state taxes, treaties may be indirectly applicable to state income taxes. Some states, such as Connecticut, amended their specific tax code to include income exempt under a tax treaty. Other states such as Pennsylvania detail their own definition of income and do not provide treaty exemptions.
Tax treaties apply to foreign nationals who are residents (not necessarily citizens) of one or both of the treaty countries. Treaty country residents are foreign nationals subject to income taxes as a tax resident under the internal law of the treaty country. For instance, the U.S. taxes their residents on their worldwide income. Therefore, a foreign national doing business in the U.S. is subject to the income tax regulations of the U.S.
A Savings Clause is common practice in U.S. tax treaties. The clause grants the United States the right to tax its citizens and residents as if the treaty was not in effect. It is designed to prevent U.S. citizens or residents from inappropriately abusing the treaty to reduce their U.S. tax liability. All but two treaties (Greece and Pakistan) include exceptions to the Savings Clause that allow foreign nationals who become residents to keep the benefits conferred under the Student/Trainee and Teacher/Researcher articles. Typically, foreign nationals who become U.S. citizens or green card holders lose these benefits.
How do you claim tax treaty benefits in the U.S.?
If a treaty does in fact exist between your country of residence and the U.S., you must notify the income payor (the withholding agent) of your foreign status in order to claim the benefits of the treaty. To achieve this, you must file Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding.
Upon properly completing and filing Form W-8BEN and providing a U.S. Taxpayer Identification Number (TIN), the person must certify that:
- It is a resident of a treaty country.
- It is the beneficial owner of the income.
- If it is an entity, it derives the income within the meaning of Section 894 of the Internal Revenue Code (IRC) (meaning it is not fiscally transparent).
- It meets any limitation on benefits provision contained in the treaty, if applicable.
Note that there are limitations on benefit (“LOB”) provisions regarding third country residents. For example, a foreign corporation may not be entitled to a reduced rate of income tax withholding unless a minimum percentage of its owners are citizens or residents of the United States (or the treaty country).
Also, if a nonresident alien makes an election with their U.S. citizen or resident spouse to receive treatment as a U.S. resident for income tax purposes, the nonresident alien cannot claim foreign resident status in order to utilize the reduced rate income tax benefits under an income tax treaty. However, recall that some exceptions in the Savings Clause in some treaties allow a resident of the U.S. to claim a tax treaty exemption on U.S. sourced income.
How can Squar Milner help?
Navigating the terms of different treaties can be complicated. However, we are here to help you maximize your tax benefits by taking advantage of reduced rates and exemptions.
Our International Tax features a number of highly technical and diligent professionals with considerable Big 4 experience. Specifically, we offer Treaty Analysis Services to help U.S. entities with foreign parents ensure that the U.S. company is protected from exposure for reduced withholding, is qualified for the treaty rates and has the required documentation on file to support the rate used.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.