The Tax Treaty Income Tax Benefits Explained
The United States has entered into international income tax treaties with nearly 60 different countries. While there are various types of bilateral agreements between the United States and foreign countries such as estate and gift tax treaties; totalization agreements; and FATCA Agreements – the bilateral income tax treaties are the most robust. In general, tax treaties can be confusing, because some articles may only apply to non-citizens or non-permanent residents — and while some articles in the treaty may seem great — once the Saving Clause is factored in, the benefits fall by the wayside (especially for U.S. persons). One common application of the saving clause that limits the applicability of the treaty is when a US person resides overseas and earned a private pension from the US (see below). Still, there are many benefits to US tax treaties – let’s review some of the important benefits.
Saving Clause in a Tax Treaty
One of the most important aspects of any international tax treaty is the saving clause –– because it can significantly impact the income tax benefits of a tax treaty. The tax treaty is designed to provide tax clarity on various different topics involving how certain income will be taxed by one or both countries that are a party to the agreement. Conversely, the purpose of the saving clause is to preserve the right of each country to forgo the tax treaty and instead tax the income the way it would ordinarily be taxed if no tax treaty was in place. This comes into play often for US persons who are receiving a foreign income but are still subject to the worldwide income taxation rules.
Public Pension & Social Security
One key income tax benefit to a tax treaty can oftentimes be found in the public pension and Social Security provisions. In general, when the income received is paid out by one county’s government, most tax treaties will limit the ability to tax this specific type of income to the country of source and not the country of residence. For example, if a resident of one of the countries that are a party to a tax treaty receives Social Security from the United States, only the United States would have the ability to tax the Social Security. This is not true of all tax treaties, and one common example to keep in mind is the US-Canadian Tax Treaty which has a very robust section on matters involving Social Security and public pension.
Research and Teaching
Several tax treaties such as the US-China Tax Treaty provide that if a person was immediately a resident of one country but then relocated to the other country who is a party to the same tax treaty agreement — and works in certain fields such as research — then for the first three years the income earned would be exempt from tax in the country that they are earning it in. This is very important, especially for foreign residents who relocate to the United States and may otherwise not be taxed by their country on the income earned in the United States as most foreign countries follow a residence-based taxation law and not a Citizen-Based taxation rule.
Income Tax Withholding
Another important benefit to many of the tax treaties is a reduction in the withholding tax. For example, when a non-resident alien has a 401(k) in the United States then the baseline withholding rate is 30% because it qualifies as FDAP. By way of various tax treaty provisions, the withholding may be significantly reduced — depending on which country and the type of passive income being generated in the United States or vice versa.
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