Treaty Tiebreaker Rule vs Closer Connection

Treaty Tiebreaker Rule vs Closer Connection

Treaty Tiebreaker Tax Rule vs Closer Connection

Treaty Tiebreaker Tax Rule vs Closer Connection: The IRS Closer Connection Test and Treaty Tiebreaker rules are two sides of the same coin. The closer connection test deals with a non-resident who meets the US Substantial Presence Test and is therefore taxed on their worldwide income just as if they were a citizen or permanent resident. If the taxpayer can show a closer connection to a foreign country(s) with Form 8840 — they will not be taxed as a US person. Legal permanent residents or even non-residents who have applied for a green card do not qualify for the closer connection test. Instead, they would submit under the treaty tiebreaker rules and make a treaty election on Form 8833 claiming residence in a foreign country.

Let’s explore the difference between the closer connection test and treaty tiebreaker rules.

Expatriation, Dual-Residence & Treaty Tiebreaker

For purposes of expatriation, a non-resident who meets the substantial presence test need not worry exit tax because they do not fall into the category of individuals who can even be subject to expatriation. For permanent residents who are coming close to the eight-year long term resident mark, a treaty position may benefit them — but it is important to apply for the position before they become a long-term resident — otherwise filing the form and claiming foreign residents will trigger the expatriating event.

Treaty Tie Breaker Rules form 8833

While not all tax treaties are the same, let’s take a look at one provision which is relatively common for our clients  — which is the Australia US tax treaty.

Australia Tax Treaty Article 4 and Treaty Tiebreaker

“Residence

(1) For the purposes of this Convention:

(a) a person is a resident of Australia if the person is:

(i) an Australian corporation; or

(ii) any other person (except a company as defined under the law of Australia relating to Australian tax) who, under that law, is a resident of Australia, provided that, in relation to any income, a person who:

(iii) is subject to Australian tax on income which is from sources in Australia; or

(iv)  is a partnership, an estate of a deceased individual or a trust (other than a trust that is a provident, benefit, superannuation or retirement fund, or that is established for public charitable purposes or for the purpose of enabling scientific research to be conducted by or in conjunction with a public university or public hospital, the income of which is exempt from tax under the law of Australia relating to Australian tax), shall not be treated as a resident of Australia except to the extent that the income is subject to Australian tax as the income of a resident, either in the hands of that person or in the hands of a partner of beneficiary, or, if that income is exempt from Australian tax, is so exempt solely because it is subject to United States tax; and

(b) a person is a resident of the United States if the person is:

(i) a United States corporation; or

(ii) any other person (except a corporation or unincorporated entity treated as a corporation for United States tax purposes) resident in the United States for purposes of its tax, provided that, in relation to any income derived by a partnership, an estate of a deceased individual or a trust, such person shall not be treated as a resident of the United States except to the extent that the income is subject to United States tax as the income of a resident, either in its hands or in the hands of a partner or beneficiary, or, if that income is exempt from United States tax, is exempt other than because such person, partner or beneficiary is not a United States person according to United States law relating to United States tax.

(2) Where by application of paragraph (1) an individual is a resident of both Contracting States, he shall be deemed to be a resident of the State:

  • in which he maintain his permanent home;
  • (b) if the provisions of sub-paragraph (a) do not apply, in which he has an habitual abode if he has his permanent home in both Contracting States or in neither of the Contracting States; or
  • (c) if the provisions of sub-paragraphs (a) and (b) do not apply, with which his personal and economic relations are closer if he has an habitual abode in both Contracting States or in neither of the Contracting States

(3) For the purposes of this paragraph, in determining an individual’s permanent home, regard shall be given to the place where the individual

  • dwells with his family, and in determining the Contracting State with which an individual’s personal and economic relations are closer, regard shall be given to his citizenship (if he is a citizen of one of the Contracting States).
  • An individual who is deemed to be a resident of one of the Contracting States for any year of income, or taxable year, as the case may be by reason of the provisions of paragraph (2) shall, for all purposes of this Convention, be deemed to be a resident only of that State for such year.”

What does this mean?

When a person is considered a resident of either Australia and the United States, but may qualify as a resident of both countries, the taxpayer will have to perform and analysis of their economic and other factors to determine the proper country of residence.

This is important for many expatriates who may be facing significant exit tax consequences depending on which country is considered their country of residence in any particular year.

Closer Connection Form 8840

The closer connection test is a bit different. It is used to avoid substantial presence which then requires the non-resident to be taxed as a US person.

As provided by the IRS:

Closer Connection Exception Definition

“Even though you would otherwise meet the substantial presence test, you will not be treated as a U.S. resident for 2020 if:

  • You were present in the United States for fewer than 183 days during 2020;
  • You establish that, during 2020, you had a tax home in a foreign country; and
  • You establish that, during 2020, you had a closer connection to one foreign country in which you had a tax home than to the United States, unless you had a closer connection to two foreign countries.

Closer Connection to Two Foreign Countries

You can demonstrate that you have a closer connection to two foreign countries (but not more than two) if all five of the following apply.

  1. You maintained a tax home as of January 1, 2020, in one foreign country.
  2. You changed your tax home during 2020 to a second foreign country.
  3. You continued to maintain your tax home in the second foreign country for the rest of 2020.
  4. You had a closer connection to each foreign country than to the United States for the period during which you maintained a tax home in that foreign country.
  5. You are subject to tax as a resident under the tax laws of either foreign country for all of 2020 or subject to tax as a resident in both foreign countries for the period during which you maintained a tax home in each foreign country.

In conclusion, the tax treaty tie-breaker vs closer connection exception analysis is complicated. When a US person is considering expatriation, they may seek to strategize in order to claim foreign residence in prior years. That is because the 8 of 15-year test for long-term residents excludes any year in which the taxpayer was considered a foreign resident.

We Specialize in IRS Offshore Disclosure & International Tax Compliance

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