What is a Tax Treaty Between United States & Foreign Country?

What is a Tax Treaty?

What is a Tax Treaty Between United States & Foreign Country: One of the most complicated aspects of being a US Person with global income — or foreign resident but earning income in a different country and residing in the US — typically turns out to be the tax implications — and dealing with the IRS. What makes this tax task so difficult, is that in some countries certain categories may be tax exempt — such as interest income in Asian countries — whereas that same income will not receive tax exempt status in the United States. Complicating the issues further is the fact that the United States follows a worldwide income tax model for US persons (CBT) — which is different than most other foreign countries that follow a Residence-Based Taxation system (RBT) — the latter being much more intuitive. As a result, when it comes time to prepare U.S. tax returns it can get incredibly (and unnecessarily) complex for Taxpayers with global income. In order to help provide some consistency with the tax requirements between the United States and foreign countries — the United states has entered into nearly 60 different international income tax treaties (There are other types of tax treaties as well, including Totalization Agreements, Estate and Gift Tax Agreements, and FATCA Agreements). Let’s go through the basics of a double income tax treaty to better understand the purpose and overall landscape.

Tax Treaties are The Same, But Different

Over the past 50+ years, the U.S. government has prepared different versions of Model Tax Treaty Agreements which helps to provide a framework for the individual different tax treaties. While many of the tax treaties have similar verbiage — they are not identical, so it is very important not to presume that one treaty will have the same rules for as another treaty will for the same type of income, just because they seem similar. This is especially important on issues including pension. 

5 Common Issues Handled in Tax Treaties

When it comes to international tax treaties there are many different issues that a taxpayer may have to contend with — depending on the facts and circumstances of their situation. Let’s go through the basics of five common issues that are usually included within a tax treaty:

Permanent Establishments (PE)

The idea behind a Permanent Establishment (PE) is that if a person in one country earns income in the other country, then generally that income will not be taxable in the other country (from income sourced in that other country) unless there is a permanent establishment. If there is a permanent establishment in the other country, then generally the other country can tax the PE on income generated from the Permanent Establishment.  Each treaty lays out the basics of what constitutes a permanent establishment — and what are the exceptions, limitations and exclusions as well.

Pension & Tax Treaties

When it comes to pensions, tax treaties will typically break it down into two main categories: private pension and public/other Government pension. Generally, with private pension, the income is taxable by location/residence — and therefore the country that Taxpayer resides in gets first crack a taxing the income — subject to the saving clause. Conversely, on issues involving public and other types of similar pension, it is usually taxable by source since it was generated through public means.

How Social Security is Handled in a Tax Treaty

Social Security is generally taxed at source. Therefore, even if a U.S. Citizen resides in the other treaty country (Contracting States) and receives Social Security from the United States — then unlike private pension, the United states would still have the opportunity to tax the Social Security. In several treaties, Social Security is exempt from the saving clause, so that whatever rules on social security are contained within the treaty would be the main source of law. If there are any disputes, Taxpayer can always request Competent Authority Assistance by way of the Mutual Agreement Procedure (MAP) within the treaty.

Passive Income Tax Treaty Basics

For the most part, passive income earned by a person in one country that is generated from the other country is taxable in the first country where the Taxpayer resides. But, the source country reserves the right to tax that same income as well — but usually the source country is limited to a set tax percentage — noting, that the Double Taxation rules limit the ability of both countries to tax the same income.

Mutual Agreement Procedure

Sometimes, Taxpayers may have a situation involving Double Taxation or some sort of tax matter which is inconsistent with how that taxpayer believes the treaty intends on handing on it. If this is the case, then the Taxpayer can look at the Mutual Agreement Procedure (MAP) along with Revenue Procedure 2015-40 to develop a strategy to determine – using the competent authority(s) — what the outcome of the tax situation should be in accordance with the spirit of the tax treaty.

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Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. 

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