Tax treaties are typically intended to lay down ground rules regarding the taxing rights of each country and, generally, to prevent double taxation. In practice, they tend to reduce or eliminate U.S. income tax liability and withholding on income sourced from the United States.

For example, suppose a citizen of Country X is temporarily present in the United States on business. In this situation, the individual is a nonresident alien under U.S. law and subject to U.S. taxation at specified rates on any salary, business income, investment and other income from the United States.

However, the U.S. treaty with Country X may exempt the person from tax or impose tax at lower rates on some or all of that income. The individual in question would be well advised to first determine whether the United States has an income tax treaty with Country X. If it doesn’t, the typical tax rules apply. However, if there’s a treaty, you should examine it for applicable exemptions or reductions in U.S. rates.

Be forewarned: Treaty reductions in foreign tax liability may not greatly benefit U.S. taxpayers because they’re taxable in the United States on foreign as well as domestic income. Thus, a reduction in foreign tax may mean a reduction in the U.S. foreign tax credit, with a corresponding increase in the amount of U.S. taxes paid. However, a reduction could help a U.S. taxpayer in certain cases, such as where the taxpayer’s foreign tax rate exceeds the U.S. federal tax rate.

How Does the Tax Code Address Treaties?

Internal Revenue Code Section 894 codifies the principle that any income excluded from the gross income of a nonresident alien or foreign corporation, or that’s otherwise exempt from U.S. taxation under the terms of an income tax treaty between the United States and another country, is excluded from gross income.

Generally, reciprocal exemptions are granted to individuals and foreign corporations that don’t have permanent establishments (PE) in the other country and that meet other requirements related to the duration, scope and nature of activities. PE is a term normally defined in a treaty. The challenge today is the definitions are often based upon brick and mortar operations and not on businesses involved in technology where intangibles are the main assets.

In addition, Sec. 6114 provides a taxpayer who takes the position that a treaty reduces or eliminates U.S. tax liability must disclose that position on Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b),” which a tax preparer will attach to a tax return unless the position qualifies for a waiver. There can be penalties assessed if Form 8833 is not filed, even though the taxpayer is exempt from U.S. taxes.

Income tax treaties usually cover only federal income taxes. Thus, unless an income tax treaty provides otherwise, neither excise taxes in general nor the excise tax on net investment income of private foundations in particular is a covered tax under U.S. income tax treaties. Then of course there are state and local sales/use taxes, as well as state income and franchise taxes. It is not usual to have a foreign corporation that is exempt from filing a Form 1120 or Form 1120-F, yet still has to file several state income tax returns (or sales tax returns) where they operate.

Have There Been Any Recent Developments?

As one might expect, changes to international tax treaties tend to happen regularly. For example, in late December 2023, the IRS issued Notice 2024-11, which updated the list of treaties that meet the requirements of Sec. 1(h)(11) regarding “qualified dividends.”

Sec. 1(h)(11) generally provides that a dividend paid to an individual shareholder from either a domestic corporation or a “qualified foreign corporation” is subject to tax at the reduced rates applicable to certain capital gains. According to the guidance, qualified foreign corporations are “certain foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the United States that the Secretary [of the U.S. Department of the Treasury] determines is satisfactory for purposes of this provision and that includes an exchange of information program.”

Notice 2024-11 announced the current list of U.S. tax treaties that meet the Sec. 1(h)(11) requirements has been updated to include:

• The treaty with Chile.
• Termination of Hungary treaty on Jan. 8, 2023.
• Pausing the exchange of information program with Russia because of the invasion of Ukraine.

Helping You Take Advantage of Treaties

Businesses and individuals involved in international transactions should be aware of the potential impact of a tax treaty in foreign countries where they do business — if one exists.

Our international tax pros regularly deal with these treaty issues for both its inbound and outbound clients. Contact us today to help you navigate them.