What’s the Deal with International Tax Treaties?
Many people naturally associate the word “treaty” with “peace.” But the U.S. federal government has signed off on quite a few international tax treaties over the years, too. If a person, business or other entity engages in activities that may trigger international tax laws, it’s a good idea to have some familiarity with the nature of these treaties.
What Treaties Do
Tax treaties tend to reduce or eliminate U.S. income tax liability and withholding on income sourced from the United States (or sourced from the treaty country). 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 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 is a treaty it may be advantageous to examine if there is applicable exemptions or reductions in the U.S. or foreign country tax rates.
The Tax Impact
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. 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. It can also be important to determine whether the foreign tax is creditable against the U.S. tax because if it is not, then your effective tax rate will be higher.
Internal Revenue Code Section 894 codifies the principle that any income excluded from the gross income of a nonresident alien or foreign corporation, or 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 operations (known as permanent establishments or “PEs”) in the other country and that meet other requirements related to the duration, scope and nature of activities. In addition, Section 6114 provides that a taxpayer who takes the position where a treaty reduces or eliminates U.S. tax liability must disclose it 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. Failure to attach this form to your U.S. income tax return can result in a penalty of $10,000 or loss of credits (in certain situations).
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 is a covered tax under U.S. income tax treaties.
State or provincial taxes are also not normally covered under treaties. There are exceptions to this rule, such as a treaty between the United States and Canada that allows for a credit of the provincial taxes against the U.S. federal income tax. Unfortunately, the treaty does not protect foreign country residents from U.S. state income and franchise taxes even though it may protect them from U.S. federal income taxes.
U.S. Model Treaty
The U.S. Department of the Treasury’s model income tax treaty is the starting point for U.S. tax treaty negotiations with other countries. Studying it may be helpful in interpreting corresponding provisions of an actual treaty. However, the model treaty doesn’t have the force of law. When determining the tax consequences of a transaction in a country bound by a treaty, it’s essential to look at the actual treaty in question.
Actual treaties generally vary from the U.S. model to reflect a foreign country’s tax laws. The 2016 U.S. model tax treaty is designed to avoid double taxation and evasion of taxes on income and capital.
Recent Example
In early December 2022, the United States and Croatia signed a comprehensive income tax treaty. The first of its kind between the two countries, the new treaty closely follows the U.S. model treaty and contains the following key provisions:
- Withholding taxes on interest payments and cross-border payments of dividends paid to pension funds are eliminated.
- Royalties and withholding taxes on cross-border payments of dividends, other than those paid to a pension fund, are reduced.
- Modern anti-abuse provisions intended to stop treaty shopping and prevent income from not being taxed at all are set forth.
- Robust dispute resolution mechanisms, including mandatory binding arbitration, are in place.
- Standard provisions for the exchange of information to help the revenue authorities of both nations carry out their duties as tax administrators are included.
The new tax treaty will enter into force once the United States and Croatia have notified each other that they’ve completed their requisite domestic procedures. In the case of the United States, these include obtaining the advice and consent to ratification by the U.S. Senate.
Global Economy
International tax treaties are yet another sign of an increasingly global economy. If you have questions or concerns about the potential impact of a tax treaty on your situation, contact Moore Doeren Mayhew’s international tax advisors today.
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