A Basic Introduction to U.S. Tax Treaties

What is a tax treaty?

A tax treaty is a bilateral agreement between countries to cooperate on tax rules. The arrangement often helps people avoid paying taxes on the same income in two separate countries.

For example, Jack is a citizen and resident of Country A. Country A imposes its income tax on Jack’s income wherever he earns it. Jack also has a store in Country B where he sells bicycles and repairs them. Country B imposes an income tax on income earned from the sale of goods or services in any permanent establishment in Country B. Jack has a problem. Country A taxes all of his income from whatever source, including his income from worldwide sources. But Country B imposes its income tax on all the revenue from Jack’s store in Country B.

That means Jack will be paying tax twice on his bicycle shop income, and he can’t compete with other bicycle shops that are paying only once.

Countries deal with the double taxation problem in one of two (or both) methods. First, Country A might allow a foreign tax credit — a dollar-for-dollar reduction of Country A’s tax for tax paid to Country B.

Secondly, Country A and Country B might enter into a bilateral tax treaty for the purpose of preventing double taxation of their respective citizens. Such a treaty would allocate taxing authority between the two countries.

How do tax treaties work?

The IRS publishes a list of countries with tax treaties in effect with the United States, as well as the effective date of each treaty and protocol (amendment to the treaty). This table should only be used as a quick reference and not a complete guide to all provisions of every income tax treaty.

If a treaty doesn’t apply to a certain type of income, or if no treaty exists between the U.S. and your country, you must pay tax on the income as subject to IRS rules. Additionally, many states in the U.S. tax income on their residents, and not all states honor the provisions of U.S. tax treaties. Therefore, you could still owe taxes at the state and local level—even if a tax treaty exists with your country.

The Organization for Economic Cooperation and Development (OECD) publishes a Model Tax Convention on Income and on Capital that was last updated in 2017. The OECD is an international organization of 37 democratic member nations that works to build better policies for better lives. Membership accounts for 62.2% of the world’s gross domestic product (GDP), and most member countries have bilateral tax treaties. Additionally, most bilateral tax treaties between member and non-member nations conform to the OECD Model.

Overview of the OECD Model

The principal purpose of the OECD Model is the elimination of double taxation, which is an obstacle to cross-border services, trade and investment. The organization has the following goals:

  • Eliminate double taxation with each nation relinquishing some taxing authority, provided the other country imposes a tax of equal burden.
  • Reduce excessive taxation as a result of high withholding taxation in the country of source.
  • Prevent tax avoidance or evasion.

The Model treaty applies to any resident of one or both of the treaty partners. It governs each partner’s right to tax income and capital based on the country of residence and the country of source of the income or capital.

The main elements are as follows:

  • If the treaty gives the country of source the right to tax, the country of residence must allow relief to avoid double taxation.
  • The country of residence can provide that relief by either an exemption from tax or a dollar-for-dollar tax credit against the country of residence tax.

The tax treatment of income and capital depends on one of three categories defined by the treaty:

  • Income or capital may be taxed without limitation by the country of source.
  • Income or capital may be taxed by the country of source with limitations.
  • Income or capital may not be taxed by the country of source.

The Model treaty defines the types of income or capital that are taxable by the country of source. They include:

  • Income from immovable property located in a country, gains from the sale of such property, and gains from the sale of interests in an entity that is 50% owned by the taxpayer;
  • Profits from a permanent establishment in the country and gains from the sale of the permanent establishment;
  • Remuneration from services rendered in the country provided the service provider is present in the country for more than 183 days in any 12-month period; and,
  • Income received by entertainers and sportspersons attributable to activities in the country.

Some categories are subject to limited tax:

  • Dividends that are not connected to a permanent establishment may not be taxed at a rate higher than 5%.
  • Interest that is not connected to a permanent establishment may not be taxed at a rate higher than 10%.

Article V of the OECD Model defines a “permanent establishment” generally as “a fixed place of business through which the business of the enterprise is wholly or partly carried on.” The article further defines it with specific examples.

Who can claim tax treaty benefits?

The discussion above included categories of income or capital that are either exempt from tax by the source country or subject to a limited tax rate.

Nations typically protect their right to tax non-resident aliens by imposing withholding taxes. Section 1441 of the U.S. tax code imposes a 30% withholding on personal services income, dividends and interest. If the tax is improperly assessed or too much is assessed, the taxpayer must file a claim for a refund.

united states tax form

Understanding the Non-Resident Alien Tax Trap

Proper tax planning is essential in recognizing future tax obligations and structuring ownership of assets in a way that minimizes estate and gift taxes owed.

Tax treaties commonly deal with double taxation of income that is subject to withholding tax in the country where the income is earned.

To be eligible for U.S. treaty benefits, you must file Form 8233 with the IRS. You must also meet the following qualifications:

  • Be a resident of a country with a tax treaty with the country of source
  • Be a non-resident alien for U.S. tax purposes
  • Be currently earning in the U.S. the income qualifying for the treaty benefit
  • Have a U.S. Social Security number

A non-resident alien claiming the benefits of a tax treaty must usually renew their claim annually. The reason for the renewal requirement is that a non-residence status or eligibility can change over time.

Get help with your tax needs.

Tax treaties are another layer of complexity on top of the domestic tax laws of the country of a taxpayer’s residence and any other country where they do business. A non-resident alien doing business or working in the United States needs the expert advice of a tax specialist with knowledge of tax treaties and U.S. laws on the taxation of foreigners.

At James Moore & Co., we are experts on tax treaties. Contact us to help you with your foreign tax needs today, and watch your business grow.