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Guide to U.S. Tax Treaties in 2022

Guide to U.S. Tax Treaties in 2022

You may be subject to tax treaties if you live abroad and earn income. We will break down all you need to know about tax treaties and how they work.

Under an income tax treaty, two countries agree to limit, or exempt income taxes levied on their citizens or residents. These treaties are generally reciprocal. The general objective of a tax treaty is to remove all tax obstacles to cross-border trade. The main problem for people is the possibility of double taxation, which would also discourage trade and is therefore removed from tax treaties (in fact, tax treaties are sometimes referred to as "double taxation treaties" or DTAs). Tax treaties also promote the objectives of preventing tax evasion, protecting citizens from discrimination, and strengthening political ties.


Tax Treaty Models

According to the United Nations (U.N.), there are over 3,000 bilateral tax treaties. Most of these treaties are based on the Organization for Economic Co-operation and Development (OECD) model or on the United Nations model. Typically, under these tax treaties, a country agrees to waive all or part of taxes on certain types of income earned by residents or citizens of another country. Let's take a look at the two models.


The OECD Model

After World War I, the League of Nations attempted to develop tax treaties models but fought for everyone to adhere to them. The OECD then took over and published its first draft in 1963. This draft has been revised over the years and is used by major industrialized countries. The OECD model favors capital-exporting countries and is the model of choice when the two countries are relatively equal in terms of trade and investment flows. In general, the "source" country (source of income) waives the right to tax certain specific categories of income received by residents of its treaty partner. The home country will then tax part of the income if it is exempt from the home country.


The U.N. Model

The U.N. model focuses on treaties between developing and developed countries. Although based on the OECD model, it contains some minor modifications. The biggest difference is that it favors the tax rights of the countries of origin. Therefore, the U.N. model is a better option for a developing country. The United Nations intended to encourage more treaties with developing countries while protecting their interests.


A standard tax treaty

A tax treaty is made up of "chapters" or articles. The first chapters of a treaty do exactly what you expect: identify the parties, who are affected by the treaty, and what taxes are covered. Terms are defined as needed.

The following chapters (or articles, depending on the treaty) contain the essence of the treaty. The treaty generally defines the types of income earned by residents of both countries (often referred to as "states") and determines how they are taxed. Some examples include real estate income, corporate profits, dividends, interest, royalties, capital gains, certain services, jobs, pensions, social security, etc.

Tax treaties generally offer two options for avoiding double taxation. The exemption method provides that the State of residence is exempt from tax when the State in which the person declares income (State of origin) collects taxes (as required by national law). The credit method applies when the country of residence taxes the income; in this case, the country of residence must deduct the part that was paid in the country of origin.


The U.S. Model

The United States has its own model tax treaty based on the OECD model. These tax treaties are handled in such a way that each is negotiated individually in a multi-step process. Therefore, there may be differences (or even omissions) between U.S. treaties with different countries. This is true for all tax treaties, in fact.

There are important differences between the OECD model and the U.S. model. First, the OECD model focuses on taxation based on residence, while U.S. taxes are based on citizenship. The "savings clause" prohibits U.S. citizens and residents from using tax treaties to avoid paying taxes on their U.S. sources of income, as usual, using Form 1040-NR, the United States Non-Resident Income Tax Return for participants in a business or business in the United States.

Another important difference is that while the OECD model generally covers national and local taxes, the U.S. model does not. As a result, some states will comply with the provisions of the convention, but others will choose not to tax and may tax the income of their states.

The treaty also determines a residence. The key for residents of other countries working in the United States is whether the person is a resident alien or a non-resident. With regard to dual residency, for the purposes of the treaty, individuals are assigned to a single country, remaining dual residency for all other purposes.

There are other differences, some of which may be of interest to the individual, such as the taxation of interest income, etc. In other words, tax treaties cover both passive and active income.

Treaties do not impose taxes, among other things. Taxes remain the responsibility of domestic law.


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