Posted by Tiffany Gaskin

U.S. Income Tax Treaties

U.S. Income Tax Treaties

The USA has tax treaties with numerous foreign countries. Under these treaties, residents of foreign countries pay taxes at a reduced rate or are exempt from U.S. taxes on certain income items they receive from sources in the United States. These reduced rates and exemptions vary by country and specific income. Under the same treaties, residents or citizens of the United States pay tax at a reduced rate or are exempt from foreign taxes on certain items of income they receive from sources in foreign countries. Most tax treaties contain the so-called "saving clause," which prevents a U.S. citizen or resident from using the provisions of a tax treaty to avoid taxation of U.S. source income.

If the treaty does not cover a certain type of income, or there is no treaty between your country and the United States, you must pay income tax in the same manner and at the same rates as in instructions from the United States Income tax returns.

Several U.S. states tax income earned in their states. Therefore, you should contact the state's tax authorities in which you earn your income to find out if state taxes apply to any of your income. Some states in the United States do not follow the provisions of tax treaties.


What is a tax treaty?

A tax treaty is a bilateral (two-party) agreement signed by two countries to resolve double taxation of passive and active income for each of their respective citizens. Tax treaties generally determine the amount of taxes a country can collect on taxpayers' income, capital, wealth, or assets. A tax treaty is also called a double taxation agreement (DTA).

Some countries are considered tax-havens. Typically, a tax haven is a country or location with little or no corporate tax, allowing foreign investors to do business in that country. Tax havens are generally not included in tax treaties.


How a tax treaty works

When a person or company invests in a foreign country, the question may arise about which country should tax the investor's income. The two countries, the country of origin and the country of residence, can enter into a tax treaty to decide which country should tax the investment income to prevent the same income from being taxed twice.

The country of origin is the host country for foreign investment. The home country is sometimes referred to as the capital importing country. The country of residence is the country of residence of the investor. The country of residence is sometimes also referred to as the capital-exporting country.

To avoid double taxation, tax treaties can follow one of two models: the Organization for Economic Co-operation and Development (OECD) model and the United Nations (U.N.) model.


U.N. Tax Treaty Model vs. OECD Tax Treaty Model 

The OECD (Organization for Economic Co-operation and Development) is a group of 37 countries that aims to promote global trade and economic progress. 

The OECD Convention on Income and Tax on Capital is more favorable to countries exporting capital than importing capital. The country of origin must waive all or part of the taxes on certain income categories received by residents of the other treaty country.

The two countries concerned will benefit from such an agreement if the trade and investment flow between the two countries is equal and the country of residence taxes any exempt income by the source country.

The second model tax treaty is officially known as the United Nations model double taxation convention between developed and developing countries. The United Nations is an international organization that seeks to increase political and economic cooperation among its member countries.

A model U.N. treaty grants favorable tax rights to the country's foreign investments. This favorable tax regime generally benefits developing countries that receive domestic investments. It gives countries of origin higher tax rights on the commercial income of non-residents than the OECD model convention.


Special considerations

One of the most significant aspects of a tax treaty is the withholding tax policy of the treaty. It determines the amount of tax levied on income earned (interest and dividends) on securities held by a non-resident.

For example, if a tax treaty between Country A and Country B states that withholding tax on bilateral dividends is 10%, Country A will tax the dividend payments to Country B at a rate of 10%, and vice versa.

The USA has tax treaties with several countries that help reduce or eliminate taxes paid by foreign residents. These reduced rates and exemptions vary by country and specific income.

Under these conventions, U.S. residents or citizens are taxed at a reduced or foreign tax rate on certain income items they receive from foreign sources. Tax treaties are considered reciprocal because they apply in both treaty countries.

Tax treaties often include a clause known as a "saving clause," which is intended to prevent U.S. residents from taking advantage of parts of the tax treaty to avoid taxation of a domestic source of income.

For people living in countries that do not have tax treaties with the United States, any income source in the United States is taxed in the same manner and at the same rates stated in the instructions of the applicable U.S. tax return.

For people residing in the United States, it is important to note that some states in the United States do not comply with the tax treaty provisions.


Summary 

  • A tax treaty is a bilateral (bipartite) agreement entered into by two countries to resolve issues related to the double taxation of passive and active income for each of their respective citizens.

  • Some countries are considered tax havens; these countries generally do not enter into tax treaties.

  • The two countries can enter into a tax treaty to agree on which country should tax the investment income to prevent the same income from being taxed twice.

  • When a person or company invests in a foreign country, the question may arise about which country should tax the investor's income.


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Tiffany Gaskin
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