Exploring the Interplay of Tax Treaties and Income from Abroad

Exploring the Interplay of Tax Treaties and Income from Abroad

How Tax Treaties Impact Cross-Border Transactions

The United States has entered into several different international tax agreements with foreign countries involving how certain residents and citizens are taxed — and what position that Internal Revenue Service may take on a particular tax issue. Since different countries will have disparate tax regimes that impact the tax outcome of certain forms of income — with the United States being one of only two countries that follows a Citizen-Based worldwide income taxation model — US Taxpayers must have a general understanding of how the United States and/or a foreign jurisdiction may seek to tax certain income depending on issues such as where the income is sourced and the residence of the taxpayer. Not all tax treaties are the same, although most tax treaties touch upon similar key issues that impact taxpayers across the globe such as passive income; pension income; real estate income; and more. Let’s go through five key things to know about international tax treaties:

Four Key Things To Know About International Tax Treaties

Here are four (4) important facts about tax treaties:

Saving Clause & Exceptions

One of the most confounding aspects to an international tax treaty is the infamous saving clause — which is designed to limit the application of the tax treaty, and works like this:

      • The tax treaty will identify different tax issues, such as private pension (usually Article 18);
      • The Treaty will state that the country of residence (not source) has the right to tax the pension income.
        • For example, Denise is a US Citizen who resides in a foreign country and receives a US Pension. The foreign country does not tax pension income
      • But the saving clause reserves the right of either country to tax the income
        • Therefore: the US (worldwide income) can still tax Denise’s Pension Income;
      • Unless Private Pension is one of the saving clause exceptions in the particular treaty. An exception to the the saving clause means the treaty would still determine how the income is taxed.

Residence vs Source

Two key components to any type of taxation are whether the tax is based on the residence of the taxpayer or the source of the income — and there are usually nuances within the treaty for the same category of income. Going back for a minute to pensions, here is how many tax treaties handle pension income:

      • A private pension is taxed in the country of residence (subject to the saving clause and exceptions);
      • A public pension and/or Social Security is generally taxed only at source, so that the country paying the Social Security gets to tax the income.

The Use of May vs Shall

While there is some case law out there debating the distinction between using the terms may and shall — for all intents and purposes when the term May is used — it means that either country can tax the income.

      • For example, a tax treaty may provide that income from real property is taxed in the country where the property is located but may be taxed by the country of source as well.
      • alternatively, other treaties may provide that the country of source of where the property is located will use common phraseology such as “shall only be taxable in the country of source…

Protocols and Amendments

Sometimes, tax treaties will be updated and revised so that new protocols are put in place. These protocols will identify certain specific articles within the treaty (not necessarily the entire treaty) that have been revised, removed, or updated – and it is important to make sure that you were referring to the most recent protocol when assessing tax implications of certain income affected by the treaty.

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Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. Contact our firm today for assistance.