How a No-Treaty Country Impact US Tax Rules
The United States has entered into nearly 60 international bilateral double taxation agreements with foreign countries across the globe. In addition to bilateral double taxation agreements, the United States has also entered into various other types of agreements — such as FATCA Agreements; Totalization Agreements, and Gift and Estate Tax Treaties. When the United States enters into a tax treaty with a foreign country, it makes the overall tax situation cleaner — and it can provide several tax benefits to those Taxpayers who qualify for eligibility. The bigger problem becomes when the United States has not entered into a tax treaty with a foreign country — and what happens from a U.S. tax perspective. Let’s look at some of the basics — noting, that there are many exceptions, exclusions, and limitations to be cognizant of when conducting individual tax research.
Pension Contributions as Tax-Deferred
One of the first benefits of a tax treaty is that contributions made to certain qualified foreign pension plans can be deducted from a U.S. tax return — similar to how a 401K is deducted. For example, if a US taxpayer works in the UK and earning pension contributions that are tax-deferred in the UK, then they may also be tax-deferred — according to the treaty — on a U.S. tax return. When there is no tax treaty with a foreign country, such as Singapore or Hong Kong and Provident Funds — the same treaty rules do not apply.
Pension Growth as Tax-Deferred
In addition, depending on which country in which tax treaty, oftentimes employment-borne pension which is not “available” to the taxpayer during the growth phase is not taxable — and would not be taxed until it is actually distributed to the taxpayer. Therefore, when the pension is growing — usually tax-deferred in the foreign country — the US taxpayer can maintain the tax-deferred status in the US as well — and not have to pay incremental tax annually on any growth within the pension.
Reduced Withholding and Avoid Tax
Let’s say a nonresident alien previously worked in the United States as a US person and accrued 401K — and they then relocated back to the foreign country — which is a treaty country — and is no longer considered a US person. The general rule is that US-sourced income is taxed as FDAP and withholding can be 30%. If the non-resident resides in a treaty country, then depending on the specific withholding rate allocated by treaty — the total amount of withholding may be reduced or eliminated. In addition, if the treaty is the type of treaty that taxes pension by country of resident and not source (subject to the saving clause), the non-resident may avoid all tax on the 401K.
A common provision in many tax treaties involves the permanent establishment rules. In general, the basic rule is that as long as a person in one country who is conducting business in the other country has not established a permanent establishment in the other country — then that other country will not tax the income generated through a non-permanent establishment. Thus, depending on what the foreign tax rate is, the type of income, and any limitations on foreign tax credits. When there is a treaty in place, it may exempt certain business structures that would otherwise qualify as a Permanent Establishment.
Oftentimes, tax treaties will provide that if a person is earning income in one of the countries that are a party to the tax treaty through government service — then only that foreign jurisdiction (subject to certain exceptions and limitations) that issues the payment has the opportunity to tax the income. Thus, when a person works and resides in the “other country” for that other country’s government, and the tax rate in that other country is significantly lower — it means the taxpayer may save a considerable amount of income tax (presuming that they do not get captured by the saving clause).
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and Form 8938.
Contact our firm today for assistance with getting compliant.