How to Read and Analyze a Tax Treaty
How to Read and Analyze a Tax Treaty: Technically, a tax treaty is referred to as a “Bilateral Income Tax Treaty” and millions of U.S. Taxpayers are impacted by the language found within International Tax Treaties. Generally, a U.S. Tax Treaty is signed between the U.S. and a foreign country in which the U.S. is (or was) on good terms at the time the treaty was entered into. The U.S. has entered into more than 50 bilateral tax treaties. Reviewing, evaluating, and summarizing an IRS tax treaty is a comprehensive undertaking — and oftentimes the analyses you find online are incomplete and inaccurate.
We will explain How to Read Tax Treaties correctly.
Different Types of Tax Treaties
Reading, interpreting and understanding U.S. Bilateral Income Tax Treaties is hard stuff — even for the most experienced International Tax Lawyers. There are various types of Tax Treaties, including:
- Bilateral Income Tax Treaties
- Estate Tax Treaties
- FATCA Agreements
- Totalization Agreements
General Steps For How to Read a Tax Treaty
- Start from General-to-Specific
- Skim the entire treaty
- Review the basic terms and definitions
- Hone in on the specific issue you are researching
- Read the entire article that applies
- Then read it again
- and then again
- Then refer to the Technical Explanation
- See if any rulings or memos have been issued by the IRS
- Has the issue already been litigated?
- Does the Saving Clause apply to the particular article(s).
How to Interpret a Tax Treaty
No two treaties are identical. While there will be many similarities between tax treaties of different countries, they are not identical. For example, some tax treaties allow for limited taxation of certain types of retirement; others expand the concept of double taxation, and some will provide significantly reduced tax on FDAP income.
That is why it is important to make sure to read the specific tax treaty carefully, When it comes to tax treaties, a person may have a significant tax liability on the line, such as a foreign country taxing your U.S. retirement (401K, IRA, 403(b) and other vehicles) or the U.S. taxing your foreign retirement — for example Singaporean CPF (no treaty) vs Indian EPF, UK Pension, or Australian Pension (Treaty).
A list of the U.S. Tax treaties can be found here.
Common issues handled in a treaty, include:
- General Taxation of Foreign Persons
- Double Taxation
- Permanent Establishment
- Catchall protection (aka Saving Clause)
5 Important Facts about How to Ready Tax Treaties
We have lost count of the number of people who contact us to let us know the reason they didn’t report their foreign income or assets was because... I thought there was a treaty?” While this s a commonsense response and absolutely reasonable, more often than not it just doesn’t work that way – especially for U.S. Person Legal Permanent Residents (aka Green-Card Holders).
Foreign U.S. Person vs. Foreign Person (Non-U.S. Person)
What is a U.S. Person vs. Foreign Person for U.S. tax purposes?
Foreign U.S. Person
When the treaty refers to “Resident,” it simply refers to the country the person resides. When the treaty refers to a foreign person it is generally not referring to a “U.S.” person who is from foreign country, such as a Legal Permanent Resident.
That is because when a foreign person is considered a U.S. person for tax purposes, that person is subject to tax on the worldwide income.
For example, Peter is originally from Peru, but is a legal permanent resident. Therefore, the U.S. will tax him on his worldwide income, including the reporting of foreign accounts, assets, investments, and income.
A foreign person who is not considered a U.S. person may be able to avoid tax or pay reduced tax on US source income.
For example, if a non-U.S. Person receives dividends from a U.S. Source, it is considered FDAP, and tax is generally withheld at 30%.
If there is a treaty in place, the 30% may be reduced to 15%, 10%, 5% or 0.
Taxation of Foreign Retirement
This can get a bit tricky.
No Tax Treaty with the U.S.
For example is a CPF in Singapore.
A CPF is a Central Provident Fund retirement plan from Singapore. It is mandatory for people who work in Singapore to contribute. But, the U.S. does not have a Bilateral Tax Treaty with Singapore.
Since there is no U.S. Tax Treaty with Singapore (and the IRS has issued memoranda specifically on the CPF), there is no treaty to protect the earnings.
Thus, the growth within the fund is considered immediately taxable.
Treaty with the U.S.
To compare, the U.S. does have a treaty with the UK. Generally, any income accruing within the retirement fund is not going to be taxed during the growth/accumulation phase.
And, when it is distributed, there are specific, complex rules as to whether some or all of it is taxable, and who gets to collect tax.
*Growth within the fund is different than the taxation of salary contributions.
Public vs. Private Retirement/Pension
Generally (many exceptions, exclusions, and limitations apply), the country of residence of the person receiving a pension gets the chance to tax the distributions.
Still, depending on the specific tax treaty, a person’s public pension is oftentimes not taxable by the country of residence, even if a private pension would otherwise be taxable.
Example of common tax treaty language limiting taxation rights of the resident, provides:
Social Security payments and other public pensions paid by one of the Contracting States to an individual who is a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.
Double Tax/Foreign Tax Credit
Generally, in accordance with the Tax Treaty, a person is entitled to a Foreign Tax Credit and/or avoid Double Taxation on the same income.
Permanent Establishment (Business)
There are very specific rules as to whether a foreign business from one country will be taxed in the other country for business it conducts in the other country (different than rules for individuals). Generally, in order for the country to tax the foreign business, it must have a “Permanent Establishment.”
The term “permanent establishment” includes especially:
(a) a place of management;
(b) a branch;
(c) an office;
(d) a factory;
(e) a workshop; and
(f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
3. The term “permanent establishment” also includes:
(a) a building site, a construction, assembly or installation project, or supervisory activities in connection therewith, but only where such site, project or activities continue for a period of more than six months;
(b) an installation, drilling rig or ship used for the exploration or exploitation of natural resources, but only if so used for a period of more than three months; and
(c) the furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only where such activities continue (for the same or a connected project) within the country for a period or periods aggregating more than six months within any twelve month period.
4. Notwithstanding the provisions of paragraphs 1 through 3, the term “permanent establishment” shall be deemed not to include:
(a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
(b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
(c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
(d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
(e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
(f) the maintenance of a fixed place of business solely for any combination of the activities mentioned in subparagraphs (a) through (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.
The Saving Clause is use to protect the interest of the U.S., by allowing the U,S, to…tax you anyway. This helps resolve and ambiguities or conflicts in the treaty, and protect against modified, new or updated laws.
An example of a Saving Clause:
“Notwithstanding any provision of the Convention except the provisions of paragraph 3, the United States may tax its residents, as determined under Article 4 (Resident), and its citizens as if the Convention had not come into effect.
For this purpose, the term citizen” shall include a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of income tax, but only for a period of 10 years following such loss.”
Out of Compliance for Unreported Foreign Money?
International Tax is hard. Oftentimes, individuals will learn after the fact that they have not properly reported their foreign income, assets, accounts or investments. If you are out compliance, there are various amnesty/voluntary disclosure programs.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance with getting compliant.