When is Income Exempt Under a Tax Treaty

When is Income Exempt Under a Tax Treaty

When Is Income Exempt Under a Tax Treaty?

The United States has entered into several international tax treaties with foreign countries across the globe. While there is a skeleton model tax treaty that is used as a baseline for developing each individual treaty (and many treaties are similar), not all bilateral tax treaties are the same. Some tax treaties may exclude certain types of income from US taxation, but other treaties are not so generous. When it comes to exempting income from one country to the agreement (for individuals), the primary categories of income for these exclusions are:

      • New Science and Research Employees in a foreign country;

      • Social Security benefits received; and

      • Public Pension taxation in the residence county.

While the Savings Clause will also impact whether the income will always be exempt or not, oftentimes these three categories of income are excepted from the Saving Clause. Let’s take a look at three (3) provisions often found in international tax treaties that can be used to exclude income from taxation.

US Person/Worldwide Income vs. Residence

One of the most important things to remember in evaluating tax treaties is the inherent disparity between how most countries tax individuals and how the United States does it. In general, the US follows a worldwide income tax model. That means if a person qualifies as either a US Citizen, Lawful Permanent Resident, or foreign national who meets the Substantial Presence Test, they are taxed on their worldwide income. Therefore, if a person is a US citizen and resides in foreign country A but earns all of their money from foreign country B, the IRS can still require taxes paid on the global income.

Conversely, most foreign countries only tax individuals on their worldwide income when that person is considered a resident of that country. Therefore, if a foreign national comes to the United States to live and work, that foreign country will usually only tax the individual’s income that is sourced from within its foreign country’s borders — and not their global income. This leads us to our first common example of when income may be exempt in the United States for certain foreign nationals.

Researchers and Teachers

Usually, tax rules for individuals boil down to whether the income is taxed at “source” or based on “residence.” But, sometimes, determining whether or not taxable income would be taxed in both countries is not based on source or residence per se, but rather on the category of income being generated. Several tax treaties such as the China-US tax treaty provide an exemption for certain income generated from Teaching and Research (at least for a limited amount of time). With the US-China tax treaty, when a person is a visitor in the other country to the agreement temporarily and either conducts research, teaches, or gives lectures — the income from that specific source will be exempt in the country they are working in for three (3) years.

US-China Tax Treaty (Article 19)

      • “An individual who is, or immediately before visiting a Contracting State was, a resident of the other Contracting State and is temporarily present in the first-mentioned Contracting State for the primary purpose of teaching, giving lectures or conducting research at a university, college, school or other accredited educational institution or scientific research institution in the first mentioned Contracting State shall be exempt from tax in the first mentioned Contracting State for a period not exceeding three years in the aggregate in respect of remuneration for such teaching, lectures or research.” Golding & Golding Link to China Tax Treaty Summary.

Social Security

Another common type of income identified in various tax treaties which is exempt from income in the country of residence is Social Security. Since Social Security is a payment from the government, it would make sense that taxes levied on that income would be limited to the country that is issuing the Social Security and not the country in which the person resides. This is unlike most private pensions that are taxed in the country of residence, keeping in mind that the United States still follows a worldwide income tax model and most private pensions are not exempt from the Savings Clause — and therefore are still taxable in both countries.

US Korea Tax-Treaty (Article 24):

      • “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 in the case of such payments by Korea, to an individual who is a citizen of the United States) shall be taxable only in the first-mentioned Contracting State. This Article shall not apply to payments described in Article 22 (Governmental Functions).” Link to Golding & Golding Korea Tax Treaty Summary.

Public Pensions & Government Remuneration

Following the same concepts involving Social Security (in which payments are being made by one government to a citizen or resident of the country) is the idea that government remuneration and other wages and salaries made by one government to a resident of that country who is earning income from that same government, should only be taxable in the country where the income was generated. There are certain nuances to this particular article in most tax treaties, limiting it to taxpayers who are residing in the country and earning income from the government at the same time. For example, if a taxpayer resides in the other country but earns income from government remuneration in the first country, then the second country may still be able to tax the income – noting, that the foreign earned income exclusion and foreign tax credits would still apply to US persons residing overseas.

US Australia Tax Treaty (Article 19):

    • “Governmental Remuneration: Wages, salaries, and similar remuneration, including pensions, paid from funds of one of the Contracting States, of a state or other political subdivision thereof or of an agency or authority of any of the foregoing for labor or personal services performed as an employee of any of the above in the discharge of governmental functions to a citizen of that State shall be exempt from tax by the other Contracting State.” Link to Golding & Golding Australia Tax Treaty Summary.

Savings Clause

Each international tax treaty contains a Savings Clause that serves as a failsafe for each party to the agreement in that unless the specific article and/or paragraph number is exempt from the Savings Clause, each government still reserves the right to tax income as it otherwise would as if the tax treaty was not in place.

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