What is an IRS Tax Treaty?
Income Tax Treaty: IRS Double Taxation Agreements When it comes to international tax, tax treaty law is complex. That is primarily because most tax treaties are many pages long and contain voluminous amounts of information and IRS analyses, which is both dense and complicated.
That is not to say it takes an International Tax Law Specialist to understand how and apply principles of a tax treaty. But, International tax lawyers are trained (or should be) to evaluate how the tax treaty rules work for specific tax situations.
Let’s go through some of the basic tips as you go on your journey of reading tax treaties (make sure you brew some extra coffee).
Not all Tax Treaties are the Same
One common treaty scenario we see often is the U.K. and pension rules.
When an employee/employer contributes to a 401K, it is deductible. So for example, if you earn $100,000 and $10,000 of it goes into your 401(k), that $10,000 is deducted from your gross income so that you are not taxed on that $10,000 of income now.
Rather, you will be taxed at a future date at the time of distribution.
Conversely, when you contribute to a foreign pension plan, the general rule is that contributions to a non-qualified/non-exempt employment pension plan (under 402B) are not deductible from your gross income.
The US and UK treaty has a special provision which allows a U.S. person under certain circumstances to deduct that $10,000 that was contributed to a UK pension plan from a US tax return.
As you can see, this results in a significant savings to the taxpayer.
What Type of Tax Treaty is it?
There’re many different types of tax treaties.
The DTA or Double Tax Agreement are the most common come in the US has entered into more than 50 of them with different countries. Some of the other types of common tax treaties include:
- FATCA Agreements
- Estate Tax Treaties
- Totalization Agreements
While the double tax treaty (DTA) is very broad, these other types of treaties identified above are much more specific.
When it comes to Social Security, there are some basic rules that are pretty common throughout many of the different tax treaties.
Generally, only the country of source can tax the individual’s social security. This is true, even if the taxpayer resides in the United States.
For example, if David receives Social Security from country A, but resides in the United States, then under most tax treaties, only country A can tax the social security.
And, since in most countries social security is tax-free, it’s a great benefit to the taxpayer.
Pensions work a little different.
Under most treaty rules a private pension is taxable in the country of residence.
Therefore, expanding upon the example above, if David was also receiving a pension from country A, but residing in the U.S. – then the US would have the right to tax income.
*Foreign Tax Credits may apply
If the pension is a public pension, so that individual may have worked for the government or a Public University, then generally only the country of source has the right to tax income – even if the taxpayers resides in the US.
Real Estate Capital Gains
When it comes to Capital Gains for Real Estate, the general rules is to allow both states to tax the income, and to allow foreign tax credits to be applied.
Here is a common article section:
“Gains derived by a resident of a Contracting State that are attributable to the alienation of real property situated in the other Contracting State may be taxed in that other State.
Dividends are generally taxable in both the country of source and country of residence, but Foreign Tax Credits will generally apply, along with a reduced tax rate for the country of source.
Here is a common article section:
“Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.
However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the dividends are beneficially owned by a resident of the other Contracting State, the tax so charged shall not exceed, except as otherwise provided,
a) 5 per cent. of the gross amount of the dividends if the beneficial owner is a company that owns shares representing directly or indirectly at least 10 per cent. of the voting power of the company paying the dividends;
b) 15 per cent. of the gross amount of the dividends in all other cases.
This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.”
Interest is generally taxable in the state of residence, although this will vary from one tax treaty to the next.
Here is an example from the U.S. and U.K. tax treaty:
Interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State.
2. The term “interest” as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits, and, in particular, income from government securities and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds or debentures, and all other income that is subjected to the same taxation treatment as income 15 from money lent by the taxation law of the Contracting State in which the income arises.
Income dealt with in Article 10 (Dividends) of this Convention and penalty charges for late payment shall not be regarded as interest for the purposes of this Article.”
A Form 8833 is used to take a “tax treaty position” on specific matters. Not all treaty positions require a Form 8833.
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