Under an income tax treaty, two countries agree to limit or exempt income taxes levied on each other’s citizens or residents. These treaties are typically reciprocal. The overall purpose of an income tax treaty is to eliminate any tax issues that would hinder trade across borders. The main issue for individuals is the potential for double taxation, which would also discourage trade, and therefore is eliminated under tax treaties (in fact, tax treaties are sometimes called “Double Tax Agreements,” or DTA). Tax treaties also promote the goals of preventing tax evasion, protecting one’s citizens from discrimination, and strengthening political ties.
Tax Treaty Models
According to the United Nations, there are more than 3,000 bilateral income tax treaties in effect. Most of these treaties are based on either the Organisation for Economic Co-operation and Development (OECD) model or the UN model. In general, under these tax treaties, a country agrees to give up some or all tax on specific types of income earned by the residents or citizens of another country. Let’s take a moment to look at the two models.
After World War I, the League of Nations (the first attempt at intergovernmental organization and replaced by the UN at the end of World War II) attempted to develop model tax conventions but struggled to get everyone on board. The OECD then took over the work and published its first draft in 1963. This draft has been revised over the years and is used by the major industrialized nations. The OECD model does favor capital-exporting countries and is the model of choice when the two countries are relatively equal in terms of flow of trade and investment. Typically, the “source” country (source of income) relinquishes the right to tax some specified categories of income earned by residents of its treaty partner. The home country will then tax some income if it is exempted by the source country.
The UN Model focuses on treaties between developing and developed countries. Although it is based on the OECD model, it contains some small modifications. The biggest difference is that it favors the taxation rights of source countries. Therefore, the UN model is a more appropriate choice for a developing country. The UN’s intent was to encourage more treaties with developing nations while protecting their interests.
A Typical Tax Treaty
A tax treaty is made up of “chapters” or articles. The early chapters in a treaty do just what one might expect—identify the parties, who is affected by the treaty, and the taxes covered. Terms are defined as needed.
Later chapters (or articles, depending on the treaty) include the nitty-gritty of the treaty. The treaty typically details the types of income earned by residents of both countries (typically referred to as “States”) and determines how it is taxed. Some examples include income from immovable property, business profits, dividends, interest, royalties, capital gains, some services, employment, pensions, social security, and so on.
Tax treaties typically provide two options for avoiding double taxation. The exemption method requires the State of residence to exempt taxes when the state in which the individual earns income (“source” State) collects taxes (such as when required by domestic law to do so). The credit method is applied when the country of residence taxes the income; in this case, the residence country must deduct the portion that has been paid to the source country.
United States Model
The U.S. has its own tax treaty model based on the OECD model. These tax treaties are treaties, so each one is negotiated individually over the process of several stages (the UN describes the typical negotiation process in item #4 here and specifically for developing nations here). Thus, there can be differences (including omissions) between U.S. treaties with various countries. This is true of all tax treaties, actually.
There are some key differences between the OECD model and the U.S. model. First, the OECD model focuses on taxation based on residence, while the U.S. taxes based on citizenship. The “saving clause” prohibits citizens of the U.S. and residents from using tax treaties to avoid paying taxes on their U.S. sources of income. If a treaty doesn’t cover specific income or there is no treaty between a country and the U.S., individuals are required to pay income tax as usual, employing Form 1040-NR, the U.S. Nonresident Alien Income Tax Return for nonresidents engaged in a trade or business in the United States.
Another important difference is that while the OECD model typically covers state and local taxes, the U.S. model does not. Therefore, some states will honor the treaty provisions, but others choose not to do so and can tax income that originates in their states.
Residency is determined by the treaty, too. The key for residents of other countries working in the U.S. is whether the individual is a resident or nonresident alien (see IRS Publication 519 for additional information). As for dual residency, for the purposes of the treaty, individuals are assigned to one country while remaining dual residents for all other purposes.
There are other differences, including some that might affect the individual, such as taxation of interest income and so on. In other words, tax treaties do address both passive and active income.
Treaties do not impose taxes, by the way. Taxes are still in the domain of domestic law.
International Taxpayers at IRS.gov
The best place to start in researching tax treaties is probably the International Taxpayers page at IRS.gov. This is where anyone who is not a citizen or resident of the U.S. but earning income in the U.S. or any U.S. citizen or resident alien earning income outside the U.S. can find information about paying U.S. taxes.
Tax Treaties at IRS.gov
This Tax Treaties page at IRS.gov provides an overview of tax treaties along with many important links, such as the 1040 NR and 1040 NR-EZ, which “Nonresident Aliens” who are dual taxpayers use to file a return and claim treaty benefits.
IRS Publication 54 is a Tax Guide for U.S. Citizens and Resident Aliens Abroad provided by the IRS. The guide covers “special tax rules for U.S. citizens and resident aliens” working abroad or earning income in foreign countries. The publication reminds American citizens that their income is subject to U.S. income taxes—no matter where they live.
Publication 901 (U.S. Tax Treaties), also provided by the IRS, is a quick reference guide that includes exemptions by country for personal service income; pay of professors, teachers, and researchers; students and apprentices; and wages from and pensions paid by a foreign government.
Publication 519, U.S. Tax Guide for Aliens, can help individuals understand if they are classified as nonresident aliens or resident aliens, the source of different types of income, whether they can claim an exclusion from gross income, how their income is taxed, how to figure their taxes, how to determine U.S. tax liability during a dual-status tax year, how to file taxes, how to pay taxes throughout the year, and so on. The latest version is for 2019, of course, but it provides a sense of what to expect in the 2020 version.
Tax Treaty Tables
As noted in Publication 901, detailed information about specific treaties is available in the Tax Treaty Tables available on the IRS website.
- TABLE 1. Tax Rates on Income Other Than Personal Service Income Under Chapter 3, Internal Revenue Code, and Income Tax Treaties (Rev. Feb 2019) PDF (PDF)
- TABLE 2. Compensation for Personal Services Performed in United States Exempt from U.S. Income Tax Under Income Tax Treaties PDF (PDF)
- TABLE 3. List of Tax Treaties PDF (PDF)
- TABLE 4. Limitation on Benefits PDF (PDF)
United States Income Tax Treaties—A to Z
This site provides links to tax treaties between the United States and individual countries. Beginning with Armenia and ending with Venezuela, each treaty is available for review.
What is the purpose of tax treaties?
The main point of tax treaties is to facilitate trade. One hindrance to trade across borders would be the potential for double taxation of individuals involved in the trade, which treaties seek to eliminate. Sometimes referred to as Double Tax Agreements (DTA), tax treaties are also designed to mitigate tax evasion, protect against discrimination, and strengthen political ties.
Which individuals are affected by tax treaties?
An individual or business receiving income from a foreign country is subject to the provisions of a tax treaty. In the U.S., citizens and residents of foreign countries may be taxed at a reduced rate or exempt from paying U.S. taxes on specified types of income received from U.S.-based sources. Likewise, American citizens are taxed at a reduced rate or are exempt from taxes in countries where they are earning income. U.S. tax treaties typically include what is known as a “saving clause” that prevents American citizens or residents from using the treaty to avoid taxation in the U.S.
What if the U.S. does not have a treaty with my country?
With 58 tax treaties in place as of 2019, there’s a good chance the U.S. has a treaty with your country, excluding the known “tax haven countries,” which don’t tend to engage in income tax treaties at all. However, the IRS is clear about the requirement of paying income taxes in the United States if no treaty exists or doesn’t cover a particular type of income.
Are state taxes in the United States affected by income tax treaties?
In short, states are not required to abide by income tax treaties when taxing the income of their residents. Some states choose to abide by the treaties, but others opt not to honor treaty provisions. It’s up to them, and it’s up to the individual whose tax obligations are in question to determine whether the state of residence requires taxes on income or not.
Paying taxes in the United States can be a complicated affair. Paying taxes as a resident or nonresident individual earning income in the United States brings additional complications. And, for Americans earning abroad, it’s important to remember that no treaty provides you with a “get out of taxes free” card. In all cases, earners need to figure out how much they owe and to whom. The resources referenced in this article can help you sort out your own tax liabilities under existing treaties. However, a professional can help you make sure you do it right.