This is Part 3 of our series explaining the Saving Clause in the Australia / US tax treaty. In Part 1 we saw how international tax works for 90% of the world’s population: income sourced in the country where you live is taxed only by that country. Income from elsewhere is governed by the treaty and generally taxed by the source country – with a tax credit in the resident country if it is also taxed there. In Part 2 we saw how the Saving Clause works in US tax treaties: US citizens are subject to US tax wherever they live due to the unique practice of Citizenship Based Taxation; the Saving Clause allows the US tax its citizens as if most of the treaty did not exist, allowing the US to tax foreign-source income of foreign residents.
The Saving Clause allows the US to reach into the Australian tax base and tax the Australian source income of Australian resident taxpayers. This erodes the ability of the affected US Persons to take advantage of Australian public policy and tax breaks encouraging retirement savings and local investment. The Saving Clause, and the US practice of CBT more generally, frustrates Australian domestic policy by allowing a foreign government to apply its own idiosyncratic tax rules to income earned on Australian soil by Australian residents. In the long run, this will disadvantage the affected US Persons and make them more likely to require Australian government assistance in the form of the Age Pension and other social safety net programs in Australia.
Clearly, the main problem is the US practice of taxing non-resident citizens on their worldwide income (CBT) – under CBT US citizens living outside the US are treated as tax-resident in TWO countries simultaneously: wherever they actually live and the US. Without CBT, the Saving Clause wouldn’t matter. The US would still have the right to tax Australian source income, but US tax law wouldn’t actually impose any tax on non-US source income of Australian residents. While Australia cannot change US law, it can stand up for its own interests when negotiating treaties and other international agreements with the US.
How can countries like Australia protect their tax base from this exceptional US practice of Citizenship Based Taxation? Until the US changes to the international norm of residence based taxation, there will always be a possibility of some Australian source income being taxed by the US and paid by tax-compliant US citizens resident in Australia. There are three ways that countries like Australia can mitigate this problem:
- Remove the Saving Clause from the treaty (or exclude citizenship from the Saving Clause).
- Add a Citizenship “Tie-breaker” Clause.
- Add a “Tax Base Preservation” Clause.
1. Removing the Saving Clause
This would allow Australian-resident US citizens to use some clauses of the treaty to exclude Australian source income from US taxation. This would not be perfect, as it would not change US law. Let’s look at a couple of examples of how it would work:
Salary / wages: These are dependent personal services. Article 15 of the treaty (currently unavailable to US citizens due to the Saving Clause) states (in part):
… salaries, wages and other similar remuneration derived by an individual who is a resident of one of the Contracting States in respect of an employment … shall be taxable only in that State unless the employment is exercised or the services performed in the other Contracting State. If the employment is so exercised or the services so performed, such remuneration as is derived from that exercise or performance may be taxed in that other State.
Article 15 denies the right of the non-resident country to tax wages that are not earned in that country. So, in the absence of a Saving Clause, wages paid to an Australian-resident US citizen would be taxable only in Australia unless the services were performed in the US.
Sale of real property: This is covered by Article 13 of the treaty which states (in part):
Income or gains derived by a resident of one of the Contracting States from the alienation or disposition of real property situated in the other Contracting state may be taxed in that other State.
In this case, the treaty doesn’t deny the right of the non-resident country to tax gains from the sale of property situated where the taxpayer is resident. So, without the Saving Clause, Article 13 would not prevent the US from taxing US citizens on gains from the sale of real property located in Australia.
The above are only two examples of how removing the Saving Clause would affect US citizens residing in Australia. Looking through the treaty, the following types of income might still be taxable in the US even if the Saving Clause did not exist:
- Income from Real Property (this may be taxed at source, but no limitation on taxation by other country)
- Dividends (arguably limited to 15% for dividends from US companies paid to Australian residents, but no limit on tax on non-US source dividends)
- Interest (arguably limited to 10% for interest from US sources paid to Australian residents, but no limit on tax on non-US source interest)
- Royalties (arguably limited to 5% for royalties from US sources paid to Australian residents, but no limit on tax on non-US source royalties)
- Gain on sale of Real Property (this may be taxed at source, but no limitation on taxation by other country)
- US Social Security and US public pensions (these are not taxable in Australia under the treaty). This provision is currently available to US citizens as it is one of the exceptions from the Saving Clause
As a general rule, without the Saving Clause business income and earned income would only be taxable by the country where the taxpayer is resident, unless the activity is sourced or connected with the other country. So earned income or active business income earned entirely within Australia would be taxable only by Australia.
Clearly, removing the Saving Clause would, on its own, fix only part of the problem of allowing the US to reach into the Australian tax base.
2. Citizenship tie-breaker clause
This was suggested by John Richardson in a post on his website:
In this post John makes the point that US citizenship has evolved over the years. When Saving Clauses were first introduced in US tax treaties in the early 20th century, there were few, if any, dual citizens. Until the middle of the 20th century almost all countries (including the US) had laws stating that citizens would lose their citizenship as a consequence of proclaiming allegiance to another country by naturalising. Near the end of the post, John says:
No country should enter into another treaty with the United States that includes the “Savings Clause”. That said, if the “Savings Clause” is to be part of a treaty, the meaning of “citizens” should be defined by the treaty and must exclude those who are both citizens and residents of Canada (dual citizens)!
In other words, there should be a “tie-breaker” for citizenship just like there’s an article of the treaty with tie-breaker rules for residence. For the purposes of taxation, individuals should be treated as only citizens of one country. If they are dual citizens, then they should be treated as only citizens of the country where they live.
How would this provision affect the US tax liability of US citizens residing in Australia? Those US citizens who are NOT also Australian citizens would be double taxed (under the same rules as apply now). However, once an Australian-resident US citizen takes up Australian citizenship, they would be able to take advantage of the citizenship tie-breaker and be taxed as a non-resident alien (NRA) in the US. This treatment would have to be at the option of the individual, as NRA tax on certain types of US-source income could result in a higher overall tax bill than under the current CBT regime. Essentially, US CBT would not apply to dual citizens because the treaty would provide that Australian citizens resident in Australia could not also be deemed US citizens under US tax law.
Including a Citizenship Tie-breaker Clause in the treaty would encourage US citizens residing in Australia to take up Australian citizenship in order to enjoy the protection of the tax treaty from double taxation by the US.
3. Tax Base Preservation Clause
Remember that in the first post in this series, we specified the principle that
The Australian Source income of Australian Residents should be taxable only by Australia.
So, why not add a clause to the treaty that explicitly states that income arising in the country of residence is taxable only in that country? For countries using residence based taxation, this principle is implicit in both their national tax laws and in the way they interpret their international tax treaties. In treaties with the US, however, this principle needs to be explicitly stated. The US can tax its citizens however it wants, as long as it is not taxing the Australian source income of Australian-resident US citizens. In order to have the intended effect, if a Saving Clause remains, the Tax Base Preservation clause must be among those excepted from the Saving Clause.
With a Tax Base Preservation clause in the treaty, US citizens might still have to file US returns, but the return would include only non-Australian source income plus a Form 8833 stating the treaty position that Australian-source income is not taxable in the US. Since FBAR is required not by the tax code, but by the Bank Secrecy Act, any exemption for FBAR filing on Australian accounts would need to be explicitly mentioned in the treaty.
Where to next?
These fixes would help US citizens resident in Australia – and help preserve the Australian tax base. All require re-negotiation of the current tax treaty, and, therefore, will not happen overnight. There are urgent problems with the way the current treaty is being interpreted in practice (especially with regard to superannuation). These can be resolved without renegotiating the current treaty, and should be a priority.
If Australia does not address the problem with the Saving Clause, and allows the US to tax the Australian source income of Australian residents, then in any new treaty Australia needs to urgently address the treatment of superannuation by the US. They also need to address the punitive treatment of Australian managed investments under US tax law and US taxation of gains on the principal residence of Australian-resident US citizens. Finally, they need to clarify when Australia will assist the US in collecting taxes from Australian residents, especially dual citizens.
And, once the treaty is re-negotiated, the solutions above do not help Australian citizens (and former residents) who move to the US. For this reason, the Australian government should ensure that superannuation is properly covered in any new treaty – even if the effects of CBT are eliminated or mitigated.
Finally, this site is not written by legal or tax professionals. As I stated in the first post in this series, this post is just general information. If you have a real transaction worth real money, then consult with a real tax professional!
 While I have been told that there are non-US tax treaties that contain a saving clause, the only other Australian tax treaty with a saving clause is the 1980 treaty with the Philippines (which had citizenship based tax at the time the treaty was negotiated). The latest OECD model tax convention does not include a saving clause.
 With the new administration in Washington and a Republican Party platform that calls for the repeal of FATCA and CBT, many are hopeful that these US laws will soon be changed. This would clearly be the best solution. There’s even a page on this website for links to US action advocating these changes. However, the US legislative process is long and the outcome uncertain. It would be foolish to do nothing here and simply wait for the US to act.
 NRAs may pay higher US tax on US-source income such as rental property and US source interest and dividends. There would be a credit for this tax against any Australian tax paid on the same income. Additionally, NRAs with US assets in excess of US$60,000 may be subject to US estate tax while US citizens have an estate tax exemption in excess of ~ US$5 million (but worldwide assets are considered, not just US assets).