Unbeknownst to many (including some tax professionals), the U.S. has entered into tax agreements with countries around the world that modify how people and businesses are taxed. Many are surprised to find out that local legislation is often trumped by the provisions of these tax treaties. Ignoring these agreements can result in a significant loss of income. As a result, tax treaties are the first place to look when one is considering the tax implications of transacting with foreign nationals or foreign residents.
There are three types of treaties to consider:
- Income Tax Conventions
- Estate and Gift Tax Treaties
- Totalization Agreements
Income Tax Conventions, also known as Double Taxation Treaties, have been signed with over 60 countries, including with the U.S.’s largest trading partners (Canada, Mexico, and China). These conventions define certain types of income and often provide for a reduction or elimination of taxes and/or a reduction or elimination of certain withholding requirements. These treaties have a similar format and will generally cover the following types of income:
- Capital Gains
- Independent Personal Services
- Dependent Personal Services
- Branch Sourced Income
Importantly, these treaties will also define who is a tax resident and will specify certain tiebreaker rules in case it isn’t obvious where a person resides. It is important to note that the concepts of “tax residence” and “legal residence” are not the same. A person could be illegally present in a country (because of a lack or expiration of appropriate visas), but still be subject to income tax in that country. For tax purposes, determining tax residence is paramount.
Tax treaty benefits established in the conventions often differ country to country and are subject to renegotiation. In addition, the tax treaty benefit is not automatic; the taxpayer normally needs to claim the benefit on appropriate tax forms.
If there is no treaty in effect between the U.S. and another country, regular withholding and tax rates established in local legislation will apply. For example, Mexico and the U.S. have signed a tax treaty which provides that most U.S. sourced dividend payments to Mexican residents are subject to 10% tax. Brazil, on the other hand, does not currently have a tax convention ratified with the U.S. and thus non-resident aliens (for U.S. purposes) residing in Brazil are subject to tax rates on U.S. source dividend payments of 30%.
While some tax conventions will have an article on estate and gift taxes, the U.S. has also entered into separate Estate and Gift Tax Agreements with several countries. Like the tax conventions mentioned above, these are designed to reduce or eliminate estate taxes when both jurisdictions may have a claim. If estate or gift taxes are not covered in either the regular tax conventions or separate agreements, tax relief may not be available and regular tax rates will apply per local law.
It is worth mentioning that several states in the U.S. have their own income and estate tax regimens and some of these do not recognize the validity of international agreements and may seek to impose taxes on state source income or assets irrespective of what the international agreements may say.
Finally, the U.S. has entered into Totalization Agreements with about 25 countries. The purpose of these agreements is to avoid double imposition of Social Security taxes and to establish eligibility requirements. For example, taxpayers might be able to choose in which country they contribute, exempting them from payment of U.S. (or another country’s) Social Security taxes. As far as eligibility, some taxpayers did not meet eligibility requirements in either country because they did not pay into the system in either location for the required amount of time. By totaling payments into both Social Security systems, they might be able to qualify under one or the other (hence the name “totalization”). There are ratified Totalization Agreements with Canada and several European countries. While Mexico and the U.S. have negotiated such a treaty, the agreement has not been ratified by the U.S. Congress, leaving Chile as the only Latin American country with a Totalization Agreement in force with the U.S.
In conclusion, when contemplating an international transaction either because you are a U.S. citizen or because you are seeking to live or invest in the U.S., it is important that you familiarize yourself with the provisions of the different tax treaties. These international agreements will often provide significant tax relief or other benefits and should be incorporated into any planning.