When the United States and a foreign country have a tax treaty, foreign country residents may be entitled to lower tax rates or exemptions while in the United States under the terms of the treaty.
Many foreign countries have income tax treaties with the United States. Reduced rates and exemptions vary according to treaties and countries.
How Tax Treaties Work
When a person or company invests in a foreign nation, the question of which government should tax the investor’s gains may surface. Both the residence and source countries can enter into a tax treaty to compromise on which nation should tax investment income to avoid taxing the same revenue two times.
The source country is the country that acquires inward investment. The source country is sometimes known as the capital-importing country. The investor’s country of residence is the resident country. The residence country is known as the capital-exporting country.
Tax treaties might use one of two standards to avoid double taxation: the United Nations (UN) Model Convention or the Organization for Economic Cooperation and Development (OECD) Model.
The UN Tax Treaty Model vs. The OECD Tax Treaty Model
The UN Model Double Taxation Convention between Developed and Developing Countries is the formal name for the first tax treaty model. The United Nations is a global association that promotes economic and political collaboration among its member nations.
A treaty based on the UN model grants the foreign country of investment preferential tax treatment. Typically, this preferential taxation system favors developing countries that receive foreign investment. In comparison to the OECD Model Convention, the UN model grants the source country more taxing privileges over non-residents’ company income.
The UN Model Convention largely influences the OECD Model Convention.
The Organization for Economic Cooperation and Development is a collection of 37 nations dedicated to promoting global commerce and economic development.
The OECD Income and Capital Tax Convention favor capital-exporting nations over capital-importing nations. It directs the source country to waive some or all taxes on specific types of income produced by citizens of the other treaty government.
The two nations concerned will gain from such a pact if the flow of commerce and investment between the nations is reasonably similar and the residence country levies any income that the source country exempts.
The treaty’s policy on withholding taxes is one of the essential parts of a tax treaty since it dictates how much tax is paid on any earnings produced (dividends and interest) from securities held by a non-citizen.
For instance, if nation A and nation B have a tax treaty that states that their bilateral withholding tax on dividends is 10%, then nation A will tax dividend payments to nation B at 10%.
The United States has tax pacts with several countries that aim to minimize or stop the tax paid by citizens of other countries. These decreased exemptions and rates differ by country and income item.
These same pacts provide that citizens or residents of the United States are taxed at a lower rate or are excluded from foreign taxes on specific items of revenue received from foreign countries. Because they apply in both treaty countries, tax treaties are reciprocal.
Income tax treaties generally include a phrase known as a “saving clause,” which is meant to prevent citizens of the United States from using certain provisions of the tax treaty to bypass taxation on a domestic source of earnings.
Individuals who live in the United States should be aware that some particular states within the United States do not follow the conditions of tax treaties.
Individuals who are citizens of nations that don’t have tax treaties with the United States are taxed in identical ways and at the same rates as specified in the directions for the corresponding US tax return.
Who Are Tax Treaty Reductions Available To?
In general, treaty terms apply only to the country with which the treaty was signed. A US citizen or resident who receives income from a treaty country and is taxed by that country may be eligible for credits, deductions, and exemptions. However, these accords rarely result in lower taxes for American people or residents.
What Happens If There Is No Tax Treaty?
When a country and the United States do not have a tax treaty, foreign residents from that country must pay income tax in the same manner as American citizens.
Is it Necessary for Foreign Residents to Pay State Income Taxes?
Regardless of tax treaties, several individual states in the United States tax the income of their citizens, including all international residents. This is due to the fact that tax treaties normally only apply to federal taxes, not state taxes. You should consult a tax professional in your state to see whether state taxes apply to your income.
If I am a US Citizen, How is My Foreign Income Taxed?
If you are a US citizen, you must pay taxes on any income, whether earned in the US or elsewhere. In general, the laws for income, estate, gift, and anticipated tax are the same whether you live in the United States or abroad.
You must also file extra documentation with the IRS if any of the following conditions apply:
- You are a shareholder in a multinational corporation
- You own a portion of a foreign trust or receive payments from one
- You are earning interest on your international bank accounts
How Is My Foreign National Income Taxed in the United States?
Your taxes are determined by whether you are a resident alien or a non-resident alien. A foreign person is considered a resident alien if they have a green card, have been physically present in the United States for 183 days or more during the current tax year, or choose to be treated as a resident alien for tax reasons.
If a foreign national does not meet one of the three conditions listed above, they are classified as a non-resident alien.
- Resident Aliens: Resident aliens are taxed in the same manner as citizens of the United States.
- Non-Resident Aliens: Non-resident aliens are taxed differently than resident aliens. Non-resident aliens’ business income in the United States is taxed in the same way that it would be for a US citizen. They are also subject to a 30% tax on all other forms of income earned in the United States (i.e., interest payments).
- Foreign Corporations: Foreign corporations must also pay taxes on all income earned in the United States, including business and other sources of income (i.e., investment returns).
Can I Take Advantage of Tax Treaties?
Most non-resident aliens are unable to claim tax breaks for their spouses or children. On the other hand, tax treaties or unique exemptions in the IRS statute may allow certain visitors to claim tax deductions for dependents. India is one of these countries, along with South Korea, Japan, Canada, and Mexico.
What Should I Do If I Have Tax Treaty Problems?
You should speak with a tax lawyer who is familiar with tax treaties and other international tax matters.
A skilled tax attorney can inform you exactly what exemptions, deductions, or credits you are eligible for, saving you time and money.