A double tax treaty is a bilateral agreement between two countries that divides the right to tax cross-border income, so that income reached by both systems is taxed at a reduced rate in one of them or exempted there entirely. The same instrument is called an income tax treaty, a double taxation agreement or a DTA depending on who is writing, and in the United States the operative name is income tax treaty. It is one relief route rather than the only one, and it works by rule rather than by refund: the treaty changes what the source country may charge in the first place.
What a Treaty Actually Changes
The United States has income tax treaties with a number of foreign countries, and under these treaties residents, not necessarily citizens, of foreign countries may be eligible to be taxed at a reduced rate or exempt from US income taxes on certain items of income they receive from sources within the United States (IRS, Tax treaties). Two qualifiers in that sentence carry the whole subject. Residence, not citizenship, is the qualifying status. And the relief attaches to items of income, not to the person, so the answer changes by income type inside a single client.
Coverage is not general. These reduced rates and exemptions vary among countries and specific items of income, and if the treaty does not cover a particular kind of income, or if there is no treaty between the country and the United States, the tax is paid in the same way and at the same rates shown in the instructions for the nonresident return (IRS, Tax treaties). A treaty country is not a treaty answer.
The rate a treaty reduces is the statutory withholding rate that would otherwise be collected on the gross payment, and the certificate a foreign payee gives the payer to claim the reduction is covered in Form W-8BEN-E.
A Treaty Does Not Outrank the Code
This is the point most explanations of the subject skip, and it decides real positions.
For purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law (26 U.S.C. 7852(d)(1)). Treaty and statute sit at the same level, so neither takes precedence over the other merely because of what it is, and a conflict between them is not settled by pointing at the treaty. Section 894 points at that rule itself, by cross reference, for the relationship between treaties and this title (26 U.S.C. 894(a)(2)).
The instruction to read the Code with treaty obligations in view, and the foreign tax credit that sits beside it as the other relief route, are both worked through in double tax.
It Mostly Does Not Help a US Citizen
Tax treaties generally reduce the US taxes of residents of foreign countries as determined under the applicable treaties, and, with certain exceptions, they do not reduce the US taxes of US citizens or US treaty residents, who are subject to US income tax on their worldwide income (IRS, Tax treaties). The qualifier matters and is easy to lose: the rule is “with certain exceptions”, not “never”.
The reciprocity runs the other way, though. Treaty provisions generally apply to both treaty countries, so a US citizen or US treaty resident receiving income from a treaty country and subject to taxes imposed by foreign countries may be entitled to certain credits, deductions, exemptions and reductions in the rate of taxes of those foreign countries (IRS, Tax treaties). Foreign taxing authorities sometimes require certification from the US Government that the applicant filed a return as a US citizen or resident, and the IRS routes that request to Form 8802, Application for United States Residency Certification, and Form 6166, Certification of U.S. Tax Residency (IRS, Tax treaties).
Permanent Establishment Carries a Statutory Deeming Rule
Treaty relief on business profits usually turns on whether the foreign person has a permanent establishment in the United States, and the Code settles one branch of that question by fiat rather than by facts.
For purposes of applying any exemption from, or reduction of, any tax provided by any treaty to which the United States is a party with respect to income which is not effectively connected with the conduct of a trade or business within the United States, a nonresident alien individual or a foreign corporation shall be deemed not to have a permanent establishment in the United States at any time during the taxable year (26 U.S.C. 894(b)). The deeming rule is limited on both ends. It reaches only income that is not effectively connected, and it does not apply in respect of the tax computed under section 877(b) (26 U.S.C. 894(b)).
The State Return Is a Separate Question
A federal treaty position does not travel down to the states on its own. Many of the individual states of the United States tax the income of their residents, and some states honor the provisions of US tax treaties while some states do not (IRS, Tax treaties). A client whose federal position is settled can still owe state tax on the same income, so the state answer has to be asked separately of the state’s own authority.
Claiming a Treaty Position Is a Disclosure
Taking a treaty position is a reportable act, not a silent one.
Each taxpayer who, with respect to any tax imposed by this title, takes the position that a treaty of the United States overrules or otherwise modifies an internal revenue law of the United States shall disclose that position, in the manner the Secretary prescribes, on the return of tax for that tax or any statement attached to the return, or, if no return of tax is required to be filed, in the form the Secretary prescribes (26 U.S.C. 6114(a)). Both limbs are live, so a taxpayer with no filing obligation is not excused from disclosing. The Secretary may waive the requirement for classes of cases where the waiver will not impede the assessment and collection of tax (26 U.S.C. 6114(b)).
The penalty is fixed rather than proportional. If a taxpayer fails to meet the requirements of section 6114, a penalty equal to $1,000, or $10,000 in the case of a C corporation, is imposed on each such failure (26 U.S.C. 6712(a)). It can be waived on a showing of reasonable cause and good faith (26 U.S.C. 6712(b)), and it is in addition to any other penalty imposed by law (26 U.S.C. 6712(c)).
Where a US Firm Meets It
A treaty question usually reaches a firm as a vendor’s certificate or a client’s foreign income, and the work is classification before it is computation. Which treaty applies turns on residence, which turns on the tests set out in nonresident alien, and a client who changed status mid-year is handled as a dual status alien rather than under one regime for the whole year. The wider set of filings a cross-border client triggers is covered in international tax services.
Common Questions
A bilateral agreement that allocates taxing rights over cross-border income between two countries. In US practice it lets residents of the other country be taxed at a reduced rate or be exempt from US income tax on certain items of income sourced in the United States (IRS, Tax treaties). It is an allocation of rights, not a refund mechanism.
No. Relief is item by item and country by country, since reduced rates and exemptions vary among countries and specific items of income, and uncovered income is taxed as if there were no treaty at all (IRS, Tax treaties). Where a treaty does not reach, the foreign tax credit is the other route, and it is set out in double tax.
Not by virtue of being a treaty. Neither a treaty provision nor a revenue law has preferential status by reason of being a treaty or law (26 U.S.C. 7852(d)(1)), so the two are read together and neither wins an argument by naming itself. A taxpayer who does take the position that a treaty overrules or modifies an internal revenue law has to disclose it (26 U.S.C. 6114(a)).
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