To be righteous citizens and to play by the rules, we all must pay the taxes that are issued to us by the authorities. No matter where we are; abroad or in our own country, we must pay our taxes. When the hefty amount of these taxes prove to be a burden, we can’t help but think of ways to somehow get them reduced, or deducted. Foregoing everything that is illegal and unlawful, we might have good news for you, especially if you are a US citizen and are now living in another country. Thanks to the IRS and one of their policies, you might have a chance to reduce, or being exempted completely, from some of these taxes. Exciting, isn’t it?
So, how is that even possible? Why would a country give such a special treatment to its citizens? To be honest, the system was put into place not out of specialness, but because of fairness. A US citizen has to pay his taxes in the US but would it be fair for the same person to pay full taxes of that country too? It is a little harsh, undoubtedly. So, the Internal Revenue Service (IRS) took matters into their own hands and formed a treaty of sorts with several other countries around the globe. As a result of this US tax treaty, a US citizen is subject to American expatriate tax benefits when they are living abroad, and the same benefits goes for any other countrymen working or living in the US.
Granted the system, procedures and the rate of reduction and exemption are all different in different countries, but one way or another, the US citizens will ultimately benefit from such an arrangement. The US tax treaty has been currently signed with at least 60 other countries at the moment and keeps on increasing as the years pass. However, you might be wondering what the reason behind this treaty is? Surely, one party or another might be on the sacrificial side? Actually, that is not the case. The main reason behind these treaties, as stated earlier, is because of double taxation. To pay American Expatriate tax and then the tax of their host country would affect the financial position of any citizen harshly. As a result, the number of tax evasion cases had increased sharply. This means that US tax treaty has also helped eradicate tax evasion at large. Most of the reductions and exemptions due to US tax treaties differ and the rates, amounts and requirements depend on the circumstances of the US citizen in another country. Reasons of travelling, type of residency and nationality also affects the ultimate decision.
What is a Tax Treaty?
While we have been going on and on about the US tax treaties, the concept is still foreign to many people. So, starting from the very beginning, let’s make sure we all understand what tax treaties really are.
A tax treaty is basically a joint and mutual agreement that is contracted between two countries. In case of US tax treaties, it is an agreement between the US and any other country. With a mutual agreement, the state and the country reaches a decision to eliminate double taxation on passive and active income. In this treaty, a specific rate of tax is fixed which the host country can assign on the income of the visiting citizen from another country. Remember that tax haven countries are excluded from tax treaties as these countries already assign minimalist tax rates and are not subjected to further reduction.
What is Meant by a Bilateral Tax Treaty?
There are people who usually live in two places at once; it is because of personal choice or maybe, it is their business that results in this situation. Regardless, a person has to pay taxes and in this case, they have to pay taxes in both the jurisdictions. A bilateral Tax treaty is an agreement between two countries that works on the sole conflict of paying taxes twice in both the jurisdictions.
Understanding Double Taxation:
By now, you might have gotten some insight into double taxation but to understand it more accurately, let’s use some real time examples to understand two types of scenarios of double taxation.
- Let’s, for example, imagine that a US citizen earns his income in the US and pays the taxes like they usually have to be paid. However, then, he deposits this income amount into another country where again he has to pay the income tax on the same amount. Consequently, it results in double taxation of the same income. US treaties have arrangements with other countries that prevent such situations.
- When you sell something, you pay tax on it and then, count your profit. After that, you pay sales tax again as you move to another country. So basically, you are paying tax two times on the same item instead of one.
What is IRS?
We now have enough knowledge about tax treaties, their reasons, and some basic procedures involved into it. So, let’s move onto the real system of US tax treaties, the credit for which goes to the IRS. But what is this IRS and what is its involvement in the elaborate taxation system of the United States?
IRS is the abbreviation of Internal Revenue Service, and is nicknamed the Tax Man. This service is a government-regulated agency of the US which was established for the purpose of collecting taxes from US citizens and enforcing them. The headquarters of the IRS is situated in Washington D.C and keeps a close eye on the taxation of each and every US citizen. IRS came into formation in the year 1862 by the efforts of the 16th president of the US, Abraham Lincoln. The IRS takes care of every kind of tax on income. It works under the department of treasury of the United States. Other than that, the responsibility of corporate gift giving, estate taxes and excise duties also falls on the shoulders of the IRS.
United States Tax Treaty:
The IRS is a reputable government department and is very efficient in performing their job. So, once they established an efficient tax system inside the United States of America, they began to take actions to safeguard the rights of tax payments of their citizens, even when they were not in the US. As a result of this strategic plan, IRS published a document which showcased all the treaties that were ascertained between U.S and other countries of the world. The document also recognized all the reductions, obligations and eliminations that could be claimed by a US citizen living or working in another host country. But that’s not all; because these treaties work on both sides, they’ll also be benefiting both jurisdictions. The same benefits of tax reductions will also apply on the citizens of another country with whom US tax treaties have been signed. However, the reduction or elimination depends solely on the kind of agreement a specific country has penned with the United States. This means that there are different levels of benefits for different country. However, one will also find many taxes and eliminations that have not been discussed in the document at all, which translates into indifference. That is, these kinds of taxes will remain the same for everyone and are not subjected to any reduction or elimination.
There are many income tax treaties that contain of a part, referred to as a Saving Clause. This clause exclusively states that certain sources of income are not subject to US tax treaties and must be treated as regular tax. Why? Because there are various states in US that tax income which is sourced directly in their states and to avoid reduction in them, US tax treaty provisions are not applied to them.
Tax Treaties Can Be Applied On:
Knowledge is power, and knowing the kind of income which enjoys the benefits of US tax treaties will help any person who is travelling to US, or a US citizen himself who is fond of travelling abroad. Allow us to elaborate:
Personal Services Income:
Countries with better economical conditions and even better relations with the US allow the citizens of the state to be exempted from paying taxes on personal service income. But then, there are many factors at play here which decides the nature of provisions in this regard. What matters is the length of the stay of the US citizen in the host country, the type of personal service income that is in question and the net amount of compensation. Do remember that there are 60 countries involved in US tax treaties, and each one has different stipulations regarding personal service income. So, in short, different countries have different rules and provide different benefits.
Personal service incomes are usually earned in the kind of businesses or professions in which a wide range of personal services are provided; namely, law, engineering, design, medicine, accounting, finance, performing arts and a few more. In these kinds of services, compensation is also involved as these eservices are given to an individual or a group for personalized issues. Basically, any service that requires knowledge and specialization of a person rather than capital in order to generate more income is referred to as a personal service.
There are 2 types of personal services; independent and dependent. The former is the one where an individual is working a free worker, is self-employed, a freelancer or an independent contractor. Dependent personal services are those in which a US citizen is involved with an organization of a foreign country and is working under the supervision of a foreign employer. According to the US tax treaties, there is a time limit to the number of days a foreigner must spend in US, and the same goes for the US citizen. Generally, the time period, as approved by the IRS, is 183 days and no more. Countries which provide the provision of personal service income tax exemption include the following:
- United Kingdom
There are those who pursue a full time career in the United States, or US’ own citizens who go abroad for business proposes. Individuals like these benefit largely from US tax. Individuals who are students, researchers, trainees and teachers who travel to another country for a brief time period are also acknowledged in the US tax treaty. In fact, US citizens who go abroad for any of these purposes are entirely exempted from tax in their host country. Consequently, this clause also has some limits, including the time-period spent in another country, and the income in question must only be from their position as a trainee, student, teacher, researcher etc. income earned from any of these resources do not count, and is not subject to regular tax obligations.
Other Sources of Income:
Most people earn their income by investing in a foreign market while they themselves reside in the US. This means that even when they are paying the expatriate tax in the US, they are also paying in the host countries from whose market they are earning their income. So, this makes it a case of double taxation. To avoid this, the US tax treaty includes compact withholding taxes on incomes such as dividends, royalty transactions and interest.
Tax Saving Clause:
We have already established that the IRS’s main reason behind establishing US tax treaties with other countries is to prevent double taxation. However, it might serve one other purpose too, and that is to help US citizens save on their American tax when they are already liable to pay taxes abroad. Therefore, U.S tax treaties have one very important clause, what you might call a Tax Saving Clause. The clause makes sure that no one may benefit from US tax treaties to reduce the tax they are liable to pay.
New US Model Tax Treaty:
While US tax treaties have been established and have been in effect since the times of Abraham Lincoln, the treasury department of the US finally came up with a new U.S model of income Tax convention. The main focus behind U.S tax treaties is to prevent double taxation as much as possible, without giving any one a chance to evade tax, reduce their taxes, or avoid it all together. It is a tricky job to draw a thin line between the two and to make sure that it remains in effect efficiently. For that reason alone, the treasury department keeps coming up with new provisions and guidelines. The 2016 model also introduced some new things to make the entire procedure perfect. Let’s have a look at these new additions:
- Article 11 (Interest):
The jurisdiction that is a partner in the US treaty can now apply tax on the rising interest based on the domestic law of the country in question, especially if the person is benefitting from the NID (Notional Interest Deduction).
- Required Arbitration:
The new model asks the related parties to resolve any issue with the help of mandatory binding arbitration that follows the “Last Best Offer” approach.
- Preferential Tax Regimes:
Another introduction in the new model is the non-reduction rule on withholding taxes on the payments of highly mobile income. This concerns that income that is easy to move from one country to another, even across oceans, with the help of deductible income. Individuals related to these kinds of incomes enjoy reduced taxation or sometimes, no-taxation at all.
How to Claim for Tax Treaties:
Before we delve deeper into the procedure, remember that no clause in the US tax treaty exists that excuses an individual to file the American Expatriate forms.
- List of Countries:
One can easily look through the list of countries that have established a treaty with the US and find out if their country is one of them, or whether they are presently working in one of those countries. As of now, the US tax treaties involve 60 countries. However, with the passage of time, the senate of US is working towards increasing this number and establishing more and more treaties. Usually, it requires 5 years to establish a treaty.
Not everyone can avail the provision of US tax treaties. There are certain requirements that need to be fulfilled that are mentioned in IRS publication 901 in detail and must be re-offered before application. Other than that, the citizen must also have a social security number (SSN), or an ITIN (Individual Taxpayer Identification Number). It is required that the tax treaty exemption form must be filled accurately for applying for tax exemptions.
- Non-Resident Aliens:
It is a situation of unawareness that needs to be corrected. Most non-resident aliens lack knowledge about US tax treaties, or the fact that they too can benefit from it. They can excuse them of a large amount of tax, or even get exempted from it if it falls in the right category as mentioned in the IRS publication. Those who are working as students, trainees and apprentices can enjoy the provision of US tax treaty for up to 5 years. Other non-resident aliens are given a slightly less time limit.
These U.S tax treaties can be rightfully used to prevent falling victim to double taxation. However, it would not be wise to use it as a further source of tax exemption or reduction.