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• Income Tax Treaties– Treaties with about 60 countries– All major trading partners

• Totalization Agreements– Agreements with 24 countries

Agenda for Class 7

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Overview – Income Tax Treaties• Purpose to mitigate international double

income taxation – Through tax reductions or exemptions on certain

types of income

– Derived by residents of one treaty country

– From sources within the other treaty country

• Must be considered for any inbound or outbound transaction

• Reciprocal agreements• Reduce tax of residents of foreign

countries– If no treaty, withhold at statutory rate

– Does not reduce US tax of US taxpayers (US citizens, resident aliens, domestic corporations)

• States may not recognize treaties

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Procedures• Negotiated by team of people from

each country• Exchange instruments of ratification• Treaty must be approved and ratified

by both countries approval process before treaty is effective

• OECD (Organization for Economic Cooperation and Development) model– Extensive commentaries on each of the model’s

articles– US courts have relied on these commentaries when

construing treaties between US and other OECD countries

• Protocols clarify treaty language

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Basic Provisions

• Effective date• Resident vs. national of a contracting

state• Permanent establishment• Reduced withholding rates• Patterned after US Model Income Tax

Convention of November 15, 2006– US Model Treaty– Traditional baseline negotiating position of the US – Each treaty separately negotiated and is unique

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Interaction with Local Law• In most foreign countries, treaty

provision will supercede the foreign country’s domestic law

• “Treaty override” – legislation that conflicts with an earlier treaty

• Supremacy clause of US Constitution treats treaties and federal legislation equally

• If a treaty provision conflicts with legislation, later enactment prevails

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Resident• Tax exemptions and reductions available only

to a resident of one of the treaty countries– US Model: resident is any person who, under a country’s

internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation

– Resident taxed by virtue of a personal relationship rather than source of income

• Does not include someone who is subject to tax in a country only with respect to income derived from sources in that country

• Determined by reference to the domestic laws of a specific country

– Income from a partnership or other pass-through entity is derived by a resident of a treaty country to the extent the income is taxable to a person that qualifies as a resident of that treaty country

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Tie-Breaker Rules• Because each country has its own

unique definition of residency, a person may qualify as a resident in more than one country

• Hierarchical in nature• Model Treaty – Article 4(3)

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Savings Clause• Treaty country saves the right to tax its

own citizens as though the treaty did not exist

• Model Treaty – Article 1(4)

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Permanent Establishment• Taxation is key issue for any company

exporting goods or services to another country

• Most countries assert jurisdiction over all income derived from sources within its borders, regardless of the residence or citizenship of the entity receiving the income

• Administrative cost of collecting the tax on these activities may exceed the related tax revenues

• Seen as imposing unreasonable compliance cost on foreign companies

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Permanent Establishment (Model Treaty)• Under a PE provision, the business

profits of a resident of one treaty country are exempt from taxation by the other treaty country unless profits are attributed to PE within the host country

• A fixed place of business does not constitute a PE if that facility is used for – Auxiliary function – purchasing, storing, displaying, or

delivering inventory– Activities of a preparatory nature – collecting

information about potential customers– A building or construction site is a PE if it continues for

> 12 months

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Permanent Establishment (Model Treaty)• Article 5(5) – PE exists if employees conclude

sales in the host country in the taxpayer’s name

• Employees, who limit activities to auxiliary or preparatory functions, with sales concluded in the home country, will not create a PE

• Article 5(6) – Marketing products through independent brokers or distributors do not create a PE, regardless of whether these independent agents conclude sales contracts in the exporter’s name

• Article 5(7) – The mere presence in the importing country of a locally incorporated subsidiary does not create PE for a parent company incorporated in another country

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Permanent Establishment (Model Treaty)• Article 7(1) – If PE, then importing

country may tax taxpayer’s business profits, but only to the extent profits attributable to the PE

• Article 7(2) – PE profit is based on arm’s length transactions, separate and distinct entity

• More functions performed and greater risk assumed should generate more profits

• Differentiation between US trade or business and PE

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Income from Employment (Article 14)• Similar to PE concept• Threshold of activity for host country

taxation• Usually income derived from services

in treaty country is taxed• Exempt under treaty if

– The employee is present in the host country for 183 days or less,

• In the taxable year or 12 months concerned• Referred to as 183 day rule

– The employee compensation is paid by or on behalf of an employer which is not a resident of the host country, and

– The compensation is not borne by a PE or fixed base which the employer has in the host country

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OECD Model – Who is the Employer?• Who bears the responsibility or risk for the

results produced by the individual’s work?• Who has the authority to instruct the

individual?• Who controls and has responsibility for the

place at which the work is performed?• Who bears, in an economic sense, the cost of

the remuneration paid to the individual?• Who puts the tools and materials necessary

for the work at the individual’s disposal?• Who determines the number and

qualifications of the individuals performing the work?

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Pension, Social Security• Pension (Article 17(1))

– Periodic payment or lump sum vs. periodic payments in certain treaties

– Taxable in resident country– Only if not taxed in other country previous to distribution

• Social security (Article 17(2))– Only taxed in country paid from– 85% of the social security benefits received by NRA are

subject to 30% withholding tax §871(a)(3)

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Annuities, Alimony, Child Support• Annuities (Article 17(3)) – taxable in

country of residence• Alimony (Article 17(4))

– Taxable to recipient in country of residence– Many treaties have “taxable in country of payor”

• Child support (Article 17(5)) – exempt from tax in both countries

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Participant in Pension Plans (Article 18)• Contributions deductible or excludible• Benefits accrued not taxable• Income earned not taxable until

distributed• Distributions can be rolled over and

won’t be taxed• Application

– Contributions before arrived in new country– Competent authority agrees that pension plan

corresponds to pension plan under local law– Limited to benefits of qualified plan under local law

• Not in many treaties – overrides taxation for US purposes

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Relief from Double Taxation• Provision for foreign tax credits –

Article 23• Re-sourcing

– Source rules apply regardless of any contrary US treaty obligation, unless the treaty specifically expresses an intent to override the rules

– §904(g)(10)(A) – treaty treats income as foreign source, Code treats as US source, taxpayer can treat as foreign source

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Dividends, Interest, Royalties• Most countries impose flat withholding

tax received by offshore investors• Treaties provide for a reduced

withholding tax as long as income not attributed to PE

• Dividends– 5% for 10% or more shareholder (Article 10(2)(a))– 15% for all other shareholders (Article 10(2)(b))– 0% for subsidiary to parent – Australia, Japan, Mexico,

Netherlands, UK

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Dividends, Interest, Royalties• Interest

– Usually 15% or less– Model Treaty – exempt from withholding (Article 11(1))

• Royalties– Usually 10% or less– Rates vary whether the payment is an industrial royalty

(patent, trade secret, formula), motion picture or television royalty, or some other type of royalty

– Model Treaty – exempt from withholding (Article 12(1))

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Gain from Disposition of Property• Generally taxed only by the country in

which the property resides (Article 13(1))

• Disposition of personal property attributed to PE – gain taxed in country where PE located (Article 13(3))

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Income from Real Property (Article 6)• Home and host country maintain the

right to tax real property income• Article 6(5) – if real property income

taxed in other treaty country, taxpayer can elect to have income taxed on net basis at graduated tax rates rather than taxed on gross basis through flat withholding taxes – §871(d) – election to treat real property as effectively

connected income

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Anti-Treaty Shopping Provisions• Strategically located holding companies can

take advantage of lower treaty withholding rates

• Netherlands – – Extensive treaty network and exemption for foreign source

dividends– Dutch holding company has been historically popular– 1993 Dutch US treaty contains anti-treaty shopping provision

which restricts the availability of treaty shopping

• Limitation on Benefits (LOB) – Article 22 of Model Treaty

• Judicial decisions have supported IRS assertion of substance over form such as back-to-back loan arrangements

• §7701(l) gives IRS authority to disregard the existence of an intermediary with respect to treaty shopping

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Non-Discrimination• US can’t tax a foreign national at a

greater rate than a US taxpayer• Article 24 of Model Treaty• BFR test available to resident aliens

that are nationals of appropriate treaty countries

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Competent Authority (Article 25)• Competent authority – administers treaties• Treaties provide a procedure by which a

resident of a treaty country can request assistance from competent authority of that county in obtaining relief when one or more treaty countries take action inconsistent with the treaty

• Competent authority empowered to resolve case by mutual agreement with competent authority of other treaty country

• Potential problems– Request for competent authority can be declined

– Competent authorities may be unable to reach an agreement

– Timing may be outside statute of limitations

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Exchange of Information (Article 26)• Enhance compliance with respect to

international compliance• Competent authority receiving request

obtains information in the same way as if the information was need for its own purposes, i.e., audits

• Examples– Share information about taxpayer both countries are

auditing– Stock option income for employees– Recipients of dividend, interest, or royalties resident

within other treaty country

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Disclosure• Claiming treaty benefit on tax return

that conflicts with IRC must be disclosed

• “Conflict” – US tax liability different• Disclosure process

– Attaching a statement to the return– Filing Form 8833

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Miscellaneous• US – USSR treaty remains in effect for

independent countries• US – China treaty doesn’t apply to HK

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Totalization Agreements• Default position – social security tax is

imposed where a person works• Purpose

– To provide continued coverage of the home-country system and exemption from a host country’s social security system, i.e., to stop the imposition of social tax on the same income by two countries

– Determine the qualification requirements and level of benefits available to those who have contributed to more than one country’s social security system

• Income tax treaty = host country has the prior right to taxation

• Totalization agreement = individual remains covered under home-country system

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Detached Worker Rule• Temporary work assignment in a country

other than the individual’s home country – employee takes along his home-country coverage for the duration of the assignment

• Requirements– The employee must be working in a position that is covered by

his home country’s social security law before the transfer.– The employee must have been employed by the transferring

employer before the transfer.– The work at the temporary assignment location must be

performed for the employer that transferred the employee– The assignment must be temporary as defined in the

totalization agreement

• Temporary usually means 5 years or less• Extension beyond 5 years is up to the host

country’s social security authorities

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Procedures• Employer must provide continued

coverage in the home-country system• Apply for a certificate of coverage

online www.socialsecurity.gov/coc• Employer retains the certificate in the

home and host payroll department • www.ssa.gov/international

– Copies of totalization agreements on the website– Complete application on line

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Totalization of Benefits• An employee may not be able to qualify

to stay in their home country social system and are included in the host country system

• The employee may not meet the minimum period of coverage required for qualification of benefits

• Provides a method an employee may receive partial coverage by including period of coverage in other country

• Apply to any office of Social Security Administration in US or other country

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Miscellaneous• Not all benefits are covered by the

agreement, e.g., France– Health insurance– Unemployment insurance– Workers’ compensation– Family allowances– Cash sickness benefits– Maternity benefits

• May receive retroactive coverage• Self employed person – coverage

follows residency and generally no time limit.