An Overview of the US Model Tax Treaty

The United States Model Income Tax Convention is the nation’s foundational template for negotiating bilateral tax treaties. Published by the U.S. Department of the Treasury, it is not a law but a starting point that outlines the government’s preferred terms. The model’s primary objectives are to mitigate the effects of double taxation on income earned by residents of one country from sources in the other and to prevent tax evasion. While each signed treaty is a unique, bilaterally negotiated agreement, most begin with the U.S. Model as a baseline. The Treasury Department periodically updates the model to address evolving international tax norms and to align with changes in U.S. law.

Foundational Concepts of Residency and Business Presence

A concept in the U.S. Model Treaty is “residence,” as treaty benefits are generally available only to residents of one or both signatory countries. Article 4 defines a “resident of a Contracting State” as any person who, under that country’s laws, is subject to tax there based on criteria like domicile, residence, place of management, or place of incorporation.

An individual can be considered a resident of both countries under their respective laws, creating dual residency. The model provides “tie-breaker” rules to assign a single country of residence for treaty purposes. The tests are applied sequentially:

• Where the individual has a “permanent home” available.
• If a permanent home is in both or neither, the test considers the “center of vital interests” by examining where personal and economic ties are closer.
• If this is indeterminate, the next rule looks to the individual’s “habitual abode,” the country where they spend more time.
• If a habitual abode is in both or neither, the final factor is citizenship.

If a company is a resident of both countries under their domestic laws, it is generally not treated as a resident of either for the purpose of claiming most treaty benefits. This provision prevents companies from exploiting dual residency.

The “Permanent Establishment,” or PE, is the threshold for taxing the business profits of a foreign enterprise. Under Article 7, a country can tax the business profits of an enterprise from the other signatory country only if it operates through a PE. A PE is a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” Examples include:

• A branch
• An office
• A factory
• A workshop
• A mine

A construction project is a PE only if it lasts for more than twelve months. A PE can also be created if a dependent agent in one country habitually concludes contracts in the name of the enterprise.

Taxation Rules for Business and Investment Income

The taxation of business income hinges on the Permanent Establishment (PE) concept. The business profits of an enterprise of one treaty country are taxable only in that country unless the enterprise carries on business in the other treaty country through a PE. If a PE exists, the host country may tax the enterprise’s profits, but only the portion attributable to that PE.

The determination of attributable profits is based on the “arm’s length” principle, meaning the PE is treated as a distinct and separate enterprise. All expenses incurred for the PE, including an allocation of administrative expenses, are allowed as deductions.

Investment income, such as dividends, interest, and royalties, is treated differently. The model treaty allows the source country—the country where the income arises—to tax this income, but it imposes limits on the tax rate.

For dividends, the model proposes a two-tiered limit on the withholding tax the source country can impose. The rate is capped at 5% of the gross dividend if the beneficial owner is a company that owns at least 10% of the dividend-paying company for a 12-month period. In all other cases, the rate is capped at 15%. This is a reduction from the 30% statutory withholding tax rate the U.S. imposes on dividends paid to foreign persons.

For interest and royalties, the model proposes a complete exemption from withholding tax in the source country with a 0% rate. However, this benefit can be denied by anti-abuse provisions, particularly if the interest or royalties are paid to a related entity that benefits from a special low-tax regime in its home country.

Taxation Rules for Individual Earnings and Pensions

For individuals, the model provides rules for income from employment. Salary, wages, and similar remuneration are taxable only in the individual’s country of residence, unless the employment is exercised in the other country. In that case, the “source” country may also tax the income earned there.

This source-country taxing right is subject to the “183-day rule.” Remuneration an individual earns from work in the other country is exempt from tax there if three conditions are met:

• The recipient is present in the source country for 183 days or less in any twelve-month period.
• The remuneration is paid by or on behalf of an employer who is not a resident of the source country.
• The remuneration is not borne by a permanent establishment which the employer has in the source country.

Pensions are addressed in Article 18. Pensions and other similar remuneration for past employment are taxable only in the individual’s country of residence. The model also requires a country of residence to exempt from tax any pension payment that would have been exempt in the country where the pension fund is located. For instance, a distribution from a U.S. Roth IRA would also be treated as exempt by the other treaty country.

The model treaty includes separate articles for income earned by certain individuals, such as government employees, students, and artists. For example, remuneration for services rendered to a government entity is typically taxable only by that government’s country, regardless of where the services are performed.

Key Administrative and Anti-Abuse Provisions

The “Limitation on Benefits” (LOB) article is a provision to prevent “treaty shopping.” This occurs when a resident of a third country structures an investment through an entity in one of the treaty countries to gain access to the treaty’s benefits, such as reduced withholding tax rates.

To qualify for treaty benefits under the LOB article, a resident must meet one of several objective tests. For example, an individual resident automatically qualifies. Other tests may require that:

• An entity is a publicly traded company or its subsidiary.
• A certain percentage of the entity is owned by qualified residents.
• The entity does not use its income to make deductible payments to non-residents.

The model includes a dispute resolution mechanism known as the “Mutual Agreement Procedure,” or MAP. This allows taxpayers who believe they are being taxed inconsistently with the treaty to present their case to the “competent authority” of their country of residence. If the competent authorities cannot resolve a dispute, the model provides for mandatory binding arbitration.

Article 26 provides for the “Exchange of Information,” authorizing the tax administrations of the two countries to exchange information relevant for carrying out the treaty’s provisions or for enforcing their domestic tax laws. This cooperation is a tool in combating tax evasion and avoidance, and the information exchanged is subject to strict confidentiality rules.