How Do U.S. Tax Treaties Benefit Individuals and Businesses?

U.S. tax treaties are agreements between the United States and foreign countries that set rules for taxing income for individuals and businesses with connections to both nations. The primary goal is to prevent the double taxation of the same income by two different countries, which fosters international commerce. A secondary goal is to combat tax evasion through mutual assistance and the exchange of taxpayer information between tax authorities.

Core Functions of Tax Treaties

Tax treaties prevent income from being taxed twice by providing relief from double taxation. The agreements lay out rules that determine which country has the first right to tax certain income and how the other country must provide relief. This ensures taxpayers are not unfairly burdened by paying full tax to two jurisdictions on the same earnings.

The most common method the U.S. uses to provide this relief is the foreign tax credit. Under this approach, the U.S. acknowledges the income taxes paid to a foreign country on foreign-source income. A U.S. taxpayer can claim a credit for those foreign taxes, which directly reduces their U.S. income tax liability, subject to certain limitations.

Another method is the exemption method. With this approach, the country of residence agrees to exempt certain types of income earned in the other country from its own taxation. For example, a treaty might specify that business profits earned in a foreign country are exempt from tax in the home country.

Treaties also establish rules to determine a single country of tax residence for an individual or company. A person or entity can be considered a resident of both the U.S. and a foreign country under their respective domestic laws. To resolve this, treaties contain “tie-breaker” rules that establish a hierarchy of tests to assign residency to just one country for treaty purposes.

For individuals, this hierarchy begins by looking at where the person has a permanent home. If a permanent home is available in both countries, the next test considers the individual’s “center of vital interests,” analyzing where their personal and economic ties are stronger. If that is inconclusive, the rules proceed to the individual’s habitual abode and finally to their country of citizenship.

Determining Treaty Eligibility

To access the benefits offered by a tax treaty, an individual or business must be considered a “resident” of one of the treaty countries. This determination is made by the domestic tax laws of that specific country. To be a resident of the United States for treaty purposes, an individual must meet the requirements of being a U.S. citizen or a resident alien under U.S. tax law.

Modern U.S. tax treaties also contain a “Limitation on Benefits” (LOB) article. The LOB provision prevents “treaty shopping,” where residents of a third country establish an entity in a treaty country simply to gain access to that treaty’s benefits. The LOB article has objective tests an entity must meet to be a “qualified person” entitled to treaty benefits.

One test is the publicly traded company test. If a company’s principal class of shares is substantially and regularly traded on a recognized stock exchange in its country of residence, it is considered a qualified person.

Another is the ownership and base erosion test. This test requires that more than 50% of the company’s ownership be held by qualified persons from the same treaty country. It also requires that less than 50% of the company’s gross income is paid to non-residents as deductible payments, like interest or royalties.

The active trade or business test allows an entity that is not otherwise a qualified person to receive treaty benefits for income derived from an active trade or business in its country of residence. The income must be connected to that business, preventing the entity from being used as a passive conduit for income from other sources.

Common Treaty Benefits for Individuals

Passive Income

Tax treaties provide benefits for individuals on passive income, such as dividends, interest, and royalties. U.S. law imposes a 30% withholding tax on these U.S.-source payments to foreign persons. Tax treaties often reduce this rate to 15% for dividends and as low as 0% for interest and royalties, lowering the tax barrier for foreign investment.

Pensions and Social Security

Treaties provide clear rules for the taxation of retirement income. Treaties often assign the exclusive right to tax private pensions and annuities to the recipient’s country of residence. This means a resident of a treaty country receiving a U.S. pension would only pay tax on it in their home country. Rules for social security payments can vary, but many treaties also assign taxing rights to the country of residence.

Income from Personal Services

Treaties also contain provisions governing income earned from services. For independent personal services (self-employment), income is taxable only in the individual’s country of residence unless they have a “fixed base” regularly available to them in the other country. For employment income, the “183-day rule” often applies.

Under this rule, a resident of one country performing services in another will be exempt from tax in the host country if they are present there for 183 days or less in a 12-month period, their employer is not a resident of the host country, and their salary is not borne by a permanent establishment in the host country.

Special Provisions for Students, Teachers, and Researchers

Many treaties include provisions to facilitate cultural and educational exchange. These provisions often allow students, apprentices, teachers, and researchers who are temporarily present in the U.S. to exempt certain income from U.S. tax. For example, a student from a treaty country studying at a U.S. university may exempt payments received from abroad for their maintenance and education. A professor from a treaty country who temporarily teaches at a U.S. institution may be able to exempt their teaching salary from U.S. tax for a specified period, often up to two years.

Common Treaty Benefits for Businesses

The key treaty concept for businesses operating internationally is the “Permanent Establishment” (PE). A PE is a fixed place of business through which the commercial activities of an enterprise are carried on. The existence of a PE is the threshold that determines whether a country has the right to tax the profits of a foreign enterprise.

A PE can be created through physical locations and activities. Common examples include a branch, an office, a factory, a workshop, a mine, or an oil or gas well. A construction or installation project that lasts beyond a certain time frame, often 12 months, can also create a PE.

Conversely, treaties specify that certain “preparatory or auxiliary” activities do not create a PE, even if conducted through a fixed place of business. Examples of these excluded activities include:

• Using facilities solely for storing, displaying, or delivering the enterprise’s own goods.
• Maintaining a stock of goods for processing by another company.
• Maintaining a fixed place of business solely for purchasing goods.
• Maintaining a fixed place of business solely for collecting information for the enterprise.

If a foreign company from a treaty country has a PE in the United States, the U.S. is permitted to tax the business profits that are attributable to that PE. If the company does not have a PE in the U.S., its business profits are taxable only in its country of residence. This provides a clear line for businesses to understand their tax obligations when expanding into foreign markets.

How to Claim Treaty Benefits

For non-U.S. individuals or businesses receiving income from U.S. sources, treaty benefits are usually claimed at the source of payment. This is done by providing a completed IRS Form W-8 to the U.S. withholding agent, which is the person or entity making the payment. This form certifies the recipient’s foreign status and entitlement to treaty benefits, allowing the payer to apply a reduced rate of withholding tax.

Individuals use Form W-8BEN, “Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals).” Entities, such as corporations or partnerships, must use the more detailed Form W-8BEN-E. This form includes sections for the entity to certify how it meets the LOB requirements in the relevant treaty.

If a taxpayer files a U.S. tax return and takes a position that a tax treaty overrules or modifies a provision of the Internal Revenue Code, they are generally required to file Form 8833, “Treaty-Based Return Position Disclosure.” This form is attached to their tax return and explains the specific treaty provision being applied.