How the US Mexico Income Tax Treaty Works

The United States and Mexico share a comprehensive income tax treaty designed to clarify tax situations for individuals and businesses with financial ties to both nations. The agreement serves two primary functions. Its first goal is to prevent the double taxation of income, ensuring that a single stream of earnings is not fully taxed by both countries. The treaty’s second objective is to prevent tax evasion through mutual cooperation and the exchange of information between the U.S. Internal Revenue Service (IRS) and Mexico’s Servicio de Administración Tributaria (SAT).

By establishing clear rules for taxing cross-border income, the agreement provides certainty for taxpayers and aims to foster economic activity between the two countries. The treaty only applies where it benefits taxpayers; it cannot increase a person’s tax liability compared to what it would be under domestic law.

Determining Residency for Treaty Purposes

Eligibility for the benefits of the U.S.-Mexico tax treaty hinges on being a “resident” of one or both countries. For treaty purposes, a resident is any person who, under the laws of that country, is liable to tax there based on their domicile, residence, or place of management. An individual can be considered a resident of both the U.S. and Mexico simultaneously under their respective domestic tax laws, creating a “dual-resident” scenario.

To resolve this, the treaty establishes a series of four sequential “tie-breaker” rules to assign a single country of residence. The first test considers where the individual has a “permanent home” available to them. A permanent home is any form of dwelling, whether owned or rented, that is continuously available, not just for occasional stays. If a person has a permanent home in both countries, the analysis proceeds to the next test.

The second test examines the individual’s “center of vital interests.” This involves evaluating where the person’s personal and economic ties are closer. Factors include family and social relationships, occupation, political activities, and the place of business. The country where these connections are stronger is deemed the country of residence.

If the center of vital interests is not determinative, the third test looks at the individual’s “habitual abode.” This test identifies the country where the individual spends more time as a qualitative assessment of where the person customarily lives. Should this test fail to yield a clear result, the final tie-breaker is citizenship. If the individual is a citizen of both nations or of neither, the competent authorities of the U.S. and Mexico must settle the question by mutual agreement.

How the Treaty Affects Taxation of Specific Income

The treaty allocates taxing rights between the two countries for various types of income. For business profits, the concept of a “permanent establishment” (PE) is fundamental. A business’s profits are taxable only in its country of residence unless it operates through a PE in the other country. A PE is a fixed place of business, such as an office, factory, or branch, through which the business is wholly or partly carried on. If a PE exists, the country where it is located can tax the profits attributable to that PE.

Income from employment, referred to as “dependent personal services,” is typically taxed in the country where the work is physically performed. However, an exception known as the “183-day rule” exists. The employee’s country of residence retains the sole right to tax the employment income if three conditions are met: the employee is present in the other country for less than 183 days in any 12-month period, the remuneration is paid by an employer who is not a resident of the other country, and the remuneration is not borne by a PE that the employer has in the other country.

For passive income streams like dividends, interest, and royalties, the treaty allows the source country to impose a tax but caps the rate. For dividends, the withholding tax rate is generally limited to 10%. This rate can be reduced to 5% if the beneficial owner is a company that owns at least 10% of the voting stock, and may be eliminated for dividends paid to a parent company that has owned a majority of the stock for a 12-month period, provided certain conditions are met. The treaty also sets maximum withholding tax rates on interest and royalties.

Pensions and other similar remuneration paid to a resident of one country for past employment are generally taxable only in that individual’s country of residence. This rule ensures that retirees who have moved from one country to the other are not subject to tax on their pension income in the country where they formerly worked. This provision applies to private pensions and annuities, simplifying the tax obligations for many cross-border retirees.

Claiming Treaty Benefits

A taxpayer eligible for a treaty benefit must take specific procedural steps to claim it. For U.S. taxpayers, this often involves filing Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).” This form is required when a taxpayer takes a position that a treaty provision overrides the Internal Revenue Code, resulting in a tax reduction. The form requires a summary of the facts and a brief explanation of the position, and failure to disclose it can result in penalties.

For non-U.S. persons, such as a resident of Mexico receiving income from a U.S. source, the tool is Form W-8BEN, “Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting.” This form is provided directly to the U.S. withholding agent, like a bank or brokerage firm. By completing Form W-8BEN, the Mexican resident certifies their foreign status and claims a reduced rate of U.S. tax withholding on income like dividends and interest. This process prevents excessive tax from being withheld at the source.

The Saving Clause and Its Exceptions

A provision within the U.S.-Mexico tax treaty is the “Saving Clause.” This clause allows the United States to tax its citizens and residents as if the treaty did not exist. This means that a U.S. citizen living in Mexico cannot typically use the treaty to reduce U.S. tax on their worldwide income. The U.S. retains its right to tax based on citizenship, regardless of where the citizen resides or earns income.

This clause preserves the principle of U.S. taxation that citizens are taxed on their global income. For example, a U.S. citizen who is a resident of Mexico cannot use the treaty article on pensions to claim that their U.S.-source pension is only taxable in Mexico. The Saving Clause allows the U.S. to continue taxing that pension income.

However, the Saving Clause is not absolute and contains several exceptions. Certain articles of the treaty are excluded from its reach, meaning their benefits remain available to U.S. citizens and residents. The primary exception is the article governing the avoidance of double taxation. This ensures that U.S. citizens can still claim a foreign tax credit for income taxes paid to Mexico, which is the main mechanism for relieving double taxation.

Other exceptions to the Saving Clause include provisions related to social security payments and child support. These exceptions ensure that while the U.S. reserves its broad right to tax its citizens, the treaty still provides targeted relief to prevent double taxation and address specific cross-border social policy issues.