IRS Tax Treaty Benefits and How to Claim Them

A tax treaty is a formal, bilateral agreement between the United States and a foreign country designed to resolve how income earned in one country by a resident of the other is taxed. The goal is to prevent the double taxation of the same income by two different jurisdictions. These agreements allocate taxing rights between the two countries. Under these treaties, residents of foreign countries may be taxed at a reduced rate or be exempt from U.S. income taxes on certain types of income from U.S. sources.

These international agreements foster economic activity and investment by providing a clear tax environment. They establish mutually agreed-upon rules that supersede the domestic tax laws of each country in specific circumstances. Treaties also serve as a tool for tax authorities to cooperate through the exchange of information to prevent tax evasion.

Determining Treaty Eligibility

A person must first confirm that a tax treaty exists between the U.S. and their country of tax residence. To receive treaty benefits, an individual or entity must be considered a “resident” of the foreign country under the terms of that specific treaty. Tax residency is determined by a country’s domestic laws and can be based on factors like physical presence, a permanent home, or the country of incorporation for entities.

A person can sometimes qualify as a resident of both the U.S. and a treaty country, creating a “dual-resident” situation. In these cases, treaties contain “tie-breaker” rules to assign residency to a single country for treaty purposes. The first test is where the individual has a permanent home available. If a permanent home exists in both countries, the next test is the “center of vital interests,” which examines where personal and economic ties are closer, followed by the individual’s “habitual abode.”

Treaties include a “Limitation on Benefits” (LOB) article, a provision designed to prevent “treaty shopping.” This practice involves residents of a third country attempting to gain treaty benefits by routing investments through an entity in a treaty country. The LOB article ensures that only bona fide residents with a substantial connection to the treaty country can access the treaty’s benefits, often by meeting tests related to public trading or ownership.

A “saving clause” is a provision in nearly every U.S. tax treaty that preserves the right of the United States to tax its citizens and residents as if the treaty did not exist. This means a U.S. citizen living abroad generally cannot use a treaty to reduce U.S. tax on worldwide income. However, the saving clause contains specific exceptions that provide the actual treaty benefits for U.S. citizens, often applying to income like foreign pensions, annuities, or social security benefits.

Common Treaty Benefits

One of the most frequent benefits provided by tax treaties is a reduction in the withholding tax on certain U.S.-source income paid to foreign persons. Under U.S. law, passive income like dividends, interest, and royalties is subject to a 30% withholding tax. Tax treaties often lower this rate, for example, reducing the withholding tax on dividends to 15% and eliminating the tax on certain types of interest.

Treaties provide specific rules for business profits, centered on the concept of a “permanent establishment” (PE). A foreign company’s business profits are taxable by the United States only if the company maintains a PE, such as an office, branch, or factory, within the U.S. Without a PE in the United States, the business profits of a foreign enterprise are exempt from U.S. tax.

Income from personal services is another area where treaties provide benefits. For independent personal services, such as those from a consultant, income is taxable in the U.S. only if the individual has a fixed base regularly available to them in the U.S. For employment income, a “183-day rule” often exempts the income of a foreign resident from U.S. tax if the employee is present in the U.S. for 183 days or less during a 12-month period and the remuneration is paid by a non-U.S. employer.

Many treaties also contain articles addressing pensions, annuities, and social security benefits, which may be taxable only in the recipient’s country of residence. Additionally, special provisions frequently apply to income earned by students, trainees, teachers, and researchers who are temporarily present in the U.S. For example, a student from a treaty country might be able to exempt a certain amount of income from U.S. tax for a specified number of years.

Required Information and Forms for Claiming Benefits

When a taxpayer takes a position that a U.S. tax treaty overrules a provision of the Internal Revenue Code, they are often required to file Form 8833, Treaty-Based Return Position Disclosure. The form requires the filer to identify the specific treaty country and the article(s) of the treaty they are relying on. The filer must also provide a summary of the facts and an explanation of the treaty-based position.

To claim treaty benefits on certain U.S. source income, foreign persons and entities provide a Form W-8 to the U.S. withholding agent or payer. Individuals use Form W-8BEN, while entities use Form W-8BEN-E. By providing a valid W-8 form, the foreign owner establishes their foreign status and claims a reduced rate of, or exemption from, U.S. tax withholding under a treaty.

How to Claim Treaty Benefits

For taxpayers who must disclose a treaty-based return position, the completed Form 8833 is attached to their U.S. tax return for the year. For example, a non-resident alien would attach Form 8833 to their Form 1040-NR. Filing this form ensures the IRS is officially notified of the treaty’s application to the taxpayer’s return.

The process for the W-8 series of forms does not involve a direct filing with the IRS. Instead, the foreign person or entity provides the completed form, such as Form W-8BEN or W-8BEN-E, directly to the U.S. withholding agent. This form serves as the payer’s justification for applying a reduced rate of withholding tax at the time of payment.