US-Italy Tax Treaty: How It Affects Your Taxes

The United States and Italy share a bilateral income tax treaty to clarify tax obligations for individuals and businesses with financial ties to both nations. The agreement aims to prevent the double taxation of income by allocating taxing rights between the two countries. It provides clear rules, reduced tax rates in some cases, and covers various forms of income by establishing which country has the primary right to tax.

Determining Treaty Eligibility

The benefits of the U.S.-Italy tax treaty are available only to individuals considered a “resident” of the United States, Italy, or both, as defined by each country’s domestic laws. An individual can be a resident of both countries simultaneously, creating a “dual resident” status.

When an individual is classified as a resident by both countries, the treaty provides a series of four “tie-breaker” rules in Article 4 to determine a single country of residence for treaty purposes. These tests must be applied in sequential order.

• Permanent home: This test considers where the individual has a home continuously available. If a permanent home exists in both countries or neither, the next test is used.
• Center of vital interests: This test examines where the individual’s personal and economic ties, such as family and business, are closer.
• Habitual abode: If the prior test is inconclusive, this test determines where the individual spends more time.
• Citizenship: If the first three tests do not resolve residency, the individual is deemed a resident of the country where they are a citizen. If citizenship is dual or held in neither country, the authorities of the U.S. and Italy will settle the issue by mutual agreement.

Treaty Impact on Common Income Types

Pensions

The tax treatment of pension income depends on the source. Private pensions and similar remuneration are taxable only in the recipient’s country of residence. This means an Italian resident receiving a private pension from a U.S. source would only pay tax to Italy. Government pensions for services rendered are generally taxable only by the paying country.

Social Security

The treaty provides a specific rule for Social Security benefits. Under Article 18, benefits from one country’s social security system are taxable only by that country. This means U.S. Social Security benefits paid to an Italian resident are taxable only by the United States. This rule is a notable exception to the treaty’s “Saving Clause,” ensuring these benefits are not subject to double taxation for U.S. citizens in Italy.

Dividends and Interest

For dividends and interest, the treaty allows both countries to tax the income but limits the rate the source country can charge. The country of residence has the ultimate right to tax, but the source country may impose a withholding tax. For dividends, the withholding tax rate is generally limited to 15%, though the rate can be lower for certain direct investments. For interest income, the source country can withhold tax at a maximum rate of 10%, though some types of interest may be exempt.

Capital Gains

The rules for taxing capital gains vary by asset type. For gains from the sale of real property, Article 13 gives the taxing right to the country where the property is located. For example, if a U.S. resident sells a home in Italy, Italy has the primary right to tax the gain. For gains from other assets, like stocks, the gain is taxable only in the seller’s country of residence.

Business Profits

Business profits of an enterprise are generally taxable only in its country of residence. The other country may only tax those profits if they are attributable to a “permanent establishment” located within its borders. A permanent establishment is a fixed place of business, such as an office, branch, or factory.

The Saving Clause and Relief from Double Taxation

The treaty’s “Saving Clause,” found in Article 1, allows the United States to tax its citizens on their worldwide income as if the treaty did not exist. This means that even if a U.S. citizen resides in Italy and the treaty assigns primary taxing rights to Italy, the U.S. may still tax that same income based on citizenship, preserving the U.S. system of citizenship-based taxation.

To prevent double taxation in these situations, Article 23 provides relief through the foreign tax credit. The U.S. provides a credit for income taxes paid to Italy on Italian-source income. A U.S. citizen in Italy can claim this credit on IRS Form 1116 to reduce their U.S. income tax liability by the amount of taxes already paid to Italy.

The foreign tax credit is a direct reduction of U.S. tax, but it is limited to the amount of U.S. tax owed on that foreign income. If the Italian tax paid is higher, the credit will only offset the U.S. tax liability and will not result in a refund.

How to Claim Treaty Benefits

U.S. tax filers claiming treaty benefits often must disclose their position by attaching IRS Form 8833, Treaty-Based Return Position Disclosure, to their return. This form is required when a taxpayer uses a treaty provision to overrule or modify the Internal Revenue Code, resulting in a tax reduction.

However, Form 8833 is not required for certain common benefits, such as claiming a reduced withholding tax rate on dividends or interest paid to an Italian resident. Disclosure is often waived in these cases.

Italian residents receiving income from U.S. sources can claim treaty benefits directly from the payor. To receive a reduced rate of withholding tax, an Italian resident must provide the U.S. payor with a completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting. This certifies their Italian residency, allowing the payor to apply the correct, lower withholding tax rate.