Double taxation—it is an issue that faces US taxpayers who earn income in foreign countries and are required to pay tax on the same income in both the US and the foreign country. For example, Bill, a US taxpayer, earns $100 of income in a foreign country. Assume that the foreign country imposes an 10% tax on income earned, while the US taxes the same income at its top marginal rate for individuals at 37%. If no relief was in place, Bill would have to pay $10 of tax to the foreign country and then pay tax again on the same income to the US in the amount of $37. This would add up to $47 dollars of tax between both countries, for an 47% effective tax rate.
Luckily, the US and other countries around the world want to avoid this result to fairly tax their citizens and the citizens of other countries. The US provides various forms of relief from dual taxation through the Internal Revenue Code (IRC). The main two are the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). Both provisions are aimed at reducing US tax on income that is subject to taxation in another country. For a greater discussion on these relief provisions, please visit our Series 105: Relief from Dual Taxation, Part 1—Foreign Earned Income Exclusion and Foreign Tax Credit.
While the US has provided its own means for reducing the incidence of dual taxation by two countries, it is not always a guarantee that another country will afford the same, consistent relief. In order to mitigate these discrepancies, the US has entered more 55 income tax treaties with more than 65 other countries. The purpose of these treaties is to provide consists rules governing which treaty country has the primary right to tax income items. These items include a broad variety of topics, such as business profits, rental income, dividends, interest, royalties, etc. and even certain classes of persons (i.e. students, teachers, athletes, artists, apprentices, etc.).
While treaties are intended to mitigate dual taxation and provide a form set of rules between countries, they have their own nuances as to how they are interpreted and applied. Thus, they bring about their own complexities as the treaties bring about a second source of tax law that can be equal in weight to that of other laws. For example, treaties hold the same legal weight as any other law passed by congress and even override the rules and regulations provided within the IRC. Thus, if you are a taxpayer who earns income in a country that has an tax treaty in effect with the US, you will have to determine what general US tax law it overrides and determine how to apply the provisions of the treaty in conjunction with the other aspects and laws of the IRC that are not overridden.
On top of the nuances that come from interpreting and applying treaty provisions in connection with other existing tax law, the US keeps powers in this treaty that could otherwise be described as a “trump card”. This “trump card” is otherwise known as the “savings clause”. The basic premise of a tax treaty is that the US extends tax benefits to foreign residents of a tax treaty country in exchange for that country’s reciprocal grant of benefits to US persons. However, the US keeps a certain power in its hands, that is the right to subject its own citizens, including those permanently living abroad, to US domestic tax on their worldwide income as if the treaty were not in effect. This is what is known as the “savings clause” in a tax treaty. Thus, US citizens are generally not permitted to avoid taxation by establishing foreign residency and claiming US tax treaty benefits extended to foreign residents.
Before getting into the general relief that tax treaties provide, you must always make sure that you are eligible for the benefits of the treaty before diving in too deeply. Generally, the countries to a bi-lateral tax treaty limit persons eligible for their benefits in a number of ways. For individuals, generally only those persons who are a “resident” of one of the countries to the bi-lateral tax treaty may claim its benefits. A “resident” is generally defined as those individuals who qualify as a “resident” under the laws of the countries who are party to the treaty. However, if a person qualifies as a “resident” under both countries’ laws, the treaty will provide a residency tie-breaker rule to place the person as a resident of only one country for purposes of applying the provisions of the treaty.
Even after you determine you are a person or individual who qualifies as being eligible for the benefits of a treaty, you need to make sure that the benefits you are attempting to obtain are not disqualified by a “limitation on benefits” provision within the treaty. Generally, these provisions within a treaty restrict treaty benefits to those individuals legitimately connected to the treaty country and is really geared to curb what is otherwise known as “treaty shopping”. These limitations prevent citizens of other countries that do not have US tax treaties from exploiting treaty benefits by conducting their business or operations in favorable treaty countries.
If you determine that you are eligible for the benefits of a treaty and that you are not disqualified for any such benefits by a “limitation on benefits” provisions within such treaty, you are ready to apply the provisions of the treaty to lower the incidence of dual taxation. For purposes of the following discussion, we will make reference to the provisions included in the US-Australia bi-lateral income tax treaty that is currently in full force and effect. This review is geared towards the application of the treaty’s provisions as it applies to individuals, and not business entities. You can find a copy of this treaty via the following link-[insert link to US-AUS tax treaty].
Under the US-Australian tax treaty, a person is defined as a resident of—
- Australia if the person is a person (except a company as defined under the law of Australia relating to Australian tax) who, under that law, is a resident of Australia; and
- The United States if the person is a person (except a corporation or unincorporated entity treated as corporation for US tax purposes) resident I the US for purposes of its tax.
It is very easy to imagine a scenario where a person qualifies as a resident of both Australia and the US under the definitions provided in the treaty. For example, assume Bill is a natural born US citizen who moved to Australia when he was a mere 2-years old. While in Australia, Bill obtains his Australian citizen ship and lives there full time. In our example, Bill would qualify as a resident of both Australia and the US and could likely be subject to double tax on his income earned in Australia. As mentioned earlier, treaties generally provide a residency tie breaker in these situations so that a person like bill is treated as a resident of only one country for tax purposes. The US-Australian income tax treaty provides the following residency tie breaker.
Whereby the application of US-Australian tax treaty deems a person a resident of both countries, they shall be deemed to be a resident of the country—
- Where they maintain their permanent home;
- If they do not have a permanent home, where they have a habitual abode if they have a permanent home in both countries or in neither country; or
- If neither of the above apply, in determining a individual’s permanent home, regard shall be given to the place where the individual dwells with their family, and in determining the country in which an individual’s personal and economic relations are closer, regard shall be given to his citizenship (if a citizen of one of the countries)
If we apply this residency tiebreaker to our example with Bill, it looks very likely that we would be deemed as a resident of Australia for both Australia and US tax purposes. That is because Bill keeps his permanent residence in Australia. Thus, Bill will be treated as a resident of Australia and a non-resident for US purposes when determining his taxes owed to each country for the year.
This residency definition and residency tiebreaker is very important to many persons who are dual citizens of separate countries or are ex-patriates. As you can imagine in our example with Bill, if the US-Australian tax treaty did not exist, Bill would be subject to tax on his worldwide income in the US on an annual basis—not very fair for a guy who hasn’t lived there for a long time, right? Many of dual-citizens and ex-patriates will utilize this provision in an applicable tax treaty to deem themselves as a non-resident for US income tax purposes, and thereby avoid being taxed on their worldwide income, and limit such tax to only income that is earned from sources within the US.
However, it is important to note that a residency tie breaker utilized by some one only applies to the calculation of income tax for purposes of both countries. It, however, does not apply to all reporting standards to those who are US citizens. For example, a US citizen living abroad permanently in Australia and utilizing the benefits of the treaty to only be considered a resident of Australia for both Australia and US income tax purposes will still be subject to certain reporting requirements of US citizens. This includes US Treasury FinCen 114, Foreign Bank Account Report, and Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. If you would like to learn more about these forms and what they require, please visit our article Series 104: How to Report Foreign Assets.
Investment Income – Dividends, Interest and Royalties
As we discussed in Series 103: US international tax system for individuals, US residents v. Non-US residents, non-resident aliens of the US who earn investment income or other passive sourced in the US are subject to a fault 30% withholding tax on such income. This category of income is called FDAP income and is explored deeper in Series 103.
However, if an applicable treaty provides, this 30% base withholding tax can be lowered to the like of 15%, 10%, 5%, and even 0% in some situations. For purposes of the US-Australia tax treaty, these withholding rates are reduced to the following for their respective category of income—
- Dividends: Tax on dividends paid by a company which is the resident of one country to a resident of the other country to the treaty is not to exceed 15%.
- Interest: Tax on interest payments from sources in one country to a resident of the other country to the treaty is not to exceed 10%.
- Royalties: Tax on royalties from sources in one country paid to a resident of the other country to the treaty shall not exceed 10%.
It is important to note that the withholding rates vary on each country’s treaty with the US.
Additionally, if you are non-resident alien with respect to the US, you must submit IRS Form W-8BEN to the payor of the investment income to take advantage of the reduced withholding rates specified above. If not, the payor of the investment income is obligated to withhold the flat 30% tax from the proceeds that are owed to you.
Income from the Provision of Services – Independent Contractors and Employees
In addition to covering the definition of your residency and how investment income is tax between nations, treaties also address how persons, who are residents of one country and work abroad in another country are taxed on their income as an independent contractor or as an employee. Many of these provisions governing the taxation of income from personal services are consistent from treaty to treaty, but we explore the specifics of the US-Australia treaty below.
With respect to independent contractors, the US-Australia tax treaty provides that independent contractors who are a resident of one country are only taxable on such income in the country they are a resident of unless the services they performed are performed in the other country and either—
- The person is present in the other country for a period of more than 183 days in the tax year of the other country; or
- The person has a “fixed base” that is regularly available to them in the other country for the purpose of performing their activities.
For example, let’s say Bill, a US citizen. is a technology consultant who has his main base of operations in the US but has some Australian clients. Throughout the year, Bill spends January through September in the US and decides for the first time to spend the remainder of the year in Australia. During this period of time, Bill is working on both his US and Australian clients. Based on the US-Australian tax treaty provision for independent contractors, Bill would only be subject to tax on the income he earned from his independent contractor profession as a technology consultant in the US, and not in Australia. While Bill earned income from his job during his time in Australia, he was not there long enough to become subject to tax on such income in Australia. Bill did not meet the 183-day period required by the treaty. Thus, Bill will only be subject to tax on income from being a technology consultant in the US, so long as he claims the property treaty exemptions in Australia.
However, the rules are different if you earn income as employee of another. Generally, income received as an employee is taxable by the country of the taxpayer’s residence, so long as the taxpayer spends less than 183 days in the other country to the treaty, the income is paid by an employer who is not a resident of the other country, and the income paid is not deductible by the employer when determining the employers taxable income in the other country.
Really, the biggest key to take away from this provision is that if you are either an independent contractor or an employee who works between the US and Australia, you can obtain the benefits of the treaty so long as you spend less than 183-days in the country of which you are not a resident. Also, a note to keep track of, this is the provision only for the US-Australia tax treaty. While most other treaties with the US use similar provisions, they could vary slightly and have different requirements.
Retirement Income—Pensions, Annuities and Social Security
A big item to consider is the taxation of one’s retirement income if an individual works and earns income between two countries. Generally, tax treaties are set up such that pensions and other retirement income is only taxable by the country in which the retirement income was earned in consideration of past employment. As for social security, generally this is only taxable by the country from which it was paid.
The type of income and is related taxability between the US and Australia is set out below—
- Pensions: Pensions and other similar retirement income paid to an individual who is a resident of one country in consideration of past employment is only taxable in that state.
- Annuities: Annuities paid to an individual who is a resident of one of the countries shall only be taxed in that country.
- Social Security: Social security payments and other public pensions paid by one of the countries to an individual who is a resident of the other country is only taxable by the country making the payment.