Double taxation—an issue US businesses and individuals who earn income in a foreign country and are required to pay tax on the same income in both the US and the foreign country. For example, Corporation X, a US C corporation, earns $100 of income in a foreign country. Assume that the foreign country imposes a 10% tax on Corporation X’s income earned. At the same time, the US taxes Corporation X’s foreign income at the current corporate rate of 21%. If no relief is in place, Corporation X will be required to pay $10 of tax to the foreign country and then again pay tax on the same income to the US in the amount of $21. This double taxation amounts to $31 dollars of tax between both countries, for a 31% effective tax rate.
Luckily, the US and other countries around the world want to avoid this result. Specifically, the US provides various forms of relief from dual taxation through the Internal Revenue Code (IRC). The main form of relief in the IRC is provided through the Foreign Tax Credit (FTC). The FTC is aimed at reducing US tax on income that is subject to taxation in another country. For a greater discussion of the FTC and other relief provisions for US businesses, please visit our Series 204: US Based Companies with Foreign Operations; Part 2: Dual Taxation Relief and Other Incentive Provisions.
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. 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 consistent rules governing which 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 firm 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 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 business who earns income in a country that has a 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 “savings clause” provides the US certain power 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. 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 for businesses, you must 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 businesses and individuals eligible for their benefits in a number of ways. For businesses, only those considered as a “resident” of one of the countries to the bilateral tax treaty may claim its benefits. A “resident” as it pertains to a business includes an entity that is considered as a corporation or is liable to tax by reason of its place of management, place of incorporation or similar criterion in the given country.
For example, when the entity is a Delaware corporation, that corporation is considered a US resident eligible for treaty benefits. This is because the entity is taxable in the US by reason of its incorporation in the country. However, if the entity is rather an Delaware LLC, and not subject to US tax unless an election is made to be treated as a corporation for tax purposes, the LLC is not considered a US resident for treaty purposes. Rather, each owner of the LLC could be a “resident” for treaty purposes.
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 a 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 refer to the provisions included in the US-Australia bi-lateral income tax treaty that is currently in full force and effect. You can find a copy of this treaty here.
Tax treaties cover both the incidence of outbound transactions (US companies with activity abroad) and inbound transactions (foreign companies with US activity). The discussion in this section will focus primarily on the latter—how the US taxes business income earned in the US by foreign businesses and persons.
As we discussed in both Series 203: US International Tax System for Businesses and Series 205: Foreign Based Companies with US operations, the US taxes foreign businesses on income derived from a business conducted in the US. This is a concept formally known as “income effectively connected to a US trade or business”. However, most treaties modify this concept so that a foreign business’s income is only taxable in the US if it constitutes “business profits” that are “attributable to” a “permanent establishment” maintained in the US. Both sound similar, right? While sounding similar, the tray concepts generally require a greater nexus or immersion in the host country than do the statutory standards.
Below is a table comparing the two concepts—
|Treaty Requirements||Statutory (IRC) Requirements|
Presence Required in the US
“Permanent Establishment” in the US is required for taxation
Need only be “engaged in a US trade or business” to be subject to US taxation
“Business profits” that are “attributable to” the permanent establishment
“Income that is effectively connected with a US trade or business”
Rate of Tax
Normal US tax rates
Normal US tax rates
Determining how a treaty can impact the US taxation of business income requires a number of interpretive steps:
- It must be determining a business is being carried on in the US;
- If so, it must be determined if the business is carried on through a “permanent establishment”;
- If not, the income is not taxed as business profits for treaty purposes. If, however, there is “permanent establishment”, profits must be attributed to that “permanent establishment”.
- Finally, deductions must also be appropriately allocated to the “permanent establishment”
We will discuss each of these steps and requirements in turn.
United States Trade or Business
The standard for determining whether a foreign person is carrying on a business in the US for treaty purposes requires a review of all the facts and circumstances applicable to the taxpayer. Traditionally, this analysis depends upon the case law definition a trade or business in IRC Section 162. For a general rule of thumb, if a person is engaged in an activity, for-profit, and their activity is continuous and substantial, it is likely a “trade or business” is established. This concept is more thoroughly discussed in Series 203: International Tax System for Businesses.
Permanent Establishment—US – AUS Treaty, Article 5
Generally, income tax treaties provide that business income is taxable in a country only if an enterprise possesses a “permanent establishment” in such a country. There is a qualitative difference between a “trade or business” and a “permanent establishment”. Generally, “permanent establishment” is seen as a higher threshold to subjecting business income to tax in the US.
For purposes of the US – AUS bi-lateral tax treaty, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on. Specifically, the treaty lays out the following items as constituting “permanent establishment”—
- a place of management;
- a branch;
- an office;
- a factory;
- a workshop; and
- a mine, an oil or gas well, a quarry or any other place of extraction of natural resources;
As you can see, a “permanent establishment” is equated with a fixed place of business through which the business of an enterprise is carried on. Thus, a business will have a “permanent establishment” in the US if it maintains a fixed place of business in the US itself or through the activities of another person, such as an agent, whose actions are imputed to the enterprise.
In addition, treaties provide specific situations that do not constitute “permanent establishment”. The US-AUS treaty lays out the following specific situations—
- the use of facilities for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
- the maintenance of a stock of goods or merchandise belonging to the enterprise for the purpose of storage, display or delivery;
- the maintenance of a stock of goods or merchandise belonging to the enterprise for the purpose of processing by another enterprise;
- the maintenance of a fixed place of business for the purpose of purchasing goods or merchandise, or for collecting information, for the enterprise; and
- the maintenance of a fixed place of business for the purpose of activities which have a preparatory or auxiliary character, such as advertising or scientific research, for the enterprise.
As mentioned above, “permanent establishment” may arise if the employees of a foreign business use a US office or other fixed place of business owned or leased by the foreign businesses. In addition, “permanent establishment” exists when the foreign business uses an agent who acts on behalf of the foreign business in the US. The imputation of “permanent establishment” through the use of an agent depends on whether they are “independent” (i.e. an independent contractor) or “dependent” (i.e. an employee of the business). The distinction between “independent” and “dependent” generally depends upon the extent of the agent’s ability and authority to act on the business’s behalf. For example, an agent with the ability to conclude contracts on behalf of a business with frequency and over a continuous period of time would be considered “dependent.”
Consequences of “Permanent Establishment” – Attributing Business Profits
Once “permanent establishment” is determined, the next “business profits” must be ascertained that are “attributable to” the permanent establishment. Under most treaties, only these “business profits” may be taxed by the US. Once attributed to a “permanent establishment”, such “business profits” can tax under the US’s normal system of taxation.
The determination of income subject to the US under this treaty concept follows a three-step process—
- Gross income derived by the foreign person attributable to a permanent establishment must be segregated from any other foreign or domestic source income which is not attributable to the permanent establishment;
- The foreign business’s expenses related to the permanent establishment must be segregated; and
- These expenses must be allocated between income attributable to the permanent establishment and other income.
“Business profits” generally includes income derived from any trade or business. Thus, income derived from the conduct of an active business is characterized as business profits.
Attributable To Concept.
Business profits are “attributable to” a permanent establishment if the assets or activities of the permanent establishment play a meaningful role in generating those profits.
Expenses Attributable to a Permanent Establishment
Foreign businesses with “permanent establishment” are tax on their “profits”, which requires the attribution of income and deductions. Since we’ve already covered the attribution of profits, we must discuss the attribution of deductions.
Traditionally, the treatment and attribution of expenses is directly addressed by the tax treaties. Specifically, Article 7, Section 3 of the US-AUS tax treaty states that–
“In the determination of the business profits of a permanent establishment, there shall be allowed as deductions expenses which are reasonably connected with the profits (including executive and general administrative expenses) and which would be deductible if the permanent establishment were an independent entity which paid those expenses, whether incurred in the Contracting State in which the permanent establishment is situated or elsewhere.”
Once the expenses that are “reasonably connected” with the profits of an foreign business, they can be offset against the corresponding business profits attributable to the business’s permanent establishment, and generate taxable income upon which US tax is levied.
Investment Income – Dividends, Interest and Royalties
As we discussed in Series 203: US International Tax Systems for Businesses, foreign businesses, and individuals who earn investment income 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 203.
However, if an applicable treaty provides, this 30% base withholding tax can be lowered to 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, foreign businesses must submit IRS Form W-8BEN-E 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
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 an 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 employer’s 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.