Tax Treaty: Definition & How It Helps Taxpayers

KEY TAKEAWAYS

• A tax treaty is an agreement between two countries, to help resolve potential issues with double taxation. 
• The purpose of tax treaties is to ensure citizens of both countries are taxed appropriately and aren’t paying significant taxes in both countries. 
• Tax treaties can apply to a taxpayer’s income, capital, wealth, or estate.
• There are some countries that are considered tax havens, where there is little to no corporate tax. Tax havens don’t often enter into tax treaties with other countries.

What Is a Tax Treaty? 

A tax treaty is an agreement that’s developed between two or more countries. The purpose is to help remove the possibility and issues surrounding double taxation. This relates to both active income and passive income for the residents of both countries. 

In the United States, the tax treaties allow taxpayers to be taxed at a reduced tax rate or, even be exempt from paying taxes on their income. Tax treaties vary by country and the items of income. IRS publication 901 provides details about each of the different tax treaties.

It’s worth mentioning that there are some countries around the world that are considered tax havens. This means they have significantly different rules when it comes to taxable income. Essentially, tax haven countries either have extremely low corporate taxes or none at all. It’s rare that a tax haven country enters into a tax treaty with another country due to these reasons. In the absence of a tax treaty, the tax payer will need to pay taxes in accordance with the rules of the U.S. tax code.

What Are the Objectives of Tax Treaties? 

The objective of tax treaties is to reduce or even try to eliminate the tax that’s paid by a resident of a foreign country. The U.S. has many tax treaties with multiple countries around the world. The rates and various exemptions are going to vary from country to country. 

Under some tax treaties, U.S. citizens get taxed at a reduced rate or are exempt from paying foreign taxes. Tax treaties are put into place to avoid double taxation which means that the taxpayer would be taxed by both countries on the same income. 

Here are some of the primary reasons why a country might enter into a tax treaty. 

• To encourage individuals and businesses to take part in international trade and investment opportunities
• To promote a healthy level of information exchange between countries
• To eliminate, or at the very least reduce, the possibility of excessive taxation and double taxation 
• To help promote a deeper level of cooperation between countries

What Are the Models of Tax Treaties? 

There are two primary models of tax treaties that most countries choose to follow. The first one was developed by the Organization for Economic Co-operation and Development (OECD). This model currently (as of 2022) includes a group of 38 countries that have the purpose of promoting and driving world trade. The model imposes more restriction on the taxing rights of the income origin country, which gives them lesser taxing rights.

This model is more favorable towards countries that focus on exporting capital compared to countries that focus on importing capital. It describes that whoever the source country is will have to give up either some or all of the tax earned on specific categories of income. 

Both countries benefit from these types of treaty agreements if they have a relatively equal flow of trade and investment. 

The second tax treaty model is formally referred to as the United Nations Model Double Taxation Convention between Developed and Developing Countries. The United Nations focuses on increasing both economic and political cooperation for all of its member countries. 
With this model, the foreign country making an investment is going to receive more favorable taxing rights. Despite some of the differences, the United Nations Model uses many of the same practices that the OECD model does.

What Are the Advantages of Tax Treaties? 

There can be many advantages to tax treaties and it can often depend on the individual countries involved. Yet, the primary purpose of a tax treaty is to eliminate potential tax barriers when it comes to foreign investment or cross-border trade. 

Individuals and businesses can claim a treaty exemption that either modes or reduces their taxation of income. Income can come from pensions, annuities, social security, or personal services, for example. 

Another major benefit to tax treaties is the avoidance of double taxation. This means that individuals and corporations won’t get taxed in both countries or will be able to use more beneficial tax rates. 

Who Is Eligible for a Tax Treaty? 

This can depend on the specific countries and the details outlined and described in the tax treaty. According to the Internal Revenue Service (IRS), the foreign person must prove either a U.S. or foreign Taxpayer Identification Number.

This will help certify that the person is:

• An actual resident of one of the treaty countries 
• The actual owner of any earned income 

Summary

Tax treaties are agreements that are put into place between two or more countries to help reduce the possibility of double taxation for individuals or businesses that earn income abroad. The residence country in a tax treaty relates to the investor’s home country of residence. 

The country that is hosting the inward investment is the source country or often referred to as the capital-importing country. Aside from trying to reduce or eliminate double taxation, tax treaties have a few other benefits. 

They can encourage businesses and individual taxpayers to take part in foreign investment opportunities and international trade. As well, it promotes a healthy level of cooperation and information exchange between the two countries involved in the treaty. 

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.