Perfect timing, taxwise. In June, the U.S. signed an international income tax treaty with Slovenia.
Coincidence? Not really. Income tax treaties often are a first step in the expansion of commerce between the U.S. and other nations. And while these treaties are dominated by business concerns, they also contain key provisions for individual taxpayers. Their primary goals are to prevent double taxation of individuals' income and to reduce tax evasion through the sharing of information between the two countries.
The U.S. has tax treaties with 64 countries, mainly in Europe. Incidentally, the first income tax treaty the U.S. signed was with France, in 1932.
Thanks to the recent corporate rush to set up shop in developing countries, there are a growing number of treaties in the works with countries like Bangladesh and Sri Lanka.
As a result, there is an even bigger need for guidance on the international tax front. Here are some basics on how these treaties govern individual taxpayers.
Most nations tax residents on their worldwide income. They also tax nonresidents on income derived from within their borders.
So if you're a U.S. citizen living in the United Kingdom and working for a U.K. company, the U.S. still will tax you on that money because it's part of your worldwide income. The U.K. will tax you as well because the income was derived in the U.K. Hence, the potential for double taxation of your hard-earned money.
This double taxation could put the breaks on free-flowing international trade and investment altogether. So treaties were created to stop this injustice.
These treaties provide that the country that is the source of the income has the primary right to tax it. "They have first bite of the cherry," says Jonathan Fox, a partner on the U.K. tax desk at
Ernst & Young
. So in the example above, the U.K. is the primary source of the income, so the U.S. citizen must pay U.K. taxes.
But thanks to the tax treaty between the two countries, the U.S. citizen will not owe U.S. taxes on those wages. Instead, he'll get a tax credit for any foreign tax paid up to the amount of tax the U.S. would have levied, says Bruce Reynolds, a partner in the international tax services group at
Deloitte & Touche
in Washington. (For more on foreign tax credits, see a previous
Not all countries reimburse citizens in the form of tax credits. Some will simply exempt the money from the worldwide taxable income rule. Others allow the amount of foreign tax paid to be deductible as an expense. Either way, with a treaty in place, you're not paying tax twice anymore.
Things are a bit different for investment income. To start, there is no capital gains tax on a foreigner's investments in the U.S. But dividends are taxable, and the U.S. withholds that tax up front to ensure that it is paid. If an investor's resident country is unknown or has no treaty with the U.S., the withholding is a blanket 30% on dividends.
Withholding can be substantially reduced for citizens of countries that have tax treaties with the U.S. For instance, residents of France are subject to 15% withholding on dividends and there is no withholding at all for citizens of Belgium.
Similar rules apply to all other types of individual income, including real estate, interest income and royalties. These treaties do not cover estate tax issues. They are covered by separate treaties, though not many exist.
Another major goal of tax treaties is to allow for the free exchange of information to prevent tax evasion. In essence, these treaties authorize countries to tattletale on tax cheats.
"If we believe someone has a bank account in a foreign country and was not reporting, say, a dividend
on his U.S. tax return, we can get that information from the country," says Deloitte & Touche's Reynolds.
In fact, the
pushes for information-sharing provisions when treaties are being negotiated, notes Reynolds. But this push for freedom of information can backfire. Certain jurisdictions don't want to allow free information. They pride themselves on their secrecy laws.
Since this information is so important, the U.S. will not enter into a treaty with a country that balks at sharing information. For instance, the Cayman Islands has very strict bankruptcy secrecy laws and no tax treaty with the U.S. (See a previous
Global Tax Forum for other countries with strict secrecy laws.)
The U.S. also avoids entering into tax treaties with countries that run afoul of other policy objectives, tax-related or not. Thus, the U.S. has no tax treaties with nations like Iraq and Cuba. Here's a
list of countries that have treaties with the U.S.
Unfortunately, there's no single site that documents the provisions of all of these treaties. So if you're planning to work or invest in another country, call your local tax authority to get your hands on a copy of the treaty.
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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.