What other Source Rules Focus on the Payee’s Residence?
March 25, 2014
Common income issues in international tax treaties
March 25, 2014
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Tax treaties role between the U.S. and its trade partners

The primary purpose of international tax treaties is to facilitate trade and investment by lowering tax barriers to the international flow of goods and services. Secondarily, tax treaties reduce the incidence of double taxation whereby if under domestic law a person were deemed a resident of two different foreign states and taxed accordingly.

Income tax treaties provide coordination between the separate and distinct income tax regimes of different nations. Many treaty provisions attempt to apportion tax revenues between the treaty countries by predetermining the rights of the treaty participants to tax economic transactions that touch both parties. To that end, most treaties exempt certain types of income from the tax nexus of one party to the treaty leaving the enumerated income solely taxable by the other party. Alternatively, a treaty provision may reduce the tax rate on certain transactions for one party’s residents which effectively leaves a larger ability to tax for itself. In summary, the effect of an individual treaty provision that either exempts income or reduces the tax rate to one treaty signatory is ordinarily effective in shifting tax revenue to the other.

ENHANCEMENT OF COMMERCE

Tax treaties also attempt to put a smooth path in place to facilitate business transactions and exchanges between the treaty participants that might be thwarted by overly aggressive tax provisions of a treaty participant.

Finally, tax treaties provide certainty and predictability so that taxpayers can arrange their affairs and conduct business with confidence. U.S. income tax treaties have the same force as domestic law and where provisions conflict with federal law, the later in time prevails. Commonly, tax treaties have the effect of reducing a taxpayers’ U.S. tax liability not increasing it.

BUSINESS INCOME

Generally, a resident of a contracting state avoids paying tax on business income earned in the other state unless the income is attributable to a permanent establishment (PE) in the other state. A PE can either be a physical (as in a fixed place of business i.e. office or factory) or through the concept of agency. A dependent agent of the taxpayer with authority to conclude contracts in the name of the principal and which habitually exercises that authority may be solely sufficient to constitute a PE. However, according to Article 5(4) of the U.S. Model Treaty, a PE does not include

  • The use of facilities or the maintenance of a stock of goods or merchandise in a contracting state for storage, display, or delivery;
  • The maintenance of a stock of goods or merchandise solely for processing by another enterprise;
  • The maintenance of a fixed place of business for the purpose of purchasing goods or merchandise or collecting information, or;
  • The maintenance of a fixed place of business solely for engaging in any other activity of a preparatory or auxiliary character.

PERSONAL SERVICES INCOME

In newer treaties personal services rendered in a contracting state are taxable only to the extent the income is attributable to a PE. However, under Article 14 of the U.S. Model, if a resident of a contracting state performs dependent personal services in another state, the state where the service was performed has taxing authority if any one of three conditions is satisfied. First, the recipient is present in the state where services are performed for more than 183 days during the taxable year. Second, the payment for services is paid by, or on behalf of a resident of that state. Third, the payment is borne by (i.e., is deducted by) a PE or fixed place of business.

INVESTMENT INCOME

In the absence of a tax treaty, investment income derived from U.S. sources and paid to nonresidents is subject to a 30 percent withholding tax. A tax treaty will usually lower this tax rate between the foreign states. However, where a taxpayer pays tax in both contracting states, the state of residence bears the responsibility of relieving the double taxation. Still, to the extent interest, dividends, or royalty income is attributable to a Permanent Establishment (PE) that the recipient maintains, then the income is treated as business profits fully taxable in the state where the PE is situated.

The ability to tax gains of investment property depends on the nature of the property. If gain is derived from the disposition of real property, then the income is subject to tax in the contracting state in which the real property was located. Similarly, gain derived from the sale of personal property (i.e. machinery & equipment) attributable to a PE is taxable in the state where the PE is located. Not surprisingly though, gain realized from the divestment of stocks or securities is usually taxable exclusively in the state of the seller’s residence.

Affect of Tax Treaties on the Taxing of Foreign Corporations