What is a Tax Treaty?

You have probably heard mention of a tax treaty, but you might not be sure what one is or what it entails. Many countries have entered tax treaties with other countries to avoid or to mitigate double taxation. Depending on the agreement, it can cover a wide variety of tax topics, including inheritance taxes, value added taxes, income taxes, and other kinds of taxes. There are different kinds of tax treaties, such as bilateral treaties and multilateral treaties.

U.S. Tax Treaties

The United States has tax treaties with several foreign countries. These treaties allow residents, who are not necessarily citizens of foreign countries, to be either exempted from U.S. income taxes or taxed at a lower rate. The rate applies to specific income items they receive from sources within the U.S.

If a treaty doesn’t cover a specific source of income, or if there is no treaty between the U.S. and the other country, the individual must pay taxes at the same rate and in the same manner as shown in the instructions included on the U.S. Nonresident Alien Income Tax Return, Form 1040NR.

State Tax Returns

Many individual U.S. states tax their residents’ income. Whether the provisions of the U.S. tax treaties are honored by those states can vary significantly from one state to another. It is imperative to consult with a tax professional in the state where you reside, so you can determine if individuals have their income taxed by the state and whether that tax applies to any of your income. You should also learn if the tax treaty is applicable in the state where you are residing and if so, how it affects your tax situation.

How is Income Reduced

The applicable treaty determines the amount of a reduction of the U.S. taxes as they apply to those who are legal residents of foreign countries. Unless there are certain specified exceptions, tax treaties don’t reduce the U.S. taxes of individuals who are legal U.S. citizens or U.S. treaty residents. Anyone who is a U.S. treaty resident or U.S. citizen must pay U.S. income taxes on their income regardless of where in the world it was earned.

Tax Treaties and Their Effect

The applicable treaty determines residency for tax purposes. If under a tax treaty you are treated as the resident of a foreign country, and not considered a dual resident, you are considered to be a nonresident alien when you calculate your income tax for the U.S. If you are a resident of another country and the U.S. using each country’s tax laws, you will be considered a dual resident taxpayer. If you classify as a dual resident taxpayer, you can still claim income tax treaty benefits as they apply.

Consult With A Tax Professional

You need to make sure you understand any applicable tax treaties and file your taxes properly, so contact the experienced tax planners at MKS&H! We would be happy to meet with you at your convenience to discuss the best strategies for your business.