A tax treaty is a bilateral agreement between two countries that aims to resolve issues involving the double taxation of passive and active income earned by their respective citizens. These treaties, also known as Double Tax Agreements (DTAs), dictate the amount of tax that a country can levy on a taxpayer’s income, capital, estate, or wealth.
Some nations, often labeled tax havens, have low or no corporate taxes and attract foreign investors. Generally, these countries do not participate in tax treaties.
Key Insights
- Purpose of Tax Treaties: A bilateral agreement designed to resolve double taxation issues for income earned by individuals and businesses across borders.
- Cross-Border Investments: Helps determine which country should tax the earnings when investments are made into a foreign country.
- Prevent Double Taxation: Limit or avoid the taxation of the same income by both involved countries through mutual agreements.
- Tax Havens: These countries typically refrain from entering into tax treaties, focusing instead on offering favorable tax rates to attract foreign business.
How Do Tax Treaties Work?
When someone invests abroad, both the source country (location of investment) and the residence country (home country of the investor) might have claims over the taxing rights on the investment income. Tax treaties help resolve these conflicts by defining specific taxation rights and obligations for each country, effectively preventing the same income from being taxed twice.
OECD vs. UN Tax Treaty Models
OECD Tax Treaty Model
The Organisation for Economic Co-operation and Development (OECD), consisting of 37 member countries, developed the OECD Tax Convention on Income and on Capital. This model generally favors capital-exporting countries by requiring the source country to forego some or all its tax revenue on certain income types earned by residents of the other treaty country.
UN Tax Treaty Model
Alternatively, the United Nations Model Double Taxation Convention between Developed and Developing Countries benefits capital-importing or developing countries receiving inward investments. This model grants greater taxing rights to the source country over the business income of non-residents compared to the OECD model, thereby encouraging economic equity between developed and developing nations.
The Role of Withholding Taxes
One critical aspect of a tax treaty is its policy regarding withholding taxes. This policy determines the tax rate imposed on the income (such as interest and dividends) earned by non-residents from securities.
Example: If a tax treaty between country A and country B sets a bilateral withholding tax of 10% on dividends, then dividends paid to residents of country B by entities in country A will be taxed at 10% and vice versa.
U.S. Tax Treaties
The United States has established numerous tax treaties with various countries to help minimize or eliminate the tax burden on foreign residents. These treaties are reciprocal, meaning they apply to both participating treaty countries and often include clauses meant to prevent tax abuse.
● Saving Clause: Typically included to restrict U.S. residents from exploiting the treaty to avoid taxes on domestic income.
Note that some individual U.S. states may not recognize or honor the provisions of these international tax treaties.
Related Terms: Double Tax Agreement, Investment Income, OECD Model, UN Model Convention, tax haven.
References
- Organisation for Economic Co-Operation and Development. “Glossary of Tax Terms: Taxation Treaty.”
- Organisation for Economic Co-Operation and Development. “Glossary of Tax Terms: DTA.”
- United Nations. “United Nations Model Double Taxation Convention between Developed and Developing Countries.”
- Organisation for Economic Co-operation and Development. “Model Tax Convention on Income and Capital: Condensed Version 2017.”
- Organization for Economic Co-operation and Development. “About”.
- Organization for Economic Co-operation and Development. “Where: Global Reach.”
- Organization for Economic Co-operation and Development. “Model Tax Convention on Income and on Capital: Condensed Version 2017”, Pages 15-18.
- Organization for Economic Co-operation and Development. “Model Tax Convention on Income and on Capital: Condensed Version 2017”, Page 12.
- Organization for Economic Co-operation and Development. “Glossary of Tax Terms: Withholding Tax.”
- Internal Revenue Service. “United States Income Tax Treaties A-Z.”
