By Lynn M. Eller, CPA, APCIT, PFS

U.S. businesses that expand internationally must address a variety of tax-related implications.

To ensure compliance and limit income tax exposure — especially by foreign jurisdictions — U.S. resident companies must understand how income tax treaties work.

Tax treaties generally help to reduce tax liability for cross-border companies.

In this article, the international tax team from PBMares highlights key terms and considerations about income tax treaties.

Key takeaways in this article:

  • What is an income tax treaty?
  • Benefits of understanding treaties
  • Key provisions in a tax treaty
  • Now what? Next steps and frequently asked questions

What Is a Tax Treaty?

A tax treaty is an international double taxation agreement (DTA) designed to prevent the same income from being taxed twice.

Tax treaties also aim to:

  • Prevent tax evasion and fiscal fraud
  • Promote international investment
  • Encourage international trade by creating a more predictable tax environment

Currently, the U.S. has more than 60 income tax treaties with its trading partners.

Benefits of Understanding Tax Treaties

Beyond IRS compliance, multinational companies experience several benefits from understanding the many provisions within tax treaties, including:

  • Leverage all the tax treaty benefits to which they are entitled.
  • Recognize the ways tax treaties generally help to reduce tax liability.
  • Clarifying how international business profits will be taxed is critical when analyzing outbound expansion.

Key Provisions in a Tax Treaty

Residency Rules

Tax treaties clarify rules regarding which treaty partner will tax certain income and at what rate.

  • A treaty will specify which country has the right to tax a company based on the company’s residence. Residence is often defined by where the company was incorporated or where it effectively managed at the present time.
  • Permanent Establishment (PE). A treaty will help clarify whether a company has sufficient physical presence or conducts enough of its business activities in a country to be taxed there. Typically, a PE includes a fixed place of business, such as an office or a factory.

A U.S. company’s business profits in a treaty country are subject to foreign income tax only if the U.S. company has a PE in that country. The reciprocal is also true.

Key Takeaway: By properly interpreting the treaty and adhering to certain activities, a company can avoid creating a PE in the foreign country and potentially avoid foreign taxation on the income earned in the foreign country. The company can strategically plan how to operate the business and optimize any tax benefits .

Allocation of Taxing Rights

In the absence of a tax treaty, U.S. tax withholding of 30% is generally required on payment of dividends, interest, capital gains, and royalties paid to foreign persons. Treaties typically reduce or eliminate this tax on a reciprocal basis with the treaty country.

Tax treaties define which country has the jurisdiction to tax specific types of income, including:

  • Business Profits. This income is generally taxed in the country where the company has residence unless permanent establishment can be proven in another country.
  • Dividends, Interest, and Royalties. This income is often subject to reduced withholding tax rates.
  • Capital Gains. Taxation rights on capital gains vary. Usually, the country of residence has taxation rights. Some exceptions exist, e.g., gains are related to immovable property or certain business assets.

Key Takeaway: Understanding the tax treatment for each country in which your business operates and how certain types of income will be affected is part of a strategic international tax planning.

Relief from Double Taxation

Tax treaties provide mechanisms that help to avoid double taxation. There are two main options:

  • A deduction for the foreign income taxes paid or accrued, based on the U.S. company’s method of accounting
  • A foreign tax credit, which may be subject to certain limitations
  • Certain treaty articles exempt taxation of a category of income in one or the other treaty country.

Key Takeaway: The credit creates a more favorable tax outcome at first glance, but foreign tax credits are subject to complex rules and income categorization requirements. Understanding the available choices and related limitations  is essential for businesses operating outside the US.

Other Tax Treaty Provisions

Non-Discrimination

Treaties often include non-discrimination clauses that ensure residents of one country are not treated less favorably than residents of another country in similar circumstances.

Individual Residency Conflicts

An individual taxpayer may be considered a resident of both the U.S. and the foreign country because each country applies its own domestic definition of the term resident. Tax treaties provide residency tie-breaker rules.

Mutual Agreement Procedures

Mutual agreement procedures are included in treaties to resolve disputes as to the proper interpretation and application of specific treaty provisions.

Exchange of Information

Treaties typically include provisions for the exchange of information between tax authorities, with certain constraints, in order to combat tax evasion and ensure compliance.

Now What?

Below are four practical steps multinational companies can use to minimize tax liabilities:

  1. Review Applicable Treaties. Take time to review and thoroughly understand treaties with countries where the company operates.
  2. Consult with Tax Experts. Speak with international tax advisors to navigate complex treaty provisions.
  3. Keep Good Records. Maintain thorough documentation (e.g., residency certificates and records of transactions) to support any treaty benefits claimed.
  4. Stay Updated. Monitor applicable changes in tax laws and treaty updates that might impact the company’s tax obligations.

Understanding and effectively utilizing tax treaties can significantly reduce tax liabilities, avoid double taxation, and ensure compliance with international tax regulations for cross-border companies.

Frequently Asked Questions

How can we determine if our company has a Permanent Establishment (PE) in a foreign country?

Determining whether your company has a Permanent Establishment (PE) in a foreign country depends on several factors outlined in the tax treaty between your country of residence and the foreign country.

Generally, a PE is a fixed place of business through which the business of an enterprise is entirely or partially carried out. This can include:

  • Physical Locations: Offices, branches, factories, or workshops.
  • Construction Projects: A construction site or project that lasts more than a certain period, often specified as 12 months.
  • Dependent Agents: Individuals or entities that habitually exercise authority to conclude contracts on behalf of your company in the foreign country.

Each treaty has specific nuances, so we recommend carefully reviewing the relevant treaty’s definition of a PE and consulting with an international tax advisor  to ensure compliance and understand the unique implications for your particular business.

From a tax perspective, should independent agents in foreign countries execute contracts?

For a U.S. corporation just starting to expand overseas, the general advice is to hire independent sales agents in the foreign country, but not give them authority to execute contracts.

This reduces the foreign income tax exposure for company profits, and also removes the need to deal with foreign payroll taxes.

How can our company take advantage of reduced withholding rates under a tax treaty?

To benefit from reduced withholding rates on dividends, interest, and royalties under a tax treaty, follow these steps:

  1. Identify Applicable Treaty Provisions. Review the tax treaty to determine the reduced rates and specific conditions for each type of income.
  2. Obtain Residency Certification. Obtain a certificate of tax residency from your domestic tax authority, which proves that your company is a resident of your country under the treaty.
  3. Complete Withholding Tax Forms. Complete and submit any required forms or applications to the tax authority of the source country, claiming the treaty benefits.
  4. Address Substance Requirements. Ensure your company meets any substance requirements outlined in the treaty or in relevant domestic laws (e.g., having significant business operations in your country of residence).

What should we do if we believe our company is being double taxed despite the tax treaty?

If your company is facing double taxation despite a tax treaty, take the following steps:

  1. Review the Tax Treaty. Carefully review the relevant provisions of the treaty to understand how taxing rights are allocated and the mechanisms for relief from double taxation.
  2. Gather Documentation. Collect all necessary documentation supporting your claim of double taxation (e.g., tax returns, payment receipts, and correspondence with tax authorities).
  3. Contact Tax Authorities Provide tax authorities in both countries with the treaty provisions and supporting documents that demonstrate double taxation. Engaging an international tax advisor will make this process much easier.
  4. Consider Mutual Agreement Procedure (MAP). If direct resolution is not possible, request assistance through MAP provided in the tax treaty, which allows the authorities of both countries to negotiate and resolve the dispute.

Learn More

For U.S. companies that operate with a global perspective, a comprehensive understanding of tax treaties can be a transformative game changer. With proper planning, companies can maintain compliance as they strategically minimize their tax burden.

The PBMares tax team can guide your business through what can be a complex process. We’ll help walk you through the benefits of tax treaties and the tax relief available, complete the appropriate tax forms, and ensure you properly disclose related information on tax forms.

Contact us today to learn more.