What Is a Tax Treaty?

A tax treaty is a bilateral agreement made by two countries to resolve issues involving double taxation of passive and active income. Income tax treaties generally determine the amount of tax that a country can apply to a taxpayer's income, capital, estate, or wealth. An income tax treaty is also called a Double Tax Agreement (DTA).

How a Tax Treaty Works

When an individual or business invests in a foreign country, the issue of which country should tax the investor’s earnings may arise. Both countries–the source country and the residence country–may enter into a tax treaty to agree on which country should tax the 澳洲幸运5官方开奖结果体彩网:investment income to prevent the same income from g🧔etti⛄ng taxed twice.

The source country is the country that hosts the inward investment. The source country is also sometimes referred to as the capital-importing country. The residence country is the investor's country of residence. The residence country is also sometimes referred to as the capital-exporting country.

To avoid 澳洲幸运5官方开奖结果体彩网:double taxation, tax treaties may follow one of two models: The Organization for Economic Co-operation and Development (OECD) Model and the 澳洲幸运5官方开奖结果体彩网:United Nations (UN) Model Convention.

OECD Tax Treaty Model vs. UN Tax Treaty Model

The Organization for Ecꦉonomic Co-operation and Development (OECD) is a group of 37 countries that promotes world trade and economic progress.

The OECD Tax Convention on Income and on Capital is more favorable to capital-exporting countries than capital-importing countries. It requires the source country to give up some or all of its tax on certain categories of income earned by residents of the other treaty country.

The two involved countries will benefit from such an agreement if the flow of trade and investment between the two countries is reasonably equal and the residence country taxes any income exempted by the source cou𒁏ntry.

The second tax treaty model is formally referred to as the United Nations Model Double Taxation Convention betwe🅺en Developed and Developing Countries. The UN is an international organization that seeks to increase political and economic cooperation amongst its member countries.

A treaty that follows the UN's model gives favorable taxing rights to the foreign country of investment. Typically, this favorable taxing scheme benefits developing countries receiving inward investment. It gives the source country increased taxing rights over the business income of non-residents compared to the OECD Model Convention. The United Nations Model Convention draws heavily from the OECD Model Convention.

Withholding Taxes Policy

One of the most important aspects of a tax treaty is the treaty's policy on withholding taxes, because it determines how much tax is levied on any income earned (interest and dividends) from securities owned by a non-resident.

For example, if a tax treaty between country A and country B determines that their bilateral withholding tax on dividends is 10%, then country A will tax 澳洲幸运5官方开奖结果体彩网:dividend payments that are going to country B at a rate of 10%, and vice versa.

For individuals that are residents ofꦇ countries that do not have tax treaties with the U.S., any source of income that is earned within the U.S. is taxed in the same way and at the same rates shown in the instructions for the applicable U.S. tax return.

The Bottom Line

Bilateral, or two-party, tax treaties se🌟ek to avoid double taxation for residents of each country.

The U.S. has tax treaties with multiple countries that help to reduce—or eliminate—the tax paid b🔜y residents of foreign countries. These reduced rates and exemptions vary among c🐻ountries and specific items of income.

Under these same treaꦛties, residents o🔥r citizens of the U.S. are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries.