Income Tax Treaty Basics for Global Businesses
Doing business globally requires knowledge of the benefits and requirements of income tax treaties between the countries on both sides of a cross-border transaction. Tax treaties are bilateral agreements made by two countries to reduce or eliminate double taxation for their residents.
The U.S. currently has income tax treaties with more than 50 countries to promote doing business around the world. It is very important for all U.S. companies conducting business with foreign companies to understand the U.S. income tax treaties and related tax filings. This includes foreign-owned U.S. subsidiaries with various ongoing transactions with affiliates of their global group.
Tax treaties contain key articles important in determining the specific tax rate applicable to the parties of the treaty. Here’s a short list of these key articles:
- Residence: Identification of residents liable to tax and residency tiebreakers
- Permanent Establishment: Determination of the activities which create a taxable presence in the other treaty country
- Limitation of Benefits: Determination of eligibility for the treaty benefits
- Business Profits: Determination of where and how business profits are taxed
- Dividends, Interest and Royalties: There are separate articles which define these types of income and the applicable tax rate including any tax reductions or eliminations
- Independent and Dependent Personal Services: Determination of which treaty country will tax income from services performed
Payments of fixed or determinable annual or periodical (FDAP) income such as interest, dividends and royalties from a U.S. company to a foreign company require 30% U.S. income tax withholding under the Internal Revenue Code. With an applicable treaty, this rate of income tax withholding may be reduced or eliminated.
- When a U.S. company pays interest to a Chinese company, the U.S. income tax withholding rate is reduced to 10% under Article 10, Interest of the U.S. and China income tax treaty.
- Article 12, Royalties of the U.S. and Germany income tax treaty provides that royalties will only be taxed in the country of the beneficial owner of the royalty, eliminating tax in country of the company paying the royalty. Therefore, the 30% U.S. income tax withholding required under U.S. tax law is eliminated.
As you can see from these examples, income tax treaties reflect different tax rates depending on the countries involved and types of income earned. A detailed treaty analysis may be required to determine the applicable withholding tax rate.
To claim treaty benefits, a company must meet various qualification tests described in the Limitation of Benefits article of the treaty. Generally, a taxpayer who takes tax treaty benefits should consider filing IRS Form 8833 to disclose the treaty position.
There are many filing requirements and exceptions to consider for Form 8833. Some of the most common requirements arise when FDAP income is not properly reported on Form 1042, if the FDAP income exceeds $500k, or if the treaty imposes additional conditions for the entitlement of treaty benefits. Form 8833 is an informational report that does not create tax liabilities; however, the noncompliance penalty is $10,000 per form in the case of a C corporation.
Understanding the requirements and benefits of an income tax treaty for your global business can be complex. As global expansion experts, we can help you realize the maximum benefit from an applicable treaty and meet all related filings. Contact us today to learn more.