What Does an International Tax Agreement Actually Mean?
If you are a US citizen living or doing business in a foreign country, that country probably has at least one international tax agreement with the US. The US has already concluded tax agreements with practically all of the so-called developed countries and the list continues to grow from year to year. (The list even includes a non-existent country: the USSR! There are several former Soviet Republics in which the old agreement is still in force.)
Of course, once they know that there is an agreement, most people’s reaction goes something like: “What does that tax agreement actually mean?”
Well, I usually start my answer with what it doesn’t mean.
What an International Tax Agreement Doesn’t Mean
First, it doesn’t mean that you can avoid taxes. In almost all cases, you’ll need to pay taxes in either the foreign country or the US.
And second, it doesn’t mean that you are exempt from US asset reporting requirements. You may have fewer obligations for certain types of assets thanks to an agreement, but the overall rule is that you will need to make disclosures about your foreign income, assets and investments to the US authorities.
Now that that is out of the way, the second point to consider is what type of agreement it is, or in other words, what is being agreed to by the US and the foreign country’s government.
DTAA and TIEA Agreements and Their Impact on You
The U.S. generally uses two main types of international tax agreements: Tax Information Exchange Agreements (TIEAs) and Double Taxation Avoidance Agreements (DTAAs). Technically, the US likes to use the term “Income Tax Convention” when naming DTAAs, but the actual content of this type of agreement is always written for the same purpose.
Here are a few more key points about both types of agreements:
TIEAs – These types of agreements are not designed to affect how you are taxed. Rather, they set up a framework for one country’s government to gain tax information about you in a second country. These agreements will help the first government, e.g. the US, build a case against you if you break its tax rules when you are in a foreign country. For the purpose of a TIEA, each country’s set of tax rules is its own business, and the TIEA gives each country the power to collect information from the other to see if you are breaking it.
2015 was a big year for TIEAs thanks the Foreign Account Tax Compliance Act (FATCA), which came into effect then. In summary, FATCA requires non-U.S. financial institutions to “phone home” to the U.S. authorities about U.S. citizens (or green card holders) who have accounts there.
Prior to FATCA, most countries’ laws were not set up for such a high level of cross-border financial information-sharing. Once FATCA arrived, many countries had to change their domestic laws to allow it and set up an international legal framework (a TIEA) to facilitate it. Many countries had TIEAs with the U.S. prior to FATCA, and generally those TIEAs were updated to reflect the new reality.
DTAAs – These types of agreements are designed to affect how you are taxed or, more specifically, to say which country has the right to tax you under which scenarios. If your case falls under the scenarios described in the DTAA, you will be taxed as agreed between the two governments. Remember that the DTA in DTAA stands for “double taxation avoidance,” which means that you will not be taxed twice for the same income. But you will be taxed once, in most circumstances!
DTAA’s are a complex subject, but to simplify it a little, I like to use a sports analogy. Imagine you have two sports in two different countries. The sports’ rules closely resemble each other but are still different, like American football and Canadian football. These two sports’ rules are like two countries’ domestic tax rules. They function approximately the same and have the same goal (to raise revenue), but there are always differences between the two as to how they go about it.
Now imagine that an American football team (that’s like a U.S. business or individual) wants to travel to Canada for a big match (that’s like a business deal, or being employed). Whose rules will apply? U.S. or Canadian?
In this context, a DTAA is basically a mutual rulebook, agreed to by both the authorities of both countries, that indicates whose rules will be used to tax whom depending on what they are doing. I’ll go into a few more details about that concept next.
International Tax Agreements Effect You According to Your Circumstances
Keep in mind TIEAs are not designed to affect how you are taxed but rather are “informational” in that a government (the US government in particular, thanks to FATCA) can collect data about you in other countries. Therefore, if you are affected by these agreements, it is likely a result of what you may not be doing, i.e., staying compliant with U.S. tax and disclosure rules, which puts you are on the receiving end of an enforcement action. Not recommended!
With DTAA’s, however, it is more a question of what you are doing, e.g., running a business, being employed, or being a self-employed professional, to name a few scenarios that frequently pop up in DTAAs. I won’t go into too much detail in this article, because every DTAA’s wording is a little bit different, but as a general rule most DTAA’s try to get at how deep a “connection” a business or person from one country has with a second country. (Tip: for decoding the intricacies of US DTAAs, check out the IRS’s “technical explanations” for each treaty, available here. These documents tend to have useful examples and, somewhat ironically, tend to be less technical than the treaties themselves.)
For example, if you are employed temporarily in another country, you may not be liable for income tax there thanks to the DTAA, while if you were employed for a longer period, you would be. Or if your business has an office or employee in another country you may be liable for tax on profits earned there, whereas you might not if you had no such office or employee.
In conclusion, you should probably not be concerned with what a TIEA says and rather focus on staying compliant with all relevant tax and disclosure requirements. On the other hand, what a DTAA says can have a significant effect on how you are taxed, so it will likely be worth doing a little homework about its wording.