Tax Treaties and Other International Agreements
Larkins, Ernest R., The CPA Journal
An international agreement (or convention) is a negotiated contract, usually between two countries, that establishes the legal rights and obligations of the signatory governments and their residents in relationships with each other.
Types of Agreements and Their Objectives
Generally, an international agreement can be classified either as a treaty or as an executive agreement. Both types of international agreements constitute bind ing international law. As discussed in more detail later, the primary difference lies in the manner in which each is created. Treaties require the Senate's approval while executive agreements do not.
Income Tax Treaties The U.S. has 45 income tax treaties in force. Each income tax treaty has two primary objectives. First, an income tax treaty is intended to mitigate the burden of double taxation and, as a result, encourage international trade. This objective is accomplished in a number of ways. Income tax treaties use tie-breaker rules to determine the country of residence when an individual or entity is considered to reside in both treaty countries (under the respective domestic laws). In deference to the country of res idence, treaties often place limits on the taxing power of the source or host country to avoid double taxation. Thus, treaties often prohibit the host country from taxing certain types of business income. The U.S.-Portugal treaty, for example, precludes Portugal from taxing a U.S. party's profits from conducting business in Portugal if no permanent establishment in Portugal is used to carry on the activity. Similarly, the treaty does not allow Portugal to tax the profits of a U.S. company providing international transportation services, even when some of the profits are earned in Portugal. Also, treaties generally require that investment income be taxed at rates below those specified in the country's domestic law. Though IRC section 871 (a)(1)(A) generally imposes a 30% withholding tax on dividends, the U.S.-Russia income tax treaty imposes a 10% withholding tax (five percent if the Russian recipient owns at least 10% of the payor) on dividends that U.S. corporations pay to Russian parties.
The second primary objective of income tax treaties is to establish cooperation between taxing authorities, namely the IRS and its counterpart in the signatory country. Cooperation is established through articles dealing with exchange of information, administrative assistance, and mutual agreement. The purpose of the exchange of information article is to prevent tax evasion. The IRS receives about a half million documents annually through requests pursuant to the exchange of information articles found in tax treaties. The administrative assistance article in U.S. treaties facilitates the collection of taxes. The mutual agreement article helps taxpayers to settle disputes through a mechanism known as "competent authority."
To illustrate, consider a taxpayer with income that two countries are asserting jurisdiction to tax. If a tax treaty exists between the two countries, the taxpayer can ask the competent authorities (i.e., the IRS and its foreign counterpart) to decide whether only one country should be entitled to impose its tax. U.S. taxpayers sometime assume paying taxes on the same income to both the U.S. and treaty country is acceptable since they can claim a foreign tax credit for the tax paid to the treaty country. However, failure to invoke the competent authority procedure in some situations risks the loss of foreign tax credit benefits. Rev. Proc. 9&13 (19963 IRB 31) states the rules for requesting competent authority. The CPA Journal presented an extensive discussion of the new procedure in its March 1997 issue.
Sometimes the U.S. enters income tax treaties with objectives in addition to those mentioned above. For example, treaties with developing countries often have a secondary objective of promoting economic progress or opening new markets. …