This article explores how to take advantage of the provisions in tax treaties to reduce your taxes on foreign-earned income.
Say you’re a six- or seven-figure US-based entrepreneur who’s recently brought their business abroad. You find yourself traveling weeks at a time to tend to those businesses, and in the past couple of years, you’ve traveled so many days that you’ve ended up spending less than half the year living on US soil.
Going offshore with your latest location-independent business looked like a great idea. Your current foreign ventures are thriving, and you’re even thinking about starting another one. Until you get the tax bills.
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Reporting your foreign income
Just as you hoped, your foreign businesses and investments paid off, and they have seriously boosted not only your income, but your overall tax liability.
Then, to your shock, you discover a dirty little secret: the United States taxes not only your domestically earned income, but the rest of it, too – regardless of where it’s been earned.
Your flourishing little foreign enterprises haven’t escaped the long, greedy tax grasp of Uncle Sam after all.
There are only two ways to escape the tax system: die or renounce your citizenship. Death, of course, is permanent, and renouncing your citizenship is a major step that takes time and planning.
But cheer up. You don’t have to renounce just yet.
While going offshore is often looked upon as evasion or something shady, it’s not that at all. There are legitimate, above-board tax benefits available to you – you just have to know where to find them.
You should stay compliant with US tax law. You can be legal and transparent and still take full advantage of whatever tax benefits are legally allowed.
But how can you do this when reporting your foreign income in the country where it’s earned as well as on a US-based tax return feels like you’re paying taxes twice?
You can take advantage of the provisions in tax treaties.
What Are Tax Treaties?
Income tax treaties are agreements the United States has entered into with nearly every country in the world to avoid this potential double taxation issue. It affects US taxpayers abroad as well as foreign nationals living in the States.
Tax treaties contain provisions whereby US residents living in foreign countries may (a) receive a reduced tax rate or (b) even be exempt from US taxes on certain streams of income.
How Can Tax Treaties Reduce My Taxes on Foreign-Earned Income?
Tax treaties can include (but are not limited to) income tax, estate and gift tax, commerce, friendship, and navigation.
In order to claim the benefits of these reduced tax rates or exemptions, you must complete IRS Form 8833 and include it with your US-based tax return.
What Is Form 8833?
Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b),” is used by taxpayers to make a treaty-based return position disclosure as required by Section 6114, or such dual-resident taxpayers whose treaty-based return position disclosure is required under Reg. 301.7701(b)-7.
NOTE: a dual-resident taxpayer is “an alien individual who is considered to be a resident of both the United States and another country under each country’s tax laws.” Dual-resident taxpayers who choose to claim treaty benefits as a resident of a foreign country will be treated as a nonresident alien for purposes of figuring U.S. income tax liability.
While tax treaties may be able to reduce US tax for nonresidents as well as foreign tax for US residents and citizens, the treaty applicable to your situation must be carefully reviewed to determine your eligibility.
And don’t forget about your state tax return. There are a few US states that honor tax treaty provisions, but unfortunately, most of them do not. Be sure to check the tax laws for any state where you must file a return.
Tax treaties are reciprocal, so non-US residents can apply a treaty provision to their US income just as a US resident would apply that provision to their foreign-earned income from the same country.
Who Must File Form 8833?
You must file Form 8833 if a tax treaty over-rules or modifies a provision of the Internal Revenue Code (IRC), causing a reduction of taxes that you owe.
U.S. non-residents who file Form 8833 are complying with Section 301.6114 (treaty-based return provisions) while taxpayers with dual-resident status (as defined above) file the form to comply with Section 301.7701(b)-7 (coordination with income tax treaties). There is a check box to indicate which options apply to your situation.
Some tax treaty-based provisions you benefit from include (1) the reduction or modification in the amount of tax on the gain or loss from disposing US-based real property; (b) reduction of the tax rate on dividends or interest paid by a foreign corporation(s) that is US-sourced; and (c) granting a credit for a foreign tax which is not allowed by the IRC.
Once you’ve determined that a tax treaty applies and could benefit you, then you must complete Form 8833 and include it with your return.
What Information Is Required on Form 8833?
Of the six lines on the form, the first three are straightforward. Line 1 asks for the name of the treaty country, your treaty position, and a list of the applicable article(s) of the tax treaty. On Line 2, you must list the Internal Revenue Code provision or provisions being overruled or modified. On Line 3, you give your US address.
Once you make it to Line 4, however, things get a bit more complicated. Line 4 asks you to “name the specific test in the Limitations on Benefits (LOB) article.” What test are they talking about? And what is a Limitation on Benefits?
A Limitation on Benefits is an “anti-treaty shopping provision” intended to prevent residents of third countries from obtaining benefits under a treaty. For tax treaties that include a Limitation of Benefits article, you – the taxpayer – must satisfy certain tests to be eligible for any such treaty benefits.
And not only individual taxpayers are subject to these LOB tests. Publicly traded corporations, governments, charitable organizations, trusts, and others must meet specific test requirements as well. Table 4 (Tax Treaty Table 4) defines the LOB tests referenced above and lists eleven different types of entities for which there may be an LOB test requirement.
Table 4 provides a wealth of information concerning LOBs, but it can be a challenge to work out what might be applicable for your situation. To make certain you fully understand the LOB provision of any tax treaty under which you want to claim benefits, you should carefully read the text of the relevant LOB article to find out which tests are available and what the requirements for those tests are. If a tax treaty does not include an LOB article, you won’t be required to satisfy any kind of test.
The US Department of the Treasury provides a comprehensive online resource center where you can find the text of any tax treaty or Tax Exchange Information Agreement (TIAE). At the top center of the page is a drop-down box containing the list of all foreign countries with whom the US has tax treaty agreements. Find the relevant country, click GO, and then any tax treaty or TIAE documents for that country will be listed.
Line 5 on Form 8833 is simply a yes-or-no question about whether you are disclosing a treaty-based position specifically required under Section 301.6114-1(b).
For Line 6, all taxpayers who take a treaty-based return position must provide the information requested, regardless of whether reporting is explicitly required. On Line 6, you must explain your treaty-based position and the facts you’ve based it on.
Next, list the nature and amounts (or a reasonable estimate) of your gross receipts, itemizing each gross payment, and gross income item or other items for which you are claiming the treaty benefit.
Lastly, if the tax treaty contains an LOB test, you must explain why you meet the test identified on Line 4 and the basis on which you meet any special requirements for claiming benefits.
Exceptions From Reporting
Section 301.6114-1(c) does waive reporting on certain treaty-based return positions. However, the waiver can be narrowly applied, so you must carefully review all regulations.
Some notable Form 8833 reporting exceptions include:
(a) Most US-sourced income received by a foreign person, including dividends, interests, rents, or royalties, are subject to a US tax rate of 30%. A reduced rate or exemption could apply if there is a tax treaty.
(b) When a treaty reduces or modifies income derived from dependent personal services, pensions, annuities, social security and any other public pensions of artists, athletes, students, trainees or teachers, including fellowship grants and taxable public scholarships.
(c) There is a Social Security Totalization Agreement or Diplomatic or Consular Agreement that reduces or modifies the income of a taxpayer.
(d) A treaty exempts a taxpayer from the excise tax imposed by section 4371 (taxes on insurance policies, indemnity bonds, annuity contracts, or reinsurance policies issued by any foreign insurer or reinsurer).
(e) You are a member of a partnership, trust or estate which has disclosed a treaty position that the partner or beneficiary would otherwise be required to disclose.
(f) A treaty allows you to claim a reduced tax rate on interest, dividends, rent, royalties, or any other fixed or determinable annual or periodic income that is typically subject to a rate of 30%.
(g) The items requiring disclosure total $10,000 or less.
Penalty for Failing to File Form 8833
If you are required to file Form 8833 but fail to do so, the penalty for individual taxpayers is $1,000, and for C corporations, it is $10,000. There is a chance you could be exempted from paying the fine if you can provide a reasonable explanation as to why you did not file Form 8833.
Termination of US Residency
One issue to be aware of is that filing Form 8833 could trigger a termination of your US residency.
If you are a dual-resident taxpayer and long-term resident (LTR), then filing Form 8833 in order to be treated as a resident of a foreign country for tax purposes may cause you to “have been deemed to have terminated your US residency status for federal income tax purposes.” Doing this may subject you to tax under IRC section 877A, Tax Responsibilities of Expatriation, in which case you must also file Form 8854, Initial and Annual Expatriation Statement.
NOTE: A long-term resident is someone who has been a lawful, permanent resident of the US in at least 8 out of the last 15 tax years, ending with the year your status as an LTR ends.
Get Professional Advice
While Form 8833 can at first glance look relatively painless, there are any number of “what ifs” and “maybes” that could affect how you complete the form and whether you need to include it in your US-based tax return at all.
This is why it is always advisable to consult a competent tax adviser who is familiar with the ins and outs of taxation for expats and foreign-born individuals. Click here if you would like to get in touch with the Nomad Capitalist tax expert team.
Further Information on Form 8833
For additional information about US tax treaties, consult IRS Publication 901 – U.S. Tax Treaties. This 34-page pamphlet contains a general discussion about the effects of tax treaties on certain types of income mentioned in this article. It also includes a brief discussion of provisions relative to most foreign countries.
You can find out if a tax treaty has a more favorable rate by consulting the International Tax Treaty Rates on the IRS website.
To find out more information about taxes abroad for both US citizens and resident aliens, consult IRS Publication 54, Tax Guide for US Citizens and Resident Aliens Abroad.
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