Overseas Filing For U.S. Taxpayers: Tax Treaties
This is the fourth article based on the IRS podcast: Overseas Filing for U.S. Taxpayers. Click here for the link.
The United States has tax treaties it’s negotiated with more than 60 countries, with the aim of mitigating the effects of double taxation. Under these treaties, residents or citizens of the United States are taxed as a reduced rate or are exempt from foreign taxes on certain items of income they receive from foreign countries. In the tax treaties there are specified tax rates for certain types of income, such as dividends and interest. For example, in many countries the treaty rate for interest income is zero percent. The treaty rate for dividend income may be 15%, or another rate, depending on the terms of the treaty. Keep in mind that treaty rates only affect foreign source income arising in the country for FTC computation purposes. Treaty rates may be used by taxpayers to reduce the amount of foreign taxes paid to a foreign country.
That’s why it’s very important that taxpayers are aware of the applicable treaties when they earn income or invest income in a foreign country. It’s imperative to make sure and consult the specific treaty and invoke the treaty, as necessary, with the foreign country.
This is key because sometimes taxpayers include the higher statutory withholding rate instead of the treaty rates when computing the allowable amount of the foreign credit. But creditable foreign taxes are limited to the lower treaty rate, even if taxes were withheld at a higher statutory rate. The reason for this is that if a lower treaty rate applies, you’re required to claim the treaty rate, and this is not a choice. You can only claim the lesser treaty rate and not the higher statutory withholding rate. Make sure to check the treaty for the rates to pay to the foreign country. Se an example below.
As you can see here, here’s an example of the treaty versus statutory withholding rate. Assume that a U.S. citizen received $10,000 in interest income from investment activities in a foreign country. The foreign country withheld $3,000, or 30%, in foreign taxes. Most likely the U.S. citizen was not aware that a treaty rate was in effect between the U.S. and that foreign country for this specific type of income. Under the applicable treaty, the treaty rate for interest income is zero percent. This means that the amount of creditable taxes, for purposes of the foreign tax credit, is limited to the treaty rate of zero percent, in other words, zero dollars. This means that this taxpayer will receive no credit for those foreign taxes paid in the amount of $3,000 because of the established treaty rate for this type of income. It should also be noted that the taxpayer in this example is eligible to request a refund from the applicable foreign government for the amount in excess of the treaty rate, Wich, in this case, will be $3,000, since, again, the treaty rate is zero percent, as we just mentioned.
If this taxpayer were to enter $3,000 in Part 2 of Form 1116 as foreign taxes paid, it would be incorrect.
Fulton Abraham Sanchez, the founder of FAS CPA & Consultants of Miami, FL, is a Certified Public Accountant specialized in Tax Planning. You can email him to firstname.lastname@example.org.
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