Individuals living outside of their home countries may face the prospect of paying tax in more than one country. To prevent this from happening, many countries have tax treaties to avoid or mitigate double taxation, while ensuring the taxpayer is paying an appropriate amount of tax. Tax treaties are complicated and can often require professional assistance to ensure the rules are being followed.
What is a Tax Treaty?
A tax treaty, also known as a Double Tax Agreement (DTA), is a bilateral agreement made by two countries regarding passive and active income. The overall aim is to prevent double taxation where the same income is taxable in both countries. A clear agreement between each country provides certainty for treatment of the relevant income.
The UK has DTA’s with more than 130 countries. These agreements ensure that each nation can impose a fair amount of tax.
How Do They work?
A DTA works by overruling the tax laws applied in each country and providing a new set of rules that outline how an individual should be taxed across each nation. Establishing which country has primary taxing rights for income that would be subject to double taxation is usually the first and most important step in the process. It creates certainty as to where they are expected to face an initial tax burden and whether they will face any additional tax in the second nation.
In determining where an individual’s income should be primarily taxed, residence is usually the most important factor. In the UK, the Statutory Residence Test is used, while in the US, it is the Substantial Presence Test. Other countries have their own respective residency requirements. As a result, there can be instances where a person can be deemed to be resident in two countries, which is where the need for the DTA comes in.
Where an individual is dual resident – tax resident in the UK and tax resident in another country – they may be liable to pay tax on income in both countries. This is where double taxation occurs, however the treaty kicks in to determine which country retains the right to treat the individual as a resident for tax purposes.
Where you are resident will be determined by applying a series of “tie breaker” tests as outlined in the relevant Double Tax Agreement in place with the UK. The standard Treaty tests for this use the following indicators:
- Permanent Home
- Location of individuals vital interests
- Habitual abode
An individual is employed by a company in the UK, but under that role they spend an even amount of time in the UK and in a foreign country. He has a property available in both countries but his family remain in the UK. In this scenario, the individual meets the respective tests to be resident in both countries. We therefore need to work through the indicators as listed above to determine which country they are tax resident of.
- Permanent Home – The individual has a property available in both countries so we cannot determine his residence with this tie-breaker test. We then move to the next tie-breaker.
- Location of Vital Interests – Things to consider here are; place of work, family, significant commitments and social ties. It is likely that he would meet this test due to his family and employer being based in the UK.
- Habitual Abode – This is a test of which of the two countries the individual resides in more permanently
- Nationality test – This test looks at the nationality of the individual
What else does the treaty cover?
The treaty also outlines rules for sources of income that do not relate to residence. A classic example of this is income from a rental property. Most countries retain the right to tax rental income arising in their country, regardless of the residency of the individual. This can lead to double taxation for individuals that are paying tax on their worldwide income in another country. In situations such as this, the DTA outlines the use of Foreign Tax Credits. This allows an individual to utilise tax paid in one country as a credit against foreign income in another country.
A UK national and resident receives rental income from a property they own in Spain. Under the terms of the treaty, Spain retains the right to tax the income arising from the rental property situated in Spain. The individual must report the rental income to the tax authorities in both countries, but under the DTA, can claim a Foreign Tax Credit on their UK tax return for tax paid in Spain.
US Taxation and the Savings Clause
The US is one of the few countries where an individual is taxed based on citizenship, not based on residency. As a result, many expats may have to pay tax in both the US & UK, because of the “savings clause”.
The savings clause is a part of all US tax treaties and preserves the right of the US to tax its citizens as if the treaty does not apply. As a result, US citizens must report their worldwide income on their Federal tax return each year, regardless of where they are resident. However, they can still benefit from certain credits, deductions, exemptions, and reductions in line with the taxes paid to other foreign countries.
Facilities such as the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credits (FTCs) are tools provided by the US that act as ways to alleviate the double taxation effect. Careful planning and timing of foreign tax payments can be crucial to avoiding double taxation, and where greater complexity arises, it is recommended that professional advice is sought.
What if a country does not have a treaty with the US?
There are several nations for which the US does not have a DTA with. A few examples are listed below:
- Hong Kong
- United Arab Emirates
Countries such as these without tax treaties or totalisation agreements frequently face taxation issues. A US citizen that is self-employed in Singapore is still required to pay US Social Security and Medicare taxes, as well as make contributions to the Singapore Social Security system. A lack of a bilateral agreement between the nations can lead to double taxation occurring regularly.
To aid Americans that have income from nations where there is no taxation agreement, the US has a number of provisions to help prevent double taxation:
- The Foreign Earned Income Exclusion (FEIE) – This allows an individual to exclude $107,600 (2020) of earned income from foreign sources.
- Foreign Housing Exclusion – Further exclusions of their income based on amounts paid to cover household expenses while living abroad.
- Tax Credits – Individuals can offset the tax paid in foreign countries against their US tax liabilities.
In the UK, individuals can apply Unilateral Relief when there is no DTA available. This allows individuals to claim a foreign tax credit for tax paid on income arising in a foreign country.
Are foreign pensions covered by the treaty?
Generally, under the terms of the relevant DTA, foreign pension plans are not taxable in individual’s country of residence. The income and gains within the pension should be protected by the treaty.
For US tax purposes, contributions to a qualifying foreign pension will also receive tax relief on a US tax return and the growth of the pension will not be taxable. However, where there is no treaty available, the contributions are added back to taxable income and the growth of the pension is taxed annually. The individual will need to rely on foreign tax credits to absorb any US tax liability arising on this additional income. Although, this can have certain benefits. More information on pensions for US taxpayers can be found here – https://pjdtax.co.uk/updates/uk-and-us-pensions-for-us-taxpayers/.
Please note that this article acts as a summary for the overall effects of various tax treaties. They cannot be used as a guide to individual situations and professional advice should be sought.