|Paula Singer is an international tax attorney and partner in the tax law firm, Vacovec, Mayotte & Singer in Newton and is also a co-founder of Windstar Technologies, Inc., which provides international tax compliance software for payers and employers. Singer is the author of a series of books published under the collective title, US Tax Guides for Foreign Persons and Those Who Pay Them including Tax Treaty Benefits for Foreign Nationals Performing US Services. Copyright © 2000-2003, Paula Singer, all rights reserved.
Editor's Note: This article is an updated version from that appearing in the printed edition of Vol. 6 No. 2. of Section Review. This version includes editorial changes that were not made prior to printing.
As businesses, both large and small, become increasingly more global, those who administer human resources and payroll must expand their base of knowledge to encompass the rules that apply to the cross border exchange of services. The purpose of this article is to provide an overview of (1) how income tax treaties reduce or eliminate U.S. income taxes and (2) the administrative rules that employers and other payers must follow to allow exemptions from withholding under tax treaty provisions.
An introduction to tax treaties
Income tax treaties are agreements negotiated between countries for the purpose of avoiding double taxation, providing information exchange and reducing or eliminating source country tax for treaty country residents. The United States has more than 40 income tax treaties in effect. The treaty with the former USSR applies to eight countries. A tax treaty may be renegotiated and replaced with a completely new treaty or an existing treaty may be changed by a protocol. New treaties become effective upon ratification by the U.S. Senate and the exchange of instruments of ratification with the executive branch of the treaty country. An overview of the existing treaties can be found in IRS Publication 901, US Tax Treaties. As the IRS points out, this is a starting place for information since many treaty provisions are not included in this publication. Tax treaty services can be purchased from the major tax publishing companies.
When a treaty is first published it is accompanied by a Treasury Explanation. In addition, the IRS has issued Revenue Rulings, Revenue Procedures, Technical Advice Memoranda and Private Letter Rulings giving interpretive advice on treaty application.
Tax treaty structure
Tax treaties are organized into articles that describe how treaties work, including Entry into Force, Taxes Covered, Residency and the Saving Clause, and when taxes are reduced or eliminated on income. These articles are not in the same order in each treaty. Abbreviated tax treaties with the articles in the same order are available at www.windstar.com.
Entry into Force. Frequently new treaties enter into force as of Jan. 1 of the calendar year following ratification. Occasionally a treaty will have more than one date when treaty articles come into force as is the case with the new treaty with the U.K. that replaces an existing treaty with the U.K. The effective date of the new treaty is March 31, 2003. The reduced tax withholding on dividends, interest etc. became effective May 1, 2003. The new treaty provisions applying to all other taxes are effective Jan. 1, 2004. In addition, the Entry into Force Article allows an individual to elect to use the old treaty for 2004 if this election results in a lower tax.
Taxes Covered. The Taxes Covered article states that the treaty applies to federal income taxes. Most treaties specifically exclude social security taxes. The IRS applies this exclusion to all treaties except one. The treaty with the former USSR has a broader definition of taxes covered, which includes the employee's share of social security taxes. An individual who qualifies for this treaty exemption must follow an IRS procedure to apply for a refund. Treaties can apply indirectly to state income taxes when a state defines income with reference to federal income. Some states such as Connecticut have amended their tax code to add back income exempt under a tax treaty. States such as Pennsylvania that have their own definition of income do not provide for treaty exemptions. In all, 12 states do not allow tax treaty exemptions.
Residency. Tax treaties apply to individuals who are residents of one or both of the treaty countries. A treaty country resident is an individual who is subject to income taxes as a tax resident of the country. For example, U.S. citizens are subject to U.S. taxes on worldwide income even if they live and work abroad. Foreign nationals are subject to U.S. taxes as residents if they meet either the "green card" test or the substantial presence test. Almost all treaties include a residency tie-breaker rule for individuals who are residents of both the United States and the treaty country. A dual-resident claiming to be a U.S. nonresident under a tie-breaker rule must submit a Form 1040NR with a statement describing the facts and circumstances that support the claim. Students from Barbados, Jamaica and Hungary can elect to be taxed as residents.
The Saving Clause. U.S. tax treaties also include a "saving clause" that gives the United States the right to tax its citizens and residents as if the treaty had not come into effect. The treaties include exceptions to the saving clause that allow individuals who become residents to keep the benefits conferred under the Student/Trainee and Teacher/Researcher articles. An individual who is a U.S. citizen or "green card" holder loses the benefit. This clause is hard to find in older treaties where it is included with miscellaneous provisions at the end of the treaty.
Articles conferring benefits
Treaties include two types of articles that confer benefits: 1) articles that are based on the primary purpose of an individual's visit to the United States and 2) articles that are based on the character of the payment. An individual's period of tax residency in the treaty country, and his or her U.S. tax residency status, impact the availability of benefits conferred under these two types of articles differently.
Purpose of the visit. The Student/Trainee articles and the Teacher/Researcher articles confer treaty benefits upon individuals who are residents of the treaty country at the beginning of their visit to the United States for the primary purpose of studying, securing training, teaching or engaging in research for the public benefit. The Treasury Explanations define primary purpose to mean full time. Under these articles, an individual who stays in the United States long enough to lose tax residency status in the treaty country can still keep the treaty benefits. In addition, the exceptions to the Saving Clause of all but two treaties allow an individual who becomes a resident of the United States under the substantial presence test to keep these benefits.
Character of the payment. The articles for Income from Employment, Income from Self-employment, Artists and Athletes and Directors Fees work differently. Once an individual is no longer a tax resident in the treaty country, he or she is no longer eligible for the treaty benefit. An individual who becomes a resident of the United States loses the benefit of these articles because of the Saving Clause.
The payer exempting compensation from withholding tax under a treaty article must identify the benefit limitations. Limitations can include the amount of the benefit, the period of time for which the benefit is available and the residence of the payer.
Amount of the benefit. Many treaty articles include an amount limitation. For example, most Student/Trainee articles provide an exemption from tax for a specific amount, typically $2,000 to $5,000. Amounts for trainees may be higher. Under all treaties, the individual keeps the benefit even if the amount is exceeded in the calendar year. Some treaties include a higher benefit amount for individuals who are participating in U.S. government programs. Some of the Income from Employment and Income from Self-employment articles include a benefit amount. For example, the treaty with Canada exempts amounts up to $10,000 from tax. However, if the amount is exceeded, the benefit is lost completely. The Artist and Athlete articles deny treaty benefits otherwise available under the Employment and Self-employment Income articles if the specified amount is exceeded.
Time period limitations. The articles include many types of time period limitations - fiscal (calendar) year, 12-month period beginning or ending in the calendar year, taxable year (through Dec. 31) and year. Whenever, the term "year" is not defined it means 365 consecutive days. Most Student/Trainee articles limit the benefit for five taxable years from the individual's date of arrival. Newer treaties include a shorter period for trainees. Most Teacher/Researcher articles limit the benefit to two years from the individual's date of arrival. The treaties with several countries provide that the benefit will be lost retroactively if the individual overstays the two-year period in the United States. The newer treaties provide that an individual can use the Teacher/Researcher article benefit only one time.
Many treaties also include a combined limitation of five taxable years for benefits under the Student/Trainee and Teacher/Researcher articles when claimed by an individual who remains in the United States and changes status. A number of treaties include a "back-to-back" provision that requires an individual to reestablish residency in the treaty country before claiming a subsequent treaty benefit. Based on Internal Revenue Service rulings, to claim successive Teacher/Researcher article benefits, an individual must be reestablish residency and physical presence in the treaty country and be physically absent from the United States for a one-year (365 days) period following the treaty claim, unless the treaty indicates otherwise.
Special forms and procedures
To apply the appropriate withholding and reporting rules, a payer must first determine whether an individual recipient is a resident or a nonresident for U.S. tax purposes. Unless a treaty exemption applies, most payments to nonresident aliens are subject to a withholding tax at a rate of 30 percent on gross income. Compensation for employment services is subject to special wage withholding rules. Taxable scholarship and fellowship grants paid to nonresidents who are in the United States in F, J, M or Q immigration status are subject to a 14 percent withholding rate. Special procedures and forms must be used to exempt income from withholding under a treaty.
Form 8233. An individual claiming an exemption from U.S. income tax on compensation for services must submit to the payer a completed Form 8233 with a statement certifying to the facts signed under the penalties of perjury. Certifying statements for many treaties are in Revenue Procedures 87-7, 87-8, 93-22 and 93-22A. Payers can draft statements for the situations not included in these procedures, such as exemptions for trainees. An individual claiming exemption on compensation for services must submit a new Form 8233 for the beginning of each calendar year in which the treaty exemption is being claimed.
Form W-8BEN. The IRS has released new forms and instructions to use to claim exemption from tax under a tax treaty. To claim a treaty exemption from withholding on all other types of income, an individual must submit a completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. Form W-8BEN is not submitted to the IRS for review. The payer retains the signed form to support the withholding exemptions in case of an audit.
Form W-9. A resident alien entitled to keep a treaty benefit under a Saving Clause exception must submit a Form W-9 with a special statement to the payer. The special statement is explained in IRS Publication 515, Withholding on Nonresident Aliens and Foreign Entities.
Supporting documents. Most individuals who visit the United States for studying, securing training, teaching or engaging in research have sufficient documentation as a result of immigration requirements to obtain the proper immigration status. Administrators need this documentation as well in order to allow treaty benefits based on the purpose of the visit.
SSNs and ITINs. In 1996 the IRS began requiring a permanent taxpayer identification number (TIN), either a Social Security Number (SSN) or an individual taxpayer identification number (ITIN), for a return of tax. This change did not apply to information returns such as Form 1042-S. However, the IRS has authority to impose penalties on the payer for failing to supply a TIN. With the exception of income on traded investments, a payer may not give treaty benefits to an individual who does not submit a TIN. On Dec. 17, 2003, the IRS introduced new Form W-7 ITIN application procedures that individual taxpayers as well as payers must now follow. The TIN must be included on each Form 1042-S with a treaty exemption except for forms for traded investment income.
Form 1042 and 1042-S. All income payments to nonresident aliens must be reported on Form 1042-S with a few exceptions such as wages subject to wage withholding. The Form 1042-S must include wages exempt from tax under a treaty. Taxable scholarship and fellowship grants must also be reported on Form 1042-S. Forms 1042-S must be given to the income recipients by March 15 following the calendar year of payment. Payers who submit 250 or more forms are required to submit the forms either electronically or magnetically.
Payers are required to follow the normal depository rules based on the level of payments. In addition, the payer must submit a completed Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.
Coordinating withholding and reporting
To withhold correctly and create correct reporting documents, the payroll administrator faces a challenging task. The administrator must determine from a case-by-case treaty analysis the amount and/or date limitations by individual for the year. This requires setting limits within the paying system, either manually or through an automated process allowed by the system. Income tax withholding must be reactivated once the limits are met. Individuals with limited benefits need to submit a Form W-4 as well as Form 8233 to cover subsequent withholding.
For each individual with a treaty exemption, a Form 1042-S must be prepared. If the individual has non-exempt wages as well, the individual must be issued a Form W-2 for the non-exempt wages and withholding. For an individual whose wages are fully exempt under a treaty, only a Form 1042-S is required. However, if the individual is subject to Social Security and Medicare taxes, the individual must be issued a Form W-2 reporting Social Security and Medicare wages and taxes. Some payroll systems now allow the payer to process payments other than wages that are made to nonresidents. This facilitates a consolidated magnetic filing for all Forms 1042-S at year-end.
As the IRS begins to enforce compliance by employer and payers who make payments to foreign individuals, tax exemptions allowed under tax treaties will become more important. Payers need to learn the withholding and reporting rules for allowing these treaty exemptions now.