In a globalized society, it might make sense to diversify investment portfolios with foreign holdings. Traveling and communicating across countries has never been easier, making it natural to also invest globally. As with all things, the taxation of these types of investments complicates the situation. Do you pay taxes to your resident country or to the country where your investment is held? The answer to this question: tax treaties.
A tax treaty is a bilateral agreement between two countries that outlines the taxation for different types of income. The goal is to mitigate double taxation by the taxpayer’s resident country and the country where the investment is held. Generally, tax treaties utilize one of two types of models for taxation: the UN Model Convention or the OECD Model.
The UN Model Convention, or the United Nations Model Double Taxation Convention between Developed and Developing Countries, advocates taxation by the country where the investment is held. This generally grants taxing rights to developing countries, where the investment is held.
The OECD Model, or the Organization for Economic Co-operation and Development Model, is organized by a union of 34 prosperous countries that promotes economic globalization. The model favors the country that exports versus the country that imports. The source country is encouraged to give up its tax on certain income earned by residents of the opposite country. This increases trade flow between the involved parties for overall economic growth.
Under these treaties, residents of foreign countries are often taxed in the U.S. at a reduced rate or have reduced withholding requirements on interest, dividends, and royalties. The same concept applies to U.S. residents or citizens who have income sourced from foreign countries. A tax treaty defines the specific income and taxes that apply, where residency is derived, and who is eligible for the reduced rates or withholding benefits. For instance, if a U.S. taxpayer owns a company that generates revenue in Canada, the income is not subject to taxation in Canada due to the tax treaty between these two countries. Instead, the taxpayer only pays U.S. tax on the Canadian income. Income such as salaries, self-employment income, pensions and other income might also have reduced tax rates or withholding according to the relevant tax treaty. If a tax treaty between the U.S. and another country offers a reduced withholding rate or an exemption from withholding, the taxpayer should immediately inform their employer of their foreign status to claim the benefits of the tax treaty.
Because each tax treaty can vary between countries, it is crucial that proper tax treatment is applied to the specific foreign investments. Please contact our office for more information at (858) 558-9200.