Tax treaties are the agreements made between two countries to establish rules and rights of taxations on all income. They are geared towards determining the amount of tax imposed on a taxpayer’s income and wealth by each country. There are currently over 3,000 bilateral income tax treaties in effect, of which the US holds 67.
Let’s take a look at the United States-Canada income tax treaty. Its main goal is to prevent double taxation on Canadian residents earning an income from the United States. If not for this treaty, Canadians would pay U.S. taxes to the Internal Revenue Service (IRS) and again to the Canada Revenue Agency (CRA).
Another part of this treaty is the prevention of amounts of income being withheld for taxes. This is called a tax treaty benefit. The income provider is given a form called W-8BEN which the taxpayer signs thus making the claim that because no U.S taxes have been paid, all taxes will be accounted for by filing a tax return in Canada. If in the event the taxpayer does have withholding tax amount in the U.S., this can be claimed when filing a tax return in Canada. However, due to higher income tax rates in Canada, the taxpayer may still end up owing money to the CRA. Unlike Canada where U.S. tax can be eliminated, there are other treaty countries where you may still have to pay U.S taxes but at a reduced rate.
In both the United States and Canada, you are obliged to file your income tax return annually no matter where you reside in the world or how you attain your income. This is commonly referred to as a“worldwide income”.
The treaties have been modelled after two components. The first and main model is the Organization for Economic Co-Operation and Development (OECD). In a nutshell, this is the collection of 35 countries who work towards to continued growth and development of economic progress and world trade. The second model is based on the more well-known United Nations (UN) body. This powerful organization consists of 193 members and is often more known for its association with the growth and development of impoverished countries and protection of the human rights. Both these models have slightly different agendas and some reports would claim the OECD consistently attempts to steer the UN for taxation rights in favor of the more economically sound nations.
Like most things, foreign tax treaties have their flaws. The most notable issue is the restrictions caused on the right of states to tax foreign investors and foreign-owned companies. Many claim this is to encourage international investment between treaty countries. However, developing countries usually play host to these companies and therefore aren’t reaping any rewards because of such agreements.
A lot of foreign tax treaties have a lot of positive effects and just like domestic tax laws, they often undergo review. The number of countries entering into new treaties agreements is also on the rise. As an increasing number of countries enter into these agreements, their understanding of foreign tax policies and its impact increases along with it, and essentially their confidence to make better agreements going forward.